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, 2009




or




 ̈
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
transition period
from                    to





Commission
file number 000-26422





DISCOVERY
LABORATORIES, INC.


(Exact
name of registrant as specified in its charter)





Delaware
            
            94-3171943(State
      or other jurisdiction of
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      Number)2600
      Kelly Road, Suite 100Warrington,
      Pennsylvania 18976-3622(Address
      of principal executive offices)





(215)
488-9300


(Registrant’s
telephone number, including area code)





Securities
registered pursuant to Section 12(b) of the Act:





Title of each class
                  
                  Name of each exchange on which
      registeredCommon
      Stock, $0.001 par value
                  
                  The
      Nasdaq Global MarketPreferred
      Stock Purchase Rights





Securities
registered pursuant to Section 12(g) of the Act:





None









Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.  YES ̈NOx





Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or Section
15(d) of the Exchange Act.  YES ̈NOx





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.   YESxNO ̈


Indicate by check mark whether the
registrant has submitted electronically and posted on its corporate Web site, if
any, every Interactive Data File required to be submitted and posted pursuant to
Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12
months (or for such shorter period that the registrant was required to submit
and post such files).  YES ̈NO ̈
 
 Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this
chapter) is not contained herein, and will not be contained, to the best of the
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. ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.
 
 Large
      accelerated filer
                         ̈
                        Accelerated
      filer xNon-accelerated
      filer
                         ̈
                        Smaller reporting
      company ̈
 
 Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).       YES ̈NOx
 
 The
aggregate market value of shares of voting and non-voting common equity held by
non-affiliates of the registrant computed using the closing price of common
equity as reported on The Nasdaq Global Market under the symbol DSCO on June 30,
2009, the last business day of the registrant’s most recently completed second
fiscal quarter, was approximately $126 million.  For the purposes of
determining this amount only, the registrant has defined affiliates to include:
(a) the executive officers named in Part III of this Annual Report on Form 10-K;
(b) all directors of the registrant; and (c) each shareholder, if any, that has
informed the registrant by March 1, 2009 that it is the beneficial owner of 10%
or more of the outstanding shares of common stock of the
registrant.
 
 As of
March 5, 2010,  153,892,960 shares of the
registrant’s common stock were outstanding.
 
 DOCUMENTS
INCORPORATED BY REFERENCE:
 
 Portions
of the information required by Items 10 through 14 of Part III of this Annual
Report on Form 10-K are incorporated by reference to the extent described herein
from our 2010 definitive proxy statement, which is expected to be filed by us
with the Commission within 120 days after the close of our 2009 fiscal
year.










Unless
the context otherwise requires, all references to “we,” “us,” “our,” and the
“Company” include Discovery Laboratories, Inc., and its wholly-owned, presently
inactive subsidiary, Acute Therapeutics, Inc.





FORWARD-LOOKING
STATEMENTS




This
Annual Report on Form 10-K contains “forward-looking statements” within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934.  The forward-looking statements are
only predictions and provide our current expectations or forecasts of future
events and financial performance and may be identified by the use of
forward-looking terminology, including the terms “believes,” “estimates,”
“anticipates,” “expects,” “plans,” “intends,” “may,” “will” or “should” or, in
each case, their negative, or other variations or comparable terminology, though
the absence of these words does not necessarily mean that a statement is not
forward-looking.  Forward-looking statements include all matters that
are not historical facts and include, without limitation statements concerning:
our business strategy, outlook, objectives, future milestones, plans,
intentions, goals, and future financial condition, including the period of time
for which our existing resources will enable us to fund our operations; plans
regarding our efforts to gain U.S. regulatory approval  for our lead
product, Surfaxin ®  (lucinactant) for the prevention of Respiratory
Distress Syndrome in premature infants; the possibility, timing and outcome of
submitting regulatory filings for our products under development; our research
and development programs for our KL4 surfactant
technology and our capillary aerosolization technology platform, including
planning for and timing of any clinical trials and potential development
milestones; the development of financial, clinical, manufacturing and
distribution plans related to the potential commercialization of our drug
products, if approved; and plans regarding potential strategic alliances and
other collaborative arrangements with pharmaceutical companies and others to
develop, manufacture and market our products.





We intend
that all forward-looking statements be subject to the safe-harbor provisions of
the Private Securities Litigation Reform Act of 1995.  Forward-looking
statements are subject to many risks and uncertainties that could cause actual
results to differ materially from any future results expressed or implied by the
forward-looking statements.  We caution you therefore against relying
on any of these forward-looking statements. They are neither statements of
historical fact nor guarantees or assurances of future
performance.  Examples of the risks and uncertainties include, but are
not limited to:




•
                risks
      related generally to our efforts to gain regulatory approval, in the
      United States and elsewhere, for our drug product candidates, including
      our lead products that we are developing to address Respiratory
      Distress Syndrome (RDS) in premature infants: Surfaxin®  (lucinactant)
      for the prevention of RDS, Surfaxin LSTM (our lyophilized KL4  surfactant)  and
      Aerosurf®  (our
      initial  aerosolized KL4  surfactant);
  •
                the
      risk that we and the U.S. Food and Drug Administration (FDA) or other
      regulatory authorities will not be able to agree on matters raised during
      the regulatory review process, or that we may be required to conduct
      significant additional activities to potentially gain approval of our
      product candidates, if ever;
  •
                the
      risk that the FDA or other regulatory authorities may not accept, or may
      withhold or delay consideration of, any applications that we may file, or
      may not approve our applications or may limit approval of our products to
      particular indications or impose unanticipated label
      limitations;
  •
                risks
      relating to the rigorous regulatory approval processes, including
      pre-filing activities, required for approval of any drug or combination
      drug-device products that we may develop, whether independently, with
      strategic development partners or pursuant to collaboration
      arrangements;
  •
                the
      risk that the FDA will not be satisfied with the results of our efforts to
      optimize and revalidate our fetal rabbit biological activity test (BAT)
      and to demonstrate that the BAT has the ability to distinguish change in
      Surfaxin drug product over time, which is needed to advance our KL4  surfactant
      pipeline;


ii




•
              the
      risk that changes in the national or international political and
      regulatory environment may make it more difficult to gain FDA or other
      regulatory approval of our drug product
  candidates;
  •
              risks
      relating to our research and development activities, which involve
      time-consuming and expensive preclinical studies and other efforts, and
      potentially multiple clinical trials, which may be subject to potentially
      significant delays or regulatory holds, or fail, and which must be
      conducted using sophisticated and extensive analytical methodologies,
      including an acceptable biological activity test, if required, as well as
      other quality control release and stability tests to satisfy the
      requirements of the regulatory
authorities;
  •
              risks
      relating to our ability to develop and manufacture drug products and
      drug-device combination products based on our capillary aerosolization
      technology for clinical studies and, if approved, for commercialization of
      our products;
  •
              risks
      relating to the transfer of our manufacturing technology to third-party
      contract manufacturers and
assemblers;
  •
              the
      risk that we, our contract manufacturers or any of our third-party
      suppliers may encounter problems or delays in manufacturing or assembling
      drug products, drug product substances, capillary aerosolization devices
      and related components and other materials on a timely basis or in an
      amount sufficient to support our development efforts and, if our products
      are approved, commercialization;
  •
              the
      risk that we may be unable to identify potential strategic partners or
      collaborators with whom we can develop and, if approved, commercialize our
      products in a timely manner, if at
all;
  •
              the
      risk that we or our strategic partners or collaborators will not be able
      to attract or maintain qualified
personnel;
  •
              the
      risk that, if approved, market conditions, the competitive landscape or
      otherwise may make it difficult to launch and profitably sell our
      products;
  •
              the
      risk that we may not be able to raise additional capital or enter into
      strategic alliances or collaboration agreements (including strategic
      alliances for development or commercialization of our drug products and
      combination drug-device products);
  •
              risks
      that the unfavorable credit environment will adversely affect our ability
      to fund our activities, that our share price will not reach or remain at
      the price level necessary for us to access capital under our Committed
      Equity Financing Facilities (CEFFs), that the CEFFs may expire before we
      are able to access the full dollar amount potentially available
      thereunder, and that additional equity financings could result in
      substantial equity dilution;
  •
              the
      risk that we will be unable to regain compliance with the Minimum Bid
      Price Requirement of The Nasdaq Global Market prior to the expiration of
      the grace period currently in effect, which could increase the probability
      that our stock will be delisted from Nasdaq and cause our stock price to
      decline;
  •
              the
      risk that recurring losses, negative cash flows and the inability to raise
      additional capital could threaten our ability to continue as a going
      concern;
  •
              the
      risks that we may be unable to maintain and protect the patents and
      licenses related to our products and that other companies may develop
      competing therapies and/or
technologies;


iii




•
              the
      risk that we may become involved in securities, product liability and
      other litigation;
  •
              risks
      related to reimbursement and health care reform that may adversely affect
      us;
  •
              the
      risk that the FDA may not approve Surfaxin® or may subject the marketing
      of Surfaxin® to onerous requirements that significantly impair marketing
      activities;
  •
              the
      risk that we may identify unforeseen problems that have not yet been
      discovered or the FDA could in the future impose additional requirements
      to gain approval of Surfaxin ® ;
and
  •
              other
      risks and uncertainties detailed in “Risk Factors” and in the documents
      incorporated by reference in this
report.


Pharmaceutical
and biotechnology companies have suffered significant setbacks in advanced
clinical trials, even after obtaining promising earlier trial
results.  Data obtained from such clinical trials are susceptible to
varying interpretations, which could delay, limit or prevent regulatory
approval.  After gaining approval of a drug product, pharmaceutical
companies face considerable challenges in marketing and distributing their
products, and may never become profitable.





The
forward-looking statements contained in this report or the documents
incorporated by reference herein speak only of their respective
dates.  Factors or events that could cause our actual results to
differ may emerge from time to time and it is not possible for us to predict
them all.  Except to the extent required by applicable laws, rules or
regulations, we do not undertake any obligation to publicly update any
forward-looking statements or to publicly announce revisions to any of the
forward-looking statements, whether as a result of new information, future
events or otherwise.


iv




DISCOVERY
LABORATORIES, INC.





Table
of Contents to Annual Report on Form 10-K


For
the Fiscal Year Ended December 31, 2009




PART
      IITEM
      1.
                                                BUSINESS
                                                
                                                1ITEM
      1A.
                                                RISK
      FACTORS
                                                
                                                27ITEM
      1B.
                                                UNRESOLVED
      STAFF COMMENTS
                                                
                                                44ITEM
      2.
                                                PROPERTIES
                                                
                                                44ITEM
      3.
                                                LEGAL
      PROCEEDINGS
                                                
                                                44ITEM
      4.
                                                RESERVED
                                                
                                                45PART
      IIITEM
      5.
                                                MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES
                                                
                                                45ITEM
      6.
                                                SELECTED
      FINANCIAL DATA
                                                
                                                46ITEM
      7.
                                                MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
                                                
                                                47ITEM
      7A.
                                                QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                                                
                                                63ITEM
      8.
                                                FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA
                                                
                                                63ITEM
      9.
                                                CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
                                                
                                                64ITEM
      9A.
                                                CONTROLS
      AND PROCEDURES
                                                
                                                64ITEM
      9B.
                                                OTHER
      INFORMATION
                                                
                                                67PART
      IIIITEM
      10.
                                                DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
                                                
                                                67ITEM
      11.
                                                EXECUTIVE
      COMPENSATION
                                                
                                                67ITEM
      12.
                                                SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS
                                                
                                                67ITEM
      13.
                                                CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
                                                
                                                67ITEM
      14.
                                                PRINCIPAL
      ACCOUNTANT FEES AND SERVICES
                                                
                                                67PART
      IVITEM
      15.
                                                EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES
                                                
                                                67SIGNATURES
                                                
                                                
                                                68




v





PART
I





ITEM 1.
            BUSINESS.





COMPANY
OVERVIEW





Discovery
Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a Delaware
corporation, with our principal offices located at 2600 Kelly Road, Suite 100,
Warrington, Pennsylvania.  We were incorporated as a Delaware
corporation in 1992.  Our telephone number is 215-488-9300 and our
website address is www.discoverylabs.com.  Our
common stock is listed on The Nasdaq Global Market, where our symbol is
DSCO.




We are a
biotechnology company developing surfactant therapies to treat respiratory
disorders and diseases for which there frequently are few or no approved
therapies.  Our novel KL4
proprietary technology produces a synthetic, peptide-containing surfactant
(KL4
surfactant) that is structurally similar to pulmonary surfactant, a substance
produced naturally in the lung and essential for survival and normal respiratory
function.  In addition, our proprietary capillary aerosol-generating
technology (capillary aerosolization technology) produces a dense aerosol with a
defined particle size, to potentially deliver our aerosolized KL4 surfactant
to the lung.  As many respiratory disorders are associated with
surfactant deficiency or surfactant degradation, we believe that our proprietary
technology platform makes it possible, for the first time, to develop a
significant pipeline of surfactant products targeted to treat a wide range of
previously unaddressed respiratory problems.





We are
developing our lead products, Surfaxin®(lucinactant),
Surfaxin LSTM and Aerosurf®, to
address the most significant respiratory conditions affecting pediatric
populations.  In April 2009, we received a Complete Response Letter
from the U.S. Food and Drug Administration (FDA) with respect to our New Drug
Application (NDA) for Surfaxin for the prevention of Respiratory Distress
Syndrome (RDS) in premature infants, our first product based on our novel
KL4 surfactant
technology. The letter focused primarily on certain aspects of our fetal
rabbit biological activity test (BAT, a quality control and stability release
test for Surfaxin and our other KL4 pipeline
products), specifically whether analysis of preclinical data from both the BAT
and a well-established preterm lamb model of RDS demonstrates the degree of
comparability that the FDA requires and whether the BAT can adequately
distinguish change in Surfaxin biological activity over time.  We met
with the FDA in June 2009 and by teleconference in September 2009 to discuss
specific proposals to resolve this sole remaining Chemistry, Manufacturing &
Control (CMC) issue, which must be addressed to obtain approval of
Surfaxin.  Based on these and other interactions with the FDA, we are
currently implementing a protocol intended to optimize and revalidate the BAT
and thereafter plan to initiate a comprehensive preclinical program intended to
satisfy the FDA’s requirements with respect to the BAT.  If
successful, we believe that we could be in a position to file a Complete
Response to the April 2009 Complete Response Letter in the first quarter of
2011, which could lead to approval of Surfaxin for the prevention of
Respiratory Distress Syndrome (RDS) in premature infants in 2011.  If
approved, Surfaxin would be the first synthetic, peptide-containing
surfactant for use in neonatal medicine.  For a detailed discussion on
the progress of our Surfaxin NDA, see“– Surfactant Replacement
Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature
Infants (RDS) – Surfaxin for the Prevention of RDS in Premature
Infants.” Seealso, “– Proprietary
Platform – Surfactant and Aerosol Technologies – Our KL4 Surfactant
Technology.”





Surfaxin
LS, our lyophilized KL4
surfactant, is a dry powder formulation that is resuspended as a liquid prior to
use and is intended to improve ease of use for healthcare practitioners,
eliminate the need for cold-chain storage, and potentially further improve
clinical performance.  See, “– Surfactant
Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in
Premature Infants (RDS) – Surfaxin LSTM – Lyophilized Surfaxin for RDS in
Premature Infants.” Aerosurf is our
proprietary KL4 surfactant
in aerosolized form, which we are developing using our capillary aerosolization
technology, initially to treat premature infants at risk for
RDS.  Premature infants with RDS are treated with surfactants that are
administered by means of invasive endotracheal intubation and mechanical
ventilation, procedures that frequently result in serious respiratory conditions
and complications.  If approved, we believe that Aerosurf will make it
possible to administer surfactant into the lung without subjecting patients to
invasive procedures.  We believe that Aerosurf has the potential to
enable a significant increase in the use of surfactant therapy in pediatric
medicine. See, “–
Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress
Syndrome in Premature Infants (RDS) – Aerosurf for RDS in Premature
Infants.”


1





In
addition to our lead products, we plan over time to develop our KL4 surfactant
technology into a broad product pipeline that potentially will address a variety
of debilitating respiratory conditions for which there currently are no or few
approved therapies.  Our plans include potentially taking these
initiatives through a Phase 2 proof-of-concept phase and, if successful,
thereafter determining whether to seek strategic alliances or collaboration
arrangements or to utilize other financial alternatives to fund their further
development.  We have an ongoing Phase 2 clinical trial of Surfaxin to
potentially address Acute Respiratory Failure (ARF) and our KL4 surfactant
is the subject of an investigator-initiated Phase 2a clinical trial
assessing the safety, tolerability and short-term effectiveness (via improvement
in mucociliary clearance) of aerosolized KL4 surfactant
in patients with Cystic Fibrosis (CF).  See, “– Surfactant
Replacement Therapy for Respiratory Medicine – Acute Respiratory Failure (ARF) –
Surfaxin for ARF,” and “ – Cystic Fibrosis.” We are conducting research and
preclinical development with our KL4 surfactant
potentially to address Acute Lung Injury (ALI), and, potentially in the future,
other diseases associated with inflammation of the lung, such as Asthma and
Chronic Obstructive Pulmonary Disease (COPD).  We have also initiated
exploratory preclinical studies to assess the feasibility of using our KL4 surfactant
in combination with small and large molecule therapeutics to efficiently and
effectively deliver therapies to the lung to treat a range of pulmonary
conditions and disease.  See, “– Surfactant
Replacement Therapy for Respiratory Medicine – Serious Respiratory Indications
Associated with Inflammation of the Lungs – Acute Lung Injury (ALI),” and “ –
KL4
Surfactant in Combination with Other Therapeutics to Treat a Wide Range of
Disease.”





An
important priority is to secure strategic and financial resources to potentially
maximize the inherent value of our KL4surfactant
technology.  We would prefer to accomplish our objectives through
strategic alliances.  Although we are actively engaged in discussions
with potential strategic and/or financial partners, there can be no assurance
that any strategic alliance or other financing transaction will be successfully
concluded.   Until such time as we secure sufficient
strategic and financial resources to support the continuing development of our
KL4
surfactant technology and support our operations, we will continue to
conserve our resources, predominantly by curtailing and pacing investments in
our pipeline programs.





BUSINESS
STRATEGY





Our goal
is to develop a robust pipeline of products based on our proprietary KL4 surfactant
technology to potentially significantly improve the medical outcomes of
patients, from premature infants to adults, suffering debilitating respiratory
diseases and conditions.  Key elements of our strategy for achieving
this goal include:





·
            We
      plan to continue to focus our research and development efforts on the
      management of RDS in premature infants.  We believe that the RDS
      market represents a significant opportunity from both a medical and a
      business perspective.  We further believe that our neonatal
      pipeline programs, Surfaxin, Surfaxin LS and Aerosurf, have the potential
      to greatly improve the management of RDS and, collectively, represent the
      opportunity, over time, to expand the current RDS estimated worldwide
      annual market of $200 million to a $1 billion
  opportunity.




o
            Surfaxin
      is the first synthetic, peptide-containing surfactant that, if approved,
      will represent an alternative therapy to the currently-approved,
      animal-derived surfactants.  The safety and efficacy of Surfaxin
      for RDS has previously been demonstrated in a comprehensive Phase 3
      clinical program.  In April 2009, we received a Complete
      Response Letter from the FDA with respect to our Surfaxin NDA that focused
      primarily on issues related to our BAT.  Consistent with
      previous communications from the FDA, there continues to be no questions
      regarding clinical trial data and no indication that the FDA has any
      concerns related to other quality assurance tests or the manufacturing
      process for Surfaxin.  To resolve the sole remaining CMC issue,
      we are currently pursuing a comprehensive preclinical program that, if
      successful, could lead to marketing approval of Surfaxin for the
      prevention of RDS in premature infants in the United States in
      2011.




o
            We
      also are developing a lyophilized (dry powder) formulation, Surfaxin LS,
      which, among other things, is being developed to improve ease of use for
      healthcare practitioners, eliminate the need for cold-chain storage, and
      potentially further improve clinical performance.  We are
      currently developing our regulatory strategy for a Phase 3 global
      registration clinical program intended to gain regulatory approval for
      Surfaxin LS in the United States, Europe and throughout the
      world.  We believe that, over time, Surfaxin and Surfaxin LS, if
      approved, have the potential to displace the use of the animal-derived
      surfactants.


2




o
            Aerosurf,
      our aerosolized KL4surfactant, holds the promise to significantly expand the use of
      surfactant therapy in premature infants and pediatric patients by
      potentially providing neonatologists and pediatricians with a means of
      administering KL4surfactant to infants and children without the risks currently
      associated with administration of currently-approved surfactants, which
      require invasive endotracheal intubation and mechanical
      ventilation. We believe that Aerosurf, if approved, will allow for a
      potentially significant increase in the number of infants who will benefit
      from surfactant therapy, given that many such infants currently are not
      treated because the benefits of surfactant therapy are believed to be
      outweighed by the risks of invasive administration. We are currently
      advancing our preclinical development activities and preparing to further
      engage the FDA and foreign regulators with respect to our clinical
      program.  Thereafter, we plan to initiate a Phase 2 clinical
      program for Aerosurf.





We
believe that the pipeline of Surfaxin, Surfaxin LS and particularly Aerosurf
could significantly advance the treatment of RDS and make it possible for
many more infants at risk for RDS to be treated with surfactant
therapy.  Our KL4 surfactant
technology also has the potential to address other serious and debilitating
neonatal and pediatric indications, many of which represent significant unmet
medical needs, potentially redefining pediatric respiratory
medicine.


o
                ARF
      in young children occurs after they have been exposed to serious
      respiratory infections, such as influenza (including the type A serotype
      referred to as H1N1) or respiratory syncytial virus (RSV), and leads to an
      impairment in lung function and the need for endotracheal intubation and
      mechanical ventilation (the current standard of care).Children with ARF
      usually suffer surfactant inactivation as part of the disease
      process. We are conducting a Phase 2 clinical trial to determine
      whether the administration of Surfaxin improves lung function and results
      in a shorter duration of mechanical ventilation and stay in the neonatal
      intensive care unit (NICU) or pediatric intensive care unit (PICU)
      for children up to two years of age suffering with
      ARF.  Enrollment is near completion and top-line results are
      expected to become available in the second quarter of
  2010.




·
            We
      also plan to continue to invest in a number of exploratory development
      programs.  We are initially targeting Cystic Fibrosis
      (CF), Acute Lung Injury (ALI), and the feasibility of drug
      combination therapies utilizing our KL4
      surfactant.




o
            Our
      aerosolized KL4
      surfactant is being evaluated in an investigator-initiated Phase 2a
      clinical trial in Cystic Fibrosis (CF) patients. The trial has been
      designed to assess the safety, tolerability and short-term effectiveness
      (via improvement in mucociliary clearance) of aerosolized KL4
      surfactant in CF patients. The trial is being conducted at The University
      of North Carolina with the support of the Cystic Fibrosis Foundation and
      results are anticipated in the second quarter of
  2010.




o
            We
      are presently conducting preclinical experiments in collaboration with a
      prominent academic investigator assessing the potential application of our
      aerosolized KL4
      surfactant in the prevention and treatment of ALI, a syndrome of
      inflammation and increased permeability of the lungs with an associated
      breakdown of the lungs’ surfactant
layer.




o
            We
      have also initiated a drug combination preclinical program to assess
      whether our KL4surfactant, either alone or in combination with our capillary
      aerosolization technology, may represent a novel approach for efficient
      delivery of small and large molecule therapeutics to the
    lung.




3




We plan
to initially develop these programs through a proof-of-concept phase and, if
successful, thereafter determine whether to seek strategic alliances or
collaboration arrangements or utilize other financial alternatives to fund their
further development and/or worldwide commercialization, if
approved.  There can be no assurance that we will succeed in
demonstrating proof-of-concept or entering into any such alliance or
collaboration arrangement or identifying any such financial alternative, but if
we are successful, we believe that these programs could address significant
unmet medical needs and potentially redefine therapeutic approaches to a variety
of respiratory diseases.





·
            An
      important priority for us is to strengthen our long-term strategic and
      financial position to advance our KL4
      surfactant pipeline programs and maximize shareholder
      value.  Our near-term
  plans include:




o
            We
      will continue to seek strategic alliances and other collaborative
      arrangements for the development and/or commercialization of our KL4 surfactant
      product candidates that would provide financial support (potentially in
      the form of upfront payments, milestone payments, commercialization
      royalties and a sharing of research and development expenses), development
      capabilities, and ultimately commercial expertise to advance our KL4
      technology.  We also are reviewing various financial
      alternatives that would provide infusions of capital and other resources
      needed to advance our KL4
      respiratory pipeline programs.  Although we are actively engaged
      in discussions with potential strategic and/or financial partners, there
      can be no assurance that any strategic alliance or other financing
      alternatives will be successfully
concluded.




o
            We
      have $10.5 million outstanding under our loan with Quintiles (formerly
      PharmaBio Development, Inc. and NovaQuestTM).  The outstanding
      principal and all accrued interest, is due and payable on April 30,
      2010.  We are pursuing a potential strategic restructuring of
      this loan and we are also considering alternative means of financing its
      payment should that become necessary.  However, there can be no
      assurance that any such restructuring will occur or financing alternatives
      will be obtained.




o
            Following
      receipt of the April 2009 Complete Response Letter, to conserve our cash,
      we reduced our workforce from 115 to 91 employees and implemented further
      cost-containment measures throughout 2009.  As of December 31,
      2009, we had 77 full-time employees.  We plan to continue to
      closely manage our expenditures in 2010.  Until we secure an
      alliance or other financing alternative, we plan to focus our financial
      resources on our neonatal RDS programs, primarily the potential approval
      of Surfaxin, while limiting investments in our other pipeline
      programs.





·
            We
      have, and will continue, to invest in maintaining and enforcing our
      potential competitive position by protecting our exclusive rights in and
      to our KL4 surfactant
      technology, pipeline products and capillary aerosolization technology
      through patents, patent extensions, trademarks, trade secrets and
      regulatory exclusivity designations, including potential orphan drug and
      new drug product and supplemental exclusivities.  We believe that our
      development programs may also provide opportunities for new patent
      filings, which may potentially significantly extend the benefits of
      exclusivity into the future;





·
            We
      have, and will continue to evaluate, and invest in, our quality systems
      and manufacturing capabilities, including at our manufacturing operations
      in Totowa, New Jersey, and our analytical and medical device development
      laboratories in Warrington, Pennsylvania.  We plan to
      manufacture sufficient drug product to meet our anticipated pre-clinical,
      clinical, formulation development and, if approved, potential future
      commercial requirements of Surfaxin, Aerosurf and other KL4
      surfactant product candidates.  With respect to Surfaxin LS, we
      expect to enter into arrangements with one or more contract manufacturing
      organizations.  For our capillary aerosolization systems,we plan to
      collaborate with engineering device experts and use contract manufacturers
      to produce aerosol devices and related components to meet our
      manufacturing requirements.




4





Our
estimates of market size and business opportunities included in this Business
Section and elsewhere in this Annual Report on Form 10-K are based in part on
our analysis of data derived from the following sources, among others: IMS Midas
Data MAT, September 2008; Vermont Oxford Network Data, 2006; Annual Summary of
Vital Statistics: 2006, Pediatrics, Martin et. al.; CDC National Vital
Statistics, 2005; Management and Outcomes of Very Low Birth Weight, NEJM, 2008,
Eichenwald, Stark; The Cystic Fibrosis Foundation; Discovery Labs Primary Market
Research, 2007; as well as our analysis of the SELECT and STAR trials described
below.  In addition, our analysis and assumptions take into account
estimated patient populations, expected adoption rates of our products, current
pricing, economics and anticipated potential pharmaco-economic benefits of our
drug products, if approved.  We provide estimates and projections to
give the reader an understanding of our strategic priorities, but we caution
that the reader should not rely on our estimates and
projections.  These estimates and projections are forward-looking
statements, which we intend be subject to the safe-harbor provisions of the
Private Securities Litigation Reform Act of 1995.  For a discussion of
forward-looking statements, see“Forward-Looking
Statements” on page ii of this Annual Report on Form 10-K.





PROPRIETARY
PLATFORM – SURFACTANT AND AEROSOL TECHNOLOGIES





Pulmonary
surfactants are protein and phospholipids compositions that form naturally in
the human lung and are critical to survival and normal respiratory
function.  They spread in a thin mono-layer to cover the entire
alveolar surface, or air sacs, of the lungs and the terminal conducting airways
that lead to the air sacs and facilitate breathing by continually modifying the
surface tension of the fluid that lines the inside of the lungs.  If
the lungs have a surfactant deficiency, as frequently occurs in premature
infants, or experience surfactant degradation, generally due to disease, lung
insult or trauma, the air sacs in the lungs will tend to collapse and will not
absorb sufficient oxygen, resulting in severe respiratory diseases and
disorders.  In addition to lowering alveolar surface tension,
surfactants contribute in other important ways to respiration including, but not
limited to, lowering the surface tension of the conducting airways and
maintaining airflow and airway patency (keeping the airways open and
expanded).  Human surfactants include four known surfactant proteins:
A, B, C and D.  Numerous studies have established that, of the four
known surfactant proteins, surfactant protein B (SP-B) is essential for
respiratory function.  In our KL4 surfactant,
KL4 is
our synthetic peptide that is designed to closely mimic the essential attributes
of protein B (SP-B).





Many
respiratory disorders are associated with surfactant deficiency or surfactant
degradation.  However, the use of surfactant therapy has limited
application and is FDA-approved only for treating premature infants with RDS. Currently
available surfactants are derived from pig and cow lungs using a chemical
extraction process.   Although clinically effective, these
surfactants have potential drawbacks and have not been developed to treat
broader populations and other respiratory diseases.





We
believe our KL4 surfactant
and capillary aerosolization technology will expand the therapeutic options to
treat previously unaddressed respiratory problems in a range of patient
populations, from premature infants to adults.  We also believe that
potentially combining our aerosolized KL4 surfactant
with other therapeutics could enable delivery of important therapeutics into the
lung.  We plan to develop our aerosolized KL4 surfactant
initially for RDS in premature infants and thereafter for a wide range of
indications in neonatal, pediatric and adult patient populations.





Our
KL4Surfactant
Technology





Our
proprietary KL4 surfactant
technology produces a synthetic surfactant that is structurally similar to
human pulmonary surfactant and contains a proprietary synthetic peptide, KL4
(sinapultide).  KL4 is a 21
amino acid peptide that closely mimics the essential attributes of human
surfactant protein B (SP-B), which is the surfactant protein most important for
the proper functioning of the respiratory system.  Our synthetic
surfactant may be manufactured to precise specifications and formulated as
liquid instillate, lyophilized (dry powder), or aerosolized
liquid.  We licensed exclusive worldwide rights to this technology,
which was invented at The Scripps Research Institute and exclusively licensed to
and further developed by Johnson & Johnson, Inc. (Johnson & Johnson), in
October 1996.





Our
KL4 surfactant
is a synthetic surfactant that can be manufactured consistently and with minimal
variability. We also believe that our synthetic surfactant might possess
pharmaceutical benefits not currently exhibited by the animal-derived
surfactants.  Our synthetic KL4 surfactant
has also demonstrated in preclinical studies unique characteristics, including
anti-inflammatory, antimicrobial and nonimmunogenic properties.  We
believe these characteristics will be important attributes as we develop our
KL4 surfactant
technology pipeline to potentially address a broad range of respiratory
conditions that represent significant unmet medical needs.


5




·
            In
      December 2009, research was published in the Proceedings of the National
      Academy of Sciences indicating that a naturally occurring phospholipid in
      pulmonary surfactant, palmitoyl-oleoyl-phosphatidylglycerol (POPG),
      suppresses respiratory syncytial virus (RSV) infection and associated
      inflammation in both in vitro and in vivo models (Numata et al, Proc Nat
      Acad of Sci, Dec 09).  The research demonstrates that POPG
      inhibits the spreading of RSV infection in mice exposed to
      RSV.  We believe that our KL4
      surfactant, which contains relatively high concentrations of POPG, is the
      only surfactant in which POPG is a recognized active pharmaceutical
      ingredient.  This study further supports our belief that our
      KL4
      surfactant may play a unique role in addressing several debilitating
      respiratory disorders.




·
            In
      May 2009, data from a preclinical study was presented at the Pediatric
      Academic Societies Annual Meeting (PAS), that compared Surfaxin, at a dose
      of 5.8 mL/kg (the dose used in the Surfaxin Phase 3 clinical trials for
      RDS), with Curosurf® (poractant alfa), a currently available surfactant
      derived from pig lung and the most prescribed surfactant in Europe, at a
      dose of 2.5 mL/kg (the dose prescribed in its label), in the
      well-established preterm lamb model.  The purpose of the study
      was to test the hypothesis that a larger dose volume of surfactant could
      potentially result in more homogeneous distribution of surfactant
      throughout the lungs and may ultimately result in improved pulmonary and
      clinical outcomes.  The data showed that both surfactants
      significantly increased pulmonary compliance and tidal volume in this
      preterm lamb model of RDS without adversely affecting heart rate, blood
      pressure, or cerebral blood flow, irrespective of the dose volume
      employed.  However, significantly more homogeneous lung
      distribution of Surfaxin (p < 0.001) was observed compared with
      Curosurf, as measured by pulmonary distribution of a mix of gold-labeled
      microspheres and surfactant.




·
            Also
      in May 2009, data from a preclinical study was presented at PAS that
      demonstrated a favorable physiologic benefit and subsequent survival
      impact on treating ALI in an animal model for this severe respiratory
      condition.  The objective of the study was to examine the
      effectiveness of KL4
      surfactant in treating newborn piglets with severe ALI.  The
      results demonstrated that piglets treated with KL4
      surfactant experienced a statistically significant improvement in
      oxygenation (p < 0.001), as well as better structural integrity of the
      lung tissue (p < 0.05) and improved survival (p <
    0.05).




·
            A
      study that assessed the impact of exogenous surfactants, including
      Surfaxin, on hyperoxic-induced lung injury in an in-vitro cell-culture
      model was published in Pediatric Research, a prominent peer-reviewed
      journal, in July 2008 and concluded that our KL4 surfactant reduced
      inflammation and cell injury in this model, resulting in improved cell
      survival and function compared with both a saline control and Survanta®
      (beractant), a currently available surfactant derived from cow lung and
      the most prescribed surfactant in the United
  States.




·
            In
      May 2008 at the 2008 PAS, data were presented from an animal study that
      assessed the effect of Surfaxin on biomarkers of lung inflammation and
      lung structure as compared to those treated with Survanta, Curosurf, or no
      surfactant replacement therapy.  The chosen animal model, the
      preterm lamb, was selected because it closely resembles RDS in human lungs
      and is regarded as the most relevant system to study the pathophysiology
      and treatment of RDS.  The results of the study showed that
      animals treated with Surfaxin had better lung function compared with those
      treated with Survanta, Curosurf, or no surfactant
      replacement.  In addition, animals treated with Surfaxin had
      better structural integrity, as assessed by evaluation of lung tissue, and
      lower levels of lung tissue and blood inflammatory mediators, compared
      with animals treated with Survanta or no surfactant replacement
      therapy.




·
            A
      study presented at the 2008 PAS in May 2008 investigated the antimicrobial
      properties of Surfaxin.  In that study, gram-positive and
      gram-negative bacteria-containing broth was mixed with Surfaxin and
      Survanta, as well as with saline, a negative control, and ciprofloxacin,
      an antibiotic that served as a positive control.  While both
      Surfaxin and Survanta suppressed gram-positive bacterial growth, only
      Surfaxin suppressed gram-negative bacterial
  growth.




·
            Also
      at the 2008 PAS in May 2008, a study was presented that assessed the
      potential for KL4 to
      induce an immune response known as anaphylaxis in a well-established
      animal model.  Anaphylaxis, a potentially life-threatening
      allergic reaction, can occur in humans after exposure to medications that
      contain a foreign protein.  In this study, a well-established
      animal model was used to test whether KL4
      would trigger anaphylaxis.  Supporting our belief that our
      KL4 surfactant
      has nonimmunogenic properties, this study concluded that KL4 did
      not induce active or passive anaphylaxis in this animal model, even when
      the immune system was potentiated and
  sensitized.


6




·
            In
      May 2007, a study was presented at the 2007 PAS, the objective of which
      was to determine the impact of Surfaxin on cytokine-driven lung
      inflammation and focused specifically on the transforming growth
      factor-beta (TGF-beta) superfamily.  In this study, Surfaxin
      suppressed two central members of the TGF-beta superfamily (BMP10 and
      BMP15), which could have implications in reducing inflammation and
      fibrosis (scarring) of the lung in a variety of pulmonary
      diseases.  Members of the TGF-beta superfamily are known to
      induce fibrosis (scar tissue formation) in the lung.  These
      results support our developing our KL4 surfactant  technology
      to potentially treat diseases in which respiratory inflammation plays in
      integral part, such as BPD, ARF, ALI and
CF.




We
believe that the foregoing preclinical studies demonstrate promising novel
properties and attributes of our KL4 surfactant
that potentially may be of benefit in addressing various respiratory diseases
and disorders in broad patient populations.  The clinical relevance of
such attributes has not been adequately established and, accordingly, warrants
further study.





In the
clinical environment, our synthetic, peptide-containing surfactant has
demonstrated attributes that are uniquely beneficial in the treatment of
premature infants.




·
            In
      April 2009, we presented a pharmacoeconomic analysis of data from our
      pivotal SELECT and STAR Phase 3 clinical trials for Surfaxin at the 2009
      International Congress on Clinical Pharmacy (ICCP) in Orlando, Florida.
      The analysis shows that in-hospital costs are higher for infants who
      require reintubation after surfactant administration and successful
      extubation, when compared with infants who do not require reintubation.
      The presentation also included previously-reported data demonstrating that
      infants treated with Surfaxin in the SELECT and STAR trials required less
      reintubation compared with infants treated with currently available
      animal-derived surfactants.




·
            Our
      Phase 3 clinical study, SELECT, has demonstrated that Surfaxin is safe and
      efficacious when used for the prevention of RDS in premature
      infants.  Data taken together from our SELECT and STAR studies
      demonstrate that Surfaxin improved survival (continuing through at least
      one year of life) and other outcomes versus the animal-derived comparator
      surfactants.  The SELECT and STAR trials have been presented at
      several international medical meetings and the results from the two
      studies were published in Pediatrics, the Official Journal of the American
      Academy of Pediatrics and a premier medical journal for pediatric
      healthcare practitioners.





We have
also demonstrated that we can aerosolize our KL4 surfactant
and have achieved the following important development objectives through
research and feasibility studies:




·
            full
      retention of the surface-tension lowering properties of a functioning
      surfactant necessary to restore lung function and maintain patency of the
      conducting airways;




·
            full
      retention of the surfactant composition upon aerosolization;
      and




·
            drug
      particle size believed to be suitable for deposition into
      the lung.





The
initial formulation of our KL4 surfactant
technology is a liquid instillate, administered using the same method of
administration as the currently available animal-derived surfactants; that is,
intratracheally via an endotracheal tube.  Our KL4 surfactant
technology also can be produced as a lyophilized (dry powder) formulation that
is then resuspended just prior to administration.  We have conducted
several experiments that establish that our lyophilized KL4 surfactant
retains the key characteristics of our liquid KL4 surfactant.  We
are currently conducting additional experiments and preclinical studies to fully
characterize this new formulation and assess safety and efficacy.  We
believe that our lyophilized formulation may provide benefits in a clinical
setting relative to liquid instillate surfactants, including:




·
            Lower
      viscosity, which may aid and/or improve the distribution of the surfactant
      through the lung and potentially reduce the frequency
      of  transient peridosing events typically observed with the
      intratracheal administration of
surfactants;


7




·
            Improve
      ease of administration and time of drug product
    preparation;




·
            Potentially
      eliminating continuous cold chain storage and
    refrigeration;




·
            Potentially
      eliminating the need for warming;
and




·
            Potentially
      improve drug product stability with extended shelf
  life.





Our
Capillary Aerosolization Technology





In
December 2005, we entered into a strategic alliance with Philip Morris USA Inc.
(PMUSA) d/b/a/ Chrysalis Technologies (Chrysalis) through which we gained
worldwide exclusive rights to our capillary aerosolization
technology.  We restructured our alliance in March 2008 and entered
into exclusive license agreements with PMUSA, with respect to the United States,
and Philip Morris Products S.A., with respect to all territories outside of the
United States.  We now hold exclusive worldwide licenses to the
capillary aerosolization technology for use with pulmonary surfactants
(alone or in combination with any other pharmaceutical compound(s)) for all
respiratory diseases and conditions.  In addition, we hold in the
United States exclusive rights to the capillary aerosolization technology for
use with other (non-surfactant) drugs to treat a wide range of pediatric and
adult respiratory indications in hospitals and other health care
institutions. See, “– Licensing, Patents and
Other Proprietary Rights and Regulatory Designations –Patents and Proprietary
Rights–Philip Morris
USA Inc. and Philip Morris Products S.A.”





Our
proprietary capillary aerosolization technology has the potential to enable
targeted upper respiratory, airway, or alveolar delivery of therapies for either
local or system wide pulmonary applications and has been initially designed to
produce high-quality, low-velocity aerosols for possible lung aerosol
delivery.  Aerosol is created by pumping KL4 surfactant
drug formulation through a heated capillary wherein the excipients are converted
to a vapor state.  Upon exiting the capillary, the vapor stream
quickly cools and slows in velocity, yielding a dense aerosol with a defined
particle size.  With this technology, we believe that the particle
size may be controlled and adjusted through device modifications and drug
formulation changes.  In addition, because our KL4 surfactant
technology produces a surfactant that is designed to functionally coat the
surface of the distal respiratory tree, we believe that our aerosolized KL4 surfactant
may be used in combination with other drugs (small or large molecule) to enhance
a desired therapeutic effect by improving efficiency and delivering the combined
drug more effectively into the lung than would be possible without our KL4 surfactant.





In
studies conducted with our initial prototype capillary aerosolization system,
which consists of a base unit and disposable dose packets, patient interface and
other components, to date, with our KL4
surfactant, we have generated an aerosol that:




·
            retains
      the surface-tension lowering properties of a functioning
      surfactant;




·
            retains
      the surfactant composition of our liquid KL4 surfactant;




·
            has
      a drug particle size believed to be suitable for deposition into the lung;
      and




·
            is
      produced at rates that can deliver therapeutic dosages in a reasonable
      time period, with consistent reproducible output.  Preclinical
      studies presented at PAS in 2007 comparing our capillary aerosolization
      technology to commercially-available aerosol devices, indicated that the
      capillary aerosolization system generated as much as a 10-fold higher
      aerosol output rate compared with the other devices studied;
      and




·
            produces
      in-vivo evidence of uniform lung distribution and superior efficacy vs.
      nasal continuous positive airway pressure (nCPAP)
  alone.


8




SURFACTANT
REPLACEMENT THERAPY FOR RESPIRATORY MEDICINE





The only
commercial, pulmonary surfactants available today are animal-derived, were
introduced in the United States in the 1990’s, and are approved only for RDS in
premature infants.  These products have not been approved for other
respiratory indications.  We believe that our proprietary technology
platform makes it possible, for the first time, to develop a significant
pipeline of products targeted to treat a wide range of respiratory problems,
including those for which there are currently few or no approved
therapies.  Our programs are:





Respiratory
Distress Syndrome in Premature Infants (RDS)





Serious
respiratory problems are some of the most prevalent medical issues facing
premature infants in NICUs.  One of the most common respiratory
problems is RDS.  RDS is a condition in which premature infants are
born with a lack of natural lung surfactant and are unable to absorb sufficient
oxygen.  Premature infants born prior to 37 weeks gestation have not
fully developed their own natural lung surfactant and therefore need treatment
to sustain life.  RDS is experienced in approximately half of the
babies born between 26 and 32 weeks gestational age.  The incidence of
RDS approaches 100% in babies born less than 26 weeks gestational
age.  RDS can result in long-term respiratory problems and
death.





Premature
babies with RDS often require endotracheal intubation to administer one of the
currently available animal-derived surfactants (usually within the first hours
of birth), and to provide respiratory support via mechanical ventilation.
Unfortunately, many infants relapse following initial therapy and require
reintubation and prolonged mechanical ventilation as well as supplemental
oxygen, which increases their risk of developing further serious respiratory
complications. Neonatologists generally try to avoid mechanically ventilating
infants due to perceived risks associated with intubation, such as the risk of
trauma and the need for paralytic agents and sedation. As a result, many
neonatologists will only intubate in cases of severe respiratory disease, where
the benefits of invasive surfactant administration clearly outweigh the
associated risks. For all but the very low birth weight infants with severe RDS,
a common ventilatory support treatment alternative to intubation and mechanical
ventilation is nCPAP. Unfortunately, a significant number of infants do not
adequately respond to nCPAP and require subsequent surfactant administration via
intubation and mechanical ventilation. As neonatologists cannot ascertain in
advance which patients will fail nCPAP, they are faced with a dilemma, because
the outcome for those infants who fail nCPAP and receive delayed surfactant
therapy may not be as favorable as those who receive surfactant therapy in the
first hours of life.





We
estimate that approximately 360,000 low birth weight premature infants are born
annually in the United States and at risk for RDS. Of this total, we estimate
that approximately 130,000 are diagnosed with RDS and approximately 86,000 are
treated with surfactant replacement therapy.  We also estimate that
approximately 240,000 infants receive early nCPAP (as an initial management
strategy in lieu of intubation and mechanical ventilation), with approximately
30% failing therapy and experiencing potentially disadvantaged clinical
outcomes.





We
believe that the neonatal medical community increasingly recognizes the
potential benefits of (i) a synthetic, peptide-containing surfactant, such as
Surfaxin and Surfaxin LS, and more importantly, (ii) a less-invasive method of
delivering surfactant, such as Aerosurf, to treat premature infants suffering
from respiratory disorders.  While the current RDS market for
surfactants is estimated to be approximately $75 million annually in the United
States and $200 million annually worldwide, we believe that this market has been
constrained by the lack of further development of animal-derived surfactants
coupled with the risks associated with surfactant administration in its current
form.  We believe that Surfaxin, Surfaxin LS and Aerosurf have the
potential, over time, to displace animal-derived products, expand the
surfactant-eligible patient population, and support a greatly expanded RDS
market.





Surfaxin for the Prevention
of RDS in Premature Infants





Surfaxin
is the first synthetic, peptide-containing surfactant that is structurally
similar to pulmonary surfactant and mimics the surface-active properties of
human surfactant.  Surfaxin is a liquid instillate and is administered
(usually within the first hours of birth) via endotracheal tube supported by
mechanical ventilation for respiratory support.  If approved, Surfaxin
will represent the first synthetic, peptide-containing surfactant approved for
use in pediatric medicine.


9





Our NDA
for Surfaxin, which we filed in April 2004, is supported by a Phase 3 pivotal
trial (SELECT) for the prevention of RDS in premature infants.  The
SELECT trial enrolled 1,294 patients and was designed as a multinational,
multicenter, randomized, masked, controlled, prophylaxis, event-driven,
superiority trial to demonstrate the safety and efficacy of Surfaxin over
Exosurf®, an
approved, non-protein containing synthetic surfactant.  Survanta, a
surfactant derived from cow lung and a leading surfactant used in the United
States, served as a reference arm in the trial.  Key trial results
were assessed by an independent, blinded, adjudication committee comprised of
leading neonatologists and pediatric radiologists.  This committee
provided a consistent and standardized method for assessing critical efficacy
data in the trial.  An independent Data Safety Monitoring Board was
responsible for monitoring the overall safety of the trial and no major safety
issues were identified.





Data from
the SELECT study demonstrate that Surfaxin is significantly more effective in
the prevention of RDS, death due to RDS, and the development of certain severe
respiratory problems versus the primary comparator,
Exosurf.   Although the Survanta reference arm was not the
primary focus of comparison, significantly fewer infants treated with Surfaxin
died due to RDS compared with infants treated with Survanta.





We also
conducted a supportive, multinational, multicenter, prophylaxis, randomized,
controlled, masked, Phase 3 clinical trial (STAR) which enrolled 252 patients
and was designed as a non-inferiority trial comparing Surfaxin to Curosurf, a
surfactant derived from pig lung and the leading surfactant used throughout the
developed world.  The STAR trial demonstrated the overall safety and
non-inferiority of Surfaxin compared with Curosurf.





The
SELECT and STAR trials, as well as a pooled Phase 3 analysis, have been
presented at several international medical meetings and the results from the two
studies were published in Pediatrics, the Official
Journal of the American Academy of Pediatrics and a premier medical journal for
pediatric healthcare practitioners.





Important
new analysis of data from our SELECT and STAR Phase 3 clinical studies reveals
that premature infants with RDS who were extubated after treatment with
surfactant and then subsequently required reintubation had a significantly
higher rate of mortality than those infants who did not require
reintubation.  The data also indicate that premature infants treated
with Surfaxin required less reintubation compared to those treated with Survanta
and Curosurf.  Although the data indicated that the Surfaxin-treated
infants were observed to have a statistically significant lower incidence of
invasive reintubation than those infants treated with comparator surfactants,
the clinical relevance of this finding has not been adequately established and,
accordingly, warrants further study.





In April
2009, after previously receiving three Approvable Letters, we received a
Complete Response Letter for this NDA.  As was the case with the
previous letters, which had focused primarily on the Chemistry, Manufacturing
and Controls (CMC) section of our NDA, this Complete Response Letter did not
question the quality of our clinical trial data or call for additional clinical
trials demonstrating safety or efficacy.  Rather, this Complete
Response Letter was focused certain aspects of the BAT, specifically whether
analysis of preclinical data from both the BAT and a well-established preterm
lamb model of RDS demonstrates the degree of comparability that the FDA requires
and whether the BAT can adequately distinguish change in Surfaxin biological
activity over time.





During
our Phase 3 clinical trials, we employed an array of quality control and release
tests, but we did not employ a BAT to evaluate biological activity in Surfaxin
clinical drug product.  We later validated and implemented the BAT as
a recurring quality control test to confirm biological activity for Surfaxin
release and stability.  Based on guidance from the FDA in meetings in
2006 and 2008, to demonstrate comparability between Surfaxin clinical drug
product and the to-be-manufactured drug product, we conducted studies with the
to-be-manufactured Surfaxin drug product that replicated studies that had been
previously conducted using the Surfaxin clinical drug product in the
well-established preterm lamb model.  These studies demonstrated to
the FDA’s satisfaction comparability between the Surfaxin clinical drug product
and the to-be-manufactured drug product.  However, as using the
preterm lamb model as a quality control and release test in the future
manufacture of Surfaxin is neither cost-effective nor practical, it became
necessary to correlate the data demonstrated in the preterm lamb model to the
data generated using the BAT.  Accordingly, we included data intended
to satisfy the FDA on this point in the Complete Response that we submitted in
response to an earlier Approvable Letter in October 2008.


10





Following
receipt of the April 2009 Complete Response Letter, at an end-of-review meeting
on June 2, 2009, we presented some additional data from the preterm lamb model
experiments and the BAT, together with a comprehensive statistical evaluation of
that data based on a comparison of regression lines, prepared in accordance
with standard statistical methods.  We believed that the data
adequately demonstrated comparability between the preterm lamb model and
the BAT.  However, the FDA did not accept our analysis and indicated
that, to gain approval of Surfaxin using preclinical data, the studies must
demonstrate, in a point-to-point analysis, the same relative changes in
respiratory compliance between the BAT and the preterm lamb model over
time.  Given the variability observed in the BAT at that time and the
expected variability in animal models generally, we and the FDA believed it
unlikely that we could establish the degree of consistency that the FDA required
using the animal models.





Also at
the June 2, 2009 meeting, the FDA suggested that, as an alternative to
demonstrating comparability using  preclinical data, we could consider
conducting a limited clinical trial while simultaneously employing an optimized
BAT for release and ongoing stability testing of the to-be-manufactured Surfaxin
drug product.  On September 2009, we held a teleconference with the
FDA and discussed in detail our plans to optimize the precision of the BAT
method and its subsequent validation.  We also discussed the design of
a proposed limited clinical trial and whether conducting such a trial while
simultaneously employing the newly-optimized and revalidated BAT could
potentially resolve the remaining FDA requirement for Surfaxin
approval.  We proposed a trial design intended primarily to assess a
pharmacodynamic (PD) response following Surfaxin administration in preterm
infants with RDS.  The FDA indicated that a PD approach is consistent with
their expectation for a limited clinical trial and, subject to further review
and ethical consideration, provided direction regarding trial design
specifics.





After
collaborating with leading academic neonatologists, in November 2009 we
submitted to the FDA a proposed protocol for a Surfaxin limited clinical trial
that incorporated a PD clinical trial design.  However, in
February 2010, we received a letter from the FDA advising us that, since an
acceptable animal model (preterm lamb) of RDS already exists, a PD clinical
trial approach would not be appropriate.  As a result, instead of
pursuing a limited clinical trial, we are now focused on completing the
optimization and revalidation of the BAT and developing a comprehensive
preclinical program intended to meet the FDA’s requirements.





Prior to
initiating a program to optimize the BAT, we submitted our optimization protocol
to the FDA for comment. Optimization is now well underway and, while not
complete, is presently meeting all pre-specified acceptance criteria. Upon
successful conclusion of BAT optimization and revalidation, we plan to conduct a
series of prospectively-designed, side-by-side preclinical studies employing the
optimized BAT and the preterm lamb model. The results from these studies are
intended to demonstrate to the FDA’s satisfaction that the BAT is able to
adequately discriminate biologically active Surfaxin drug product from inactive
Surfaxin drug product and establish the Surfaxin drug product’s final acceptance
criteria with respect to biological activity (as assessed by the BAT) for
release and ongoing stability. We believe that implementing the method
improvements to optimize the BAT makes it more likely that the results of the
planned preclinical program will demonstrate the level of comparability between
data generated using the BAT and the preterm lamb model that the FDA
requires.





We
believe that compared to the conduct of a PD clinical trial, this approach could
reduce the time and expense required to gain potential Surfaxin approval. If our
comprehensive preclinical program successfully establishes comparability to the
standard set by the FDA, we believe that a Complete Response could be submitted
to the FDA in the first quarter of 2011.





Surfaxin LSTM – Lyophilized
Surfaxin for RDS in Premature Infants





Surfaxin
LS is our lyophilized (dry powder) formulation of Surfaxin, which is resuspended
as a liquid just prior to administration. We believe that Surfaxin LS has the
potential to improve ease of use for healthcare practitioners, eliminate the
need for cold-chain storage, and potentially further improve clinical
performance. In addition, we believe that Surfaxin LS may demonstrate
characteristics that could provide other clinical benefits.





In
anticipation of filing an Investigational New Drug (IND) Application to gain
regulatory approval for Surfaxin LS in the United States, we plan to request a
pre-IND meeting with the FDA to discuss our proposed development program that
would consist of a single Phase 3 clinical trial. Similarly, to gain regulatory
approval for Surfaxin LS in Europe, we plan to request a scientific advice
meeting with the EMEA.   If we can gain the agreement of the two
regulatory agencies, we anticipate conducting a single clinical trial to gain
regulatory approval for Surfaxin LS in the United States and Europe. We
anticipate initiating a clinical program after we have secured appropriate
strategic alliances and necessary capital.


11





Aerosurf for RDS in
Premature Infants





Aerosurf
is our aerosolized KL4 surfactant
that is administered through less-invasive means and is being developed to
potentially obviate the need for intubation and conventional mechanical
ventilation.  We believe that Aerosurf, if approved, holds the promise
to significantly expand the use of our KL4 surfactant
in pediatric respiratory medicine by potentially providing
neonatologists with a means of administering KL4surfactant
to infants without the risks (including serious lung injury and other
complications) associated with administration of currently-approved
surfactants, which require invasive endotracheal intubation and mechanical
ventilation.





As a
precursor to the initiation of our Aerosurf program, we completed and announced
in 2005 the results of our first pilot Phase 2 clinical study of aerosolized
KL4
surfactant for the prevention of RDS in premature infants, which was designed as
an open label, multicenter study to evaluate the feasibility, safety and
tolerability of Aerosurf delivered using a commercially-available aerosolization
device (Aeroneb Pro®) via
nCPAP within 30 minutes of birth over a three hour duration.  The study
showed that it is feasible to deliver our aerosolized KL4 surfactant
via nCPAP and that the treatment was generally safe and well
tolerated.





In
addition, preclinical developmental studies using the RDS animal model were
presented at the 2007 Annual Hot Topics in Neonatology meeting held in
Washington, DC, and demonstrated that Aerosurf (using our capillary
aerosolization technology) improves lung function and reduces inflammatory
markers associated with lung injury and chronic lung disease.





We
estimate that approximately 360,000 low birth weight premature infants are born
annually in the United States and at risk for RDS.  As discussed
above, of this total, we estimate that approximately 130,000 are diagnosed with
RDS and approximately 86,000 are treated with surfactant replacement
therapy.  See, “– Surfactant Replacement
Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature
Infants (RDS).” We also estimate that approximately 240,000 infants receive
early nCPAP and approximately 30% fail therapy and experience potentially
disadvantaged outcomes.  We believe that Aerosurf, which can be
administered via nCPAP, potentially obviating the need for intubation and
mechanical ventilation, represents a significant market opportunity and has the
potential to significantly expand the use of surfactants worldwide.





We are
currently developing Aerosurf using our capillary aerosolization
technology.  See, “– Proprietary Platform
– Surfactant and Aerosol Technologies – Our Capillary Aerosolization
Technology.”  However, as these activities require significant investments
in research, engineering, device development and device manufacturing
capabilities, we found it necessary to re-prioritize certain of our development
priorities as we focused our efforts on gaining regulatory approval for Surfaxin
while conserving our cash resources.  We have continued to conduct
certain developmental and preclinical activities to support our regulatory
package.  We have met with and received guidance from the FDA with
respect to the design of our planned Phase 2 clinical
program.  We are currently advancing our preclinical development
activities and preparing to further engage the FDA and foreign regulators with
respect to our clinical program.  Thereafter, we plan to initiate a
Phase 2 clinical program for Aerosurf.





In
addition, until such time as it became necessary to conserve our cash resources
by limiting our investment in pipeline programs, we undertook development
activities focused on the next-generation capillary aerosolization system for
use in potential Phase 2/3 clinical trials for Aerosurf and, if approved, future
commercial activities.  We worked closely with a leading engineering
and design firm that has a successful track record of developing innovative
devices for major companies in the medical and pharmaceutical industries, both
in the United States and international markets.  Since suspending that
activity, our engineering team has continued to make progress with the design of
the next-generation capillary aerosolization system.  We plan to
reengage with the engineering and design firm following the potential approval
of Surfaxin.  We will determine the timing and amount of our
investment based on an assessment of our financial resources and competing
priorities at that time.


12





We
believe that Aerosurf is a highly promising program.  With the
knowledge that we gain from our development activities to treat premature
infants with RDS, we plan to leverage our technology platform to potentially
address several respiratory conditions affecting pediatric and adult patient
populations.  See, “– Licensing, Patents and
Other Proprietary Rights and Regulatory Designations –Patents and Proprietary
Rights–Philip Morris
USA Inc. and Philip Morris Products S.A.”





Bronchopulmonary
Dysplasia (BPD)





BPD, also
known as Chronic Lung Disease, affects premature infants and is associated with
surfactant deficiency and the prolonged use of mechanical ventilation and oxygen
supplementation. BPD is diagnosed when premature infants require mechanical
ventilation or supplemental oxygen either at the 28th day of
life or 36 weeks post-menstrual age. Premature babies are often born with a lack
of natural lung surfactant and are unable to absorb sufficient oxygen, resulting
in RDS. These infants often require endotracheal intubation to administer one of
the currently available animal-derived surfactants (usually within the first
hours of birth), and to provide respiratory support via mechanical ventilation.
Unfortunately, many infants relapse following initial therapy and require
reintubation and prolonged mechanical ventilation as well as supplemental
oxygen, which increases their risk of developing BPD. We believe that treatment
with repeated doses of our KL4 surfactant
after the initial RDS treatment (on day one or two of life) may prevent BPD and
improve the clinical outcome of these infants.





There are
presently no approved drugs for the prevention or treatment of
BPD.  Infants diagnosed with BPD suffer from abnormal lung development
and typically have a need for respiratory assistance, often for many months, as
well as comprehensive continuing care potentially spanning years.  It
is estimated that the cost of treating an infant with BPD in the United States
can approach $250,000 during the initial inpatient stay alone.  We
estimate that approximately 100,000 infants are at risk for BPD in the United
States and Europe each year.





In
October 2006, we announced preliminary results of our Phase 2 clinical trial for
Surfaxin for the prevention and treatment of BPD, which was designed as an
estimation study to evaluate the safety and potential efficacy of Surfaxin in
infants at risk for BPD.  The results of this trial suggest that
Surfaxin may potentially represent a novel therapeutic option for infants at
risk for BPD.  The results of this study were published in Pediatrics in January
2009.





Resources
permitting, we plan in the future to seek scientific advice from the FDA and
other regulatory agencies with respect to potential clinical trial designs to
support the further development of Surfaxin LS or Aerosurf for the prevention of
BPD.  We also may seek a strategic alliance and/or other collaborative
arrangement prior to further developing our KL4 surfactant
to address this disease.





Acute
Respiratory Failure (ARF)





ARF
occurs when lung tissue is significantly damaged, leading to an impairment in
lung function and the need for endotracheal intubation and mechanical
ventilation (the current standard of care).Children with ARF have
reduced levels of functional surfactant.  Damage to the lung that
causes ARF usually leads to surfactant dysfunction and decreased surfactant
production.  When there is insufficient functional surfactant in the
lung, the air sacs collapse and are unable to support sufficient
oxygenation.   The most common cause of respiratory failure in
these children is viral infection of the lung, including influenzas such as
the type A influenza serotype referred to as H1N1 and respiratory syncytial
virus (RSV).  We estimate that ARF affects approximately 15,000
children under two years of age in the United States with an estimated 30,000 –
40,000 children afflicted in developed countries each year, depending on
severity of the viral season.  Presently there are no approved drugs
for the treatment of ARF.





Surfaxin for
ARF





In June
2007, we initiated a clinical trial to determine if restoration of surfactant
with Surfaxin will improve lung function and result in a shorter duration of
mechanical ventilation and stay in the NICU or PICU for children up to two years
of age suffering with ARF.  The Phase 2 clinical trial is a multicenter,
randomized, masked, placebo-controlled trial that compares Surfaxin to standard
of care masked by a sham air control.  Approximately 170 children under the
age of two with ARF will receive standard of care and be randomized to receive
either Surfaxin at 5.8 mL/kg of body weight (expected weight range up to 15 kg)
or sham air control. The trial is being conducted at approximately 35-40
sites in both the Northern and Southern Hemispheres.  The objective of the
study is to evaluate the safety and tolerability of Surfaxin administration and
to assess whether such treatment can decrease the duration of mechanical
ventilation in young children with ARF.  Enrollment is near completion and
top-line results are expected to become available in the second quarter of
2010.


13





Because
of the relative weight difference between RDS and ARF patient populations and
volumetric dosing associated with our KL4 surfactant,
children with ARF who are treated with Surfaxin in our Phase 2 clinical trial
are expected to receive a dose volume that is approximately 5 times greater than
the average dose volume administered to premature infants with RDS.





Cystic
Fibrosis (CF)





CF is a
life-threatening genetic disease affecting the respiratory and other body
systems.  CF is characterized by a genetic mutation that produces
thick, viscous mucus that is difficult to clear from the airways of the lung and
typically leads to life-threatening respiratory
infections.  Preclinical and exploratory clinical studies suggest that
therapeutic surfactants may improve lung function by loosening mucus plugs and
enhancing mucociliary clearance.





CF is the
most common, life-threatening genetic disorder in the United States, occurring
in approximately one in every 3,500 Caucasian live births.  CF affects
approximately 30,000 patients in the United States and nearly 70,000
worldwide.  To date, treatment of pulmonary conditions in CF primarily
includes antibiotics to address lung infection and airway clearance therapies to
break down and remove mucus.  Life expectancy for CF has more than
doubled in the past 25 years to age 37, due to significant advances in research
and care.





In
September 2008, our aerosolized KL4 surfactant
was selected for a Phase 2a clinical trial in patients with CF that is being
conducted as an investigator-initiated study at The University of North
Carolina and is funded primarily through a grant provided by the Cystic Fibrosis
Foundation.  The trial is designed as a double-blind, randomized study
to evaluate whether our aerosolized KL4 surfactant
is safe and well tolerated in patients with mild to moderate CF lung disease,
and to assess the short-term effectiveness (via improvement in mucociliary
clearance) of our aerosolized KL4 surfactant.  We
anticipate the results from this trial in mid-2010.





We
believe that our novel synthetic, peptide-containing surfactant has unique
attributes, including potentially nonimmunogenic, anti-inflammatory and
anti-microbial properties, that when combined with a potential ability to
enhance mucociliary clearance in CF lung disease, may advance the treatment of
CF and improve treatment outcomes for these very ill patients.  We
plan on advancing this development program in collaboration with a potential
strategic partner, although there can be no assurance that we will be successful
in entering into such an arrangement.





Serious
Respiratory Indications Associated with Inflammation of the Lungs





Many
respiratory diseases are associated with an inflammatory event that causes
surfactant dysfunction and a loss of patency of the conducting
airways.  Scientific data support the premise that the therapeutic use
of surfactants in aerosol form has the ability to reestablish airway patency,
improve pulmonary mechanics and act as an
anti-inflammatory.  Surfactant normally prevents moisture from
accumulating in the airways’ most narrow sections and thereby maintains the
patency of the conducting airways.





We are
also evaluating the potential of developing our proprietary aerosolized KL4 surfactant
technology to address debilitating respiratory disorders, such as ALI, asthma,
and COPD.  As resources permit, we will consider investing in these
indications through a proof-of-concept phase and, if successful, thereafter
determine whether to seek strategic alliances or collaboration arrangements or
utilize other financial alternatives to fund their further development and/or
worldwide commercialization, if approved.  There can be no assurance
that we will be successful or that we will be able to enter into any such
strategic alliance, collaboration arrangement or financial
alternatives.  We believe that these investments could potentially
address significant unmet medical needs and redefine respiratory
medicine.


14





Acute Lung Injury
(ALI)





ALI is
associated with conditions that either directly or indirectly injure the air
sacs of the lung.  ALI is a syndrome of inflammation and increased
permeability of the lungs with an associated breakdown of the lungs’ surfactant
layer.  Among the causes of ALI are complications typically associated
with certain major surgeries, mechanical ventilator induced lung injury (often
referred to as VILI), smoke inhalation, pneumonia and sepsis.  There
are a significant number of patients at risk in the United States for ALI
annually and there are no currently approved therapies other than supportive
respiratory care.





We
believe that our aerosolized KL4 surfactant
may potentially be effective as a preventive measure to treat patients at risk
for ALI.  We are engaged in research and preclinical studies in
collaboration with a prominent academic investigator to assess the use of our
KL4
surfactant to potentially address ALI in an animal model. This prophylactic
approach may reduce the number of patients requiring costly intensive care
therapy, eliminate long periods of therapy and generate cost savings in the
hospital setting.





Asthma





Asthma is
a common disease characterized by sudden constriction and inflammation of the
lungs.  Constriction of the bronchial airway system occurs when the
airway muscles tighten, while inflammation is a swelling of the airways usually
due to an inflammatory reaction caused by an irritant.  Both of these
events cause airways to narrow and may result in wheezing, shortness of breath
and chest tightness.  Several studies have shown that surfactant
damage and dysfunction is a significant component of asthma – airway narrowing
occurs with concomitant surfactant dysfunction in the airways of the lung that
develops during an asthma attack.  We believe that our proprietary
aerosolized KL4 surfactant
has the potential to relieve the narrowing in the airways associated with
asthma.





Asthma
may require life-long therapy to prevent or treat episodes.  Ten
percent of patients are considered severe asthmatics and require moderate to
high doses of drugs.  Currently available asthma medications include
inhaled and oral steroids, bronchodilators and leukotriene
antagonists.  Bronchodilators alone cannot be used to control severe
episodes or chronic, severe asthma.  Oral steroids can cause serious
side effects when used for prolonged periods and, thus, are typically limited to
severe asthmatic episodes and chronic, severe asthma.  We believe that
our aerosolized KL4 surfactant
may relieve airway obstruction in the lung and lead to a more rapid improvement
in asthmatic symptoms.





Chronic Obstructive
Pulmonary Disease (COPD)





COPD is
an incurable, chronic respiratory disorder that includes both emphysema and
chronic bronchitis and is characterized by obstruction to airflow that
interferes with normal breathing, inflammation, mucus plugs formation infection
and disruption of the normal lung architecture.





We
believe that our novel synthetic, peptide-containing surfactant has unique
attributes, including potential anti-inflammatory and anti-microbial properties,
that, when combined with a potential ability to enhance mucus clearance (see,“Cystic Fibrosis (CF)”,
above) may be an effective treatment for COPD, potentially improving outcomes
for these very ill patients. We plan on advancing this development program in
collaboration with a potential strategic partner, although there can be no
assurance that we will be successful in entering into such an
arrangement.





KL4 Surfactant
in Combination with Other Therapeutics to Treat a Wide Range of
Disease





A key
characteristic of our KL4 surfactant
is its ability to spread throughout the lung and coat the entire surface area of
the respiratory tree. We therefore believe that our KL4
surfactant, either as a liquid or in combination with our capillary
aerosolization technology, may be a superior mechanism to deliver small- and
large-molecule therapeutics to the lung. We are currently conducting formulation
development and preclinical studies to assess the potential of combining our
KL4
surfactant with other active therapies, including potentially antibiotics,
protease inhibitors and oligonucleotides. We believe that delivering these
therapeutics in combination with our KL4 surfactant
may potentially greatly enhance their effectiveness. If we successfully
demonstrate proof-of-concept through these efforts, we would expect to develop
and, if approved, commercialize these combination products in collaboration with
one or more alliance partners, although there can be no assurance that we will
succeed in entering into any such arrangement.


15





BUSINESS
OPERATIONS





Research
and Development





Our
research and development activities are initially focused primarily on
developing our proprietary KL4 surfactant
technology and capillary aerosolization technology into a series of
pipeline programs that would support a significant pediatric critical care
franchise.  We continually evaluate our research and development
priorities in light of a number of factors, including our cash flow requirements
and financial liquidity, the availability of third party funding, advances in
technology, the results of ongoing development projects and the potential for
development partnerships and collaborations.  In connection with our
evaluations, we modify and adapt our research and development plans from time to
time and anticipate that we will continue to do so.





We are
actively assessing various strategic and financial alternatives to secure
necessary capital and advance our KL4
respiratory pipeline programs to maximize shareholder value, although we would
prefer to accomplish our objectives through strategic alliances that would
provide financial support (potentially in the form of upfront payments,
milestone payments, commercialization royalties and a sharing of research and
development expenses), development capabilities, and ultimately commercial
expertise to maximize the potential of our KL4 surfactant
technology.  We are also reviewing various financial alternatives that
would provide infusions of capital and other resources needed to advance our
KL4
respiratory pipeline programs.  Although we are considering several
potential opportunities, there can be no assurance that any strategic alliance
or other financing alternatives will be successfully concluded.  Until
such time as we secure sufficient
strategic and financial resources to support the continuing development of our
KL4
surfactant technology and support our operations, we will continue to
conserve our resources, predominantly by curtailing and pacing investments in
our pipeline programs.





If we are
able to secure the necessary capital, we also plan to invest opportunistically
in KL4 surfactant
technology pipeline programs that will target adult and other indications, which
we believe represent potentially significant market opportunities. We plan to
initially develop these programs through a proof-of-concept phase and, if
successful, thereafter determine whether to seek strategic alliances or
collaboration arrangements or utilize other financial alternatives to fund their
further development and/or worldwide commercialization, if
approved.  There can be no assurance that we will succeed in
demonstrating proof of concept or entering into any such alliance,
however.





To
support our research and development activities, we have:





·
            a
      medical staff with expertise in pediatric and pulmonary medicine and
      extensive contacts in the neonatoal medical
  community;


·
            expertise
      in the design and implementation of pre-clinical experiments and studies
      to support drug development.  We conduct certain
      development-related experiments and bench studies in-house and also engage
      professional research laboratories as well as academic and education
      centers to conduct animal studies and experiments requiring specialized
      equipment and expertise;


·
            expertise
      in the design, development and management of clinical
      trials.  Our own expertise includes scientific, medical,
      statistical and trial management capabilities.  We also rely on
      scientific advisory committees and other medical and consulting experts to
      assist in the design and ongoing monitoring of our clinical
      trials.  We also rely on contract research organizations (CROs)
      to support operations of our planned multi-center trials in certain
      countries;


·
            data
      management and biostatistics expertise to analyze and report on our
      clinical trial data, supported by third-party technology systems and
      independent consultants;


·
            regulatory
      personnel with expertise in FDA regulatory matters.  We also
      consult extensively with independent FDA and international regulatory
      experts, including former senior scientific staff of the
    FDA;


·
            engineering
      expertise that supports development of our aerosolized KL4 surfactant.  In
      addition to our own design engineering team, we plan to work with design
      engineers, medical device experts and other third-party collaborators to
      advance the development of our capillary aerosolization
      technology;


·
            quality
      operations capabilities to assure compliance with applicable
      regulations;


16





·
            manufacturing
      capabilities to manufacture our KL4surfactant
      for use in pre-clinical and clinical studies.  We also rely on
      third-party manufacturers to manufacture our capillary aerosolization
      systems and related components; and


·
            research,
      analytical and medical device development laboratories and manufacturing
      facilities and related capabilities, including our development
      laboratories that support our drug and device development
      activities.  We also rely on third party laboratories to support
      our ongoing efforts and provide certain laboratory
    services.





Research
and development costs are charged to operations as incurred.  During
the years ended December 31, 2009, 2008 and 2007, our research and development
expenses were $19.1 million, $26.6 million and $26.2 million,
respectively.





Manufacturing
and Distribution





Precision-Engineered
Surfactant





Our
KL4 surfactant
product candidates, including Surfaxin, must be manufactured in compliance with
current good manufacturing practices (cGMP) established by the FDA and other
international regulatory authorities.  Surfaxin is a complex drug
comprised of four active ingredients.  It must be aseptically
manufactured at our facility as a sterile, liquid suspension and requires
ongoing monitoring of drug product stability and conformance to
specifications.





Our
product candidates are manufactured by combining raw materials, such as KL4, which is
provided by Bachem California, Inc., and PolyPeptide Laboratories Inc., and
other active ingredients, including certain lipids that are provided by
suppliers such as Genzyme Pharmaceuticals, a division of the Genzyme
Corporation, and Avanti Polar Lipids, Inc.   Other than KL4, for which
we have two suppliers, we currently obtain our active ingredients from single
sources, although we plan to initiate a program to qualify secondary suppliers
when our financial resources permit.  Our risk of losing a source of
supply is mitigated by the fact that we generally maintain a minimum of
six-months supply of all critical active ingredients.  Suppliers of
our containers, closures and excipients used in our manufacturing process
include West Pharmaceutical Services, Inc., Gerresheimer Glass Inc. and Spectrum
Chemical Mfg. Corp.  Our inactive raw materials and critical
components are generally readily available from multiple sources.  In
addition, we plan to utilize the services of Catalent Pharma Solutions, for
labeling and packaging of Surfaxin, if approved, in the United
States.




Our
manufacturing facility in Totowa, New Jersey, consists of pharmaceutical
manufacturing and development space that is designed for the manufacture and
filling of sterile pharmaceuticals in compliance with cGMP.  See, “Item 2 –
Properties.”  These operations, which we acquired from our
then-contract manufacturer in December 2005, are an integral part of our
long-term manufacturing strategy for the continued development of our KL4 surfactant
technology, including life-cycle management of Surfaxin, new formulations
development and formulation enhancements, and expansion of our aerosolized
KL4
surfactant products, beginning with Aerosurf.  Owning our own
manufacturing operations has provided us with direct operational control and, we
believe, potentially improved economics for the production of pre-clinical,
clinical and potential commercial supply of our lead product, Surfaxin, and our
other KL4 surfactant
technology pipeline products.





In April
2006 we experienced stability failures in certain batches of Surfaxin that had
been manufactured by our contract manufacturer.  We initiated a
comprehensive formal investigation and implemented a corrective action and
preventative action (CAPA) plan.  We manufactured three new Surfaxin
process validation batches in February 2007 and in March 2008 submitted to the
FDA 12-month stability data on these new batches.  We have since
submitted 16-month stability data on these process validation
lots.  We believe stability data for these and subsequent lots support
at least a 12-month shelf life for Surfaxin.





In March
2008, the FDA completed a pre-approval inspection (PAI) of our Totowa facility
and issued an Establishment Inspection Report (EIR) indicating an approval
recommendation for our Surfaxin NDA.   For a discussion of
certain manufacturing risks and uncertainties, see“Item 1A – Risk Factors –
The manufacture of our drug products is a highly exacting and complex process,
and if we, our contract manufacturers or any of our materials suppliers
encounter problems manufacturing our products or the drug substances used to
make our products, this could potentially cause us to delay development or
clinical programs or, following approval, product launch, or cause us to
experience shortages of products inventories.”


17





Our
manufacturing strategy includes investing in our analytical and quality
systems.  In October 2007, we completed construction of a new
analytical and development laboratory in our headquarters in Warrington,
Pennsylvania and have consolidated at this location all of our analytical,
quality and development activities.  The activities conducted in our
laboratory include release and stability testing of raw materials as well as
clinical and, if approved, commercial drug product supply.  We also
perform development work with respect to our aerosolized KL4 surfactant
and novel formulations of our KL4 surfactant
technology.  The laboratory expanded our capabilities by providing
additional capacity to conduct analytical testing as well as opportunities to
exploit our internal professional expertise across a broad range of projects,
improving both operational efficiency and financial economics.





In
addition, in 2007, we built a microbiology laboratory at our Totowa facility to
support production of our drug product candidates.  In February 2010,
we completed construction of a new medical device development laboratory, which
is equipped to support the assembly of capillary aerosolization system
disposable dose packets in a controlled environment in two class 10,000 hoods
following clean room procedures.  This new laboratory greatly enhances
our ability to leverage our internal development engineering resources and
manage ongoing preclinical development activities for Aerosurf, while at the
same time controlling the related expense and conserving our financial
resources.





We plan
to have manufacturing capabilities, primarily at our Totowa manufacturing
operations, to produce commercial supplies of Surfaxin, if approved, and to meet
our anticipated pre-clinical, clinical, formulation development and, if
approved, potential future commercial requirements of our other KL4 surfactant
product candidates.  During the period of formulation development for
our lyophilized KL4
surfactant, including Surfaxin LS, to conserve our financial resources, we plan
to enter into arrangements with one or more contract manufacturing
organizations. See, Item 2 –
Properties.





Aerosol Devices and Related
Componentry





We are
developing and will potentially commercialize our aerosolized KL4 surfactant
to address a broad range of serious respiratory conditions, starting with
Aerosurf for RDS in premature infants.  See, “– Licensing, Patents and
Other Proprietary Rights and Regulatory Designations –Patents and Proprietary
Rights–Philip Morris
USA Inc. and Philip Morris Products S.A.”





To
manufacture capillary aerosolization devices and related components for our
Phase 2 Aerosurf clinical trials, we expect to utilize third-party contract
manufacturers and suppliers.  We expect to use third-party integrators
to assemble the aerosolization systems for us.  We also have the
capability to assemble the disposable dose delivery packets at our new medical
device development laboratory at our headquarters location in Warrington,
Pennsylvania.  The manufacturing process involves assembly of key
device sub-components that comprise the capillary aerosolization systems,
including the aerosol-generating device, disposable dose delivery packets, which
must be assembled in a clean room environment, and patient interface systems to
administer our aerosolized KL4
surfactant.  Under our manufacturing plan, third-party vendors will
manufacture customized parts for us and assemble the key device sub-components
and ship them to us or our third-party integrator for final assembly and
integration into the aerosolization system.  Once assembled, the
critical drug product-contact components and patient interface systems will be
packaged and sterilized.  The assembled capillary aerosolization
systems will be quality-control tested prior to release for use in our clinical
trials.  We have arranged with Kloehn, Inc. to act as
manufacturer of certain components and integrator of the prototype
aerosol-generating base unit and disposable dose delivery
packets.  See,“Item 1A – Risk Factors
– The manufacture of our drug products is a highly exacting and complex process,
and if we, our contract manufacturers or any of our materials suppliers
encounter problems manufacturing our products or the drug substances used to
make our products, this could potentially cause us to delay development or
clinical programs or, following approval, product launch, or cause us to
experience shortages of products inventories.”





Distribution





We are
currently manufacturing Surfaxin as a liquid instillate that requires cold-chain
storage and distribution.  In anticipation of potential Surfaxin
approval in May 2008, to provide for distribution services, we arranged for ASD
Specialty Healthcare, Inc. to act as our sole wholesaler in the United
States.  This arrangement continues to be available to
us.


18





Our
collaboration with Esteve provides that Esteve has responsibility for
distribution of our KL4 surfactant
products  in Andorra, Greece, Italy, Portugal and
Spain.  See, “–Business Operations –
Strategic Alliances and Collaboration Arrangements.”  In other parts
of the world, we plan to evaluate third-party distribution capabilities prior to
commercializing in those regions.





General
and Administrative





We intend
to continue investing in general and administrative resources primarily to
support our intellectual property portfolios (including building and enforcing
our patent and trademark positions), our business development initiatives,
financial systems and controls, legal requirements, management information
technologies, and general management capabilities.





Strategic
Alliances and Collaboration Arrangements





Laboratorios del Dr. Esteve,
S.A.





We have a
strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the
development, marketing and sales of a broad portfolio of potential KL4 surfactant
products in Andorra, Greece, Italy, Portugal, and Spain.  Esteve will
pay us a transfer price on sales of Surfaxin and other KL4 surfactant
products.  We will be responsible for the manufacture and supply of
all of the covered products and Esteve will be responsible for all sales and
marketing in the territory.  Esteve is obligated to make stipulated
cash payments to us upon our achievement of certain milestones, primarily upon
receipt of marketing regulatory approvals for the covered
products.  In addition, Esteve has agreed to contribute to Phase 3
clinical trials for the covered products by conducting and funding development
performed in the territory.  As part of a restructuring of this
alliance in December 2004, we regained full commercialization rights to our
KL4 surfactant
technology in portions of the original territory licensed to Esteve, including
key European markets, Central America, and South America (Former Esteve
Territories) and agreed to pay to Esteve 10% of any cash up-front and milestone
fees (not to exceed $20 million in the aggregate) that we may receive in
connection with any strategic collaborations for the development and/or
commercialization of certain of our KL4 surfactant
products, including Surfaxin and Aerosurf  in the Former Esteve
Territories.





Potential Alliances and
Collaboration Arrangements




We
continue to seek strategic alliances and other collaborative arrangements for
the development and/or commercialization of our KL4 surfactant
product candidates that would provide financial support (potentially in the form
of upfront payments, milestone payments, commercialization royalties and a
sharing of research and development expenses), development capabilities, and
ultimately commercial expertise to advance our KL4
technology.  We also are reviewing various financial alternatives that
would provide infusions of capital and other resources needed to advance our
KL4
respiratory pipeline programs.  Although we are considering several
potential opportunities, there can be no assurance that any strategic alliance
or other financing alternatives will be successfully
concluded.   See, “– Business Strategy,”
and “Management’s Discussion and Analysis of Financial Condition and
Results of Operations – Liquidity and Capital Resources – Financings Pursuant to
Common Stock Offerings.”




LICENSING,
PATENTS AND OTHER PROPRIETARY RIGHTS AND


REGULATORY
DESIGNATIONS





We
continue, to invest in maintaining and enforcing our potential competitive
position through a number of means: (i) by protecting our exclusive rights in
our KL4 surfactant
technology and capillary aerosolization technology through patents and patent
extensions, (ii) by seeking regulatory exclusivities, including potential orphan
drug and new drug product exclusivities, and (iii) through protecting our trade
secrets and proprietary methodologies that support our manufacturing and
analytical processes.


19





Patents
and Proprietary Rights





Johnson & Johnson, Ortho
Pharmaceutical Corporation and The Scripps Research
Institute





Our
precision-engineered surfactant platform technology, including Surfaxin, is
based on the proprietary synthetic peptide, KL4
(sinapultide), a 21 amino acid protein-like substance that closely mimics the
essential human lung protein SP-B.  This technology was invented at
The Scripps Research Institute (Scripps) and was exclusively licensed to and
further developed by Johnson & Johnson.  We have received an
exclusive, worldwide license and sublicense from Johnson & Johnson and its
wholly-owned subsidiary, Ortho Pharmaceutical Corporation, for, and have rights
to, a series of over 30 patents and patent filings (worldwide) which are
important, either individually or collectively, to our strategy for
commercializing our precision-engineered surfactant technology for the
diagnosis, prevention and treatment of disease.  The license and
sublicense give us the exclusive rights to such patents for the life of the
patents.





Patents
covering our proprietary precision-engineered surfactant technology that have
been issued or are pending worldwide include composition of matter, formulation,
manufacturing and uses, including the pulmonary lavage, or “lung wash”
techniques.  Our most significant patent rights principally consist of
seven issued United States patents: U.S. Patent No. 5,164,369; U.S. Patent No.
5,260,273; U.S. Patent No. 5,407,914; U.S. Patent No. 5,789,381; U.S. Patent No.
5,952,303; U.S. Patent No. 6,013,619; and U.S. Patent No. 6, 613,734 (along with
certain corresponding issued and pending foreign counterparts).  These
patents relate to precision-engineered pulmonary surfactants (including
Surfaxin), certain related peptides (amino acid protein-like substances) and
compositions, methods of treating respiratory distress syndromes with these
surfactants and compositions, and our proprietary pulmonary lavage method of
treating RDS with these surfactants.





Our
licensed patent estate also includes United States and foreign patents and
applications that relate to methods of manufacturing Surfaxin and certain
peptides that may be used in the manufacture of Surfaxin, and
other aspects of our precision-engineered surfactant
technology.  These patents include U.S. Patent No. 5,748,891; U.S.
Patent No. 5,952,303, U.S. Patent No. 6,013,764; U.S. Patent No. 6,120,795; and
U.S. Patent No. 6,492,490 (along with certain corresponding issued and pending
foreign counterparts).





U.S.
Patent No. 5,164,369; U.S. Patent No. 5,260,273; U.S. Patent No. 5,789,381 and
U.S. Patent No. 6, 613,734 have expired on November 17,
2009.   The patent term of U.S. Patent No. 5,407,914 has been
extended until November 17, 2010 with further extensions potentially available
until November 17, 2014.  European counterparts of these patents will
expire in June 2012. U.S. Patent No. 5,952,303 will expire on March
29, 2017.  U.S. Patent No. 5,748,891 will expire on October 22,
2016.  U.S. Patent No. 6,013,764 will expire on June 25,
2017.  U.S. Patent No. 6,120,795 will expire on March 4,
2017.  U.S. Patent No. 6,492,490 will expire on June 25,
2017.





We also
have licensed certain pending patent applications that relate to combination
therapies of pulmonary surfactant and other drugs, and methods of
use.  These patent applications are pending in the United States and a
number of foreign jurisdictions, including Canada, Europe and
Japan.





OurKL4- RelatedPatents and Patent
Rights





We have
been active in seeking patent protection for our innovations relating to new
formulations and methods of manufacturing and delivering synthetic peptide
containing pulmonary surfactants.  Our patent activities have focused
particularly on improved formulations and delivery of aerosolized pulmonary
surfactant.





In
November 2005, we filed U.S. and International patent applications
(US 11/274,701 which is now U.S. Patent No. 7,582,312 issued on September
1, 2009 and PCT US/2005/041281, now expired), directed to lyophilized
formulations of sinapultide pulmonary surfactants and methods of
manufacture.





In
December 2005, we filed U.S. and International patent applications (US
11/316,308 and PCT US/2005/046862), directed to sinapultide pulmonary surfactant
formulations having improved viscosity characteristics, aerosolization capacity
and storage stability.


20





In
January 2006, we filed U.S. and International patent applications (US 11/326,885
which is now U.S. Patent No 7,541,331 issued on June 2, 2009  and
PCT/US06/000308, now expired), directed to a surfactant treatment regimen for
BPD.





Each of
the above-listed PCT applications has been filed nationally in Europe and Japan,
among other countries.





In
September 2007, we filed U.S. and International patent applications (US
11/901,866 and PCT US/2007/020260, now expired) directed to surfactant
compositions and methods of promoting mucus clearance and treating pulmonary
disorders such as cystic fibrosis.





In March
2009, we filed International patent application (PCT US/2009/037409) directed to
improvements of aerosol delivery system and ventilation circuit
adaptor.





Philip Morris USA Inc. andPhilip Morris
Products S.A.





In March
2008, we restructured our December 2005 strategic alliance with Philip Morris
USA Inc. (PMUSA), d/b/a Chrysalis Technologies (Chrysalis), and assumed full
responsibility from Chrysalis for the further development of the capillary
aerosolization technology, including finalizing design development for the
initial prototype aerosolization device platform and disposable dose
packets.  In connection with the restructuring, we restated our prior
agreement as of March 28, 2008 and entered into an Amended and Restated License
Agreement with PMUSA with respect to the United States (U.S. License
Agreement), and, as PMUSA had assigned to Philip Morris Products S.A. (PMPSA)
all rights in and to the capillary aerosolization technology outside of the
United States (International Rights), effective on the same date, we entered
into a License Agreement with PMPSA with respect to the International Rights
(International License Agreement) on substantially the same terms and conditions
as the U.S. License Agreement.  We currently hold exclusive licenses
to the capillary aerosolization technology both in and outside of the United
States for use with pulmonary surfactants (alone or in combination with any
other pharmaceutical compound(s)) for all respiratory diseases and conditions
(the foregoing uses in each territory, the Exclusive Field).  In
addition, under the U.S. License Agreement, our license to use the capillary
aerosolization technology includes other (non-surfactant) drugs to treat a wide
range of pediatric and adult respiratory indications in hospitals and other
health care institutions.





As part
of the restructuring, Chrysalis completed a technology transfer, provided
development support to us through June 30, 2008, and also paid us
$4.5 million to support our future development activities.  We
are obligated to pay royalties at a rate equal to a low single-digit percent of
sales of products sold in the Exclusive Field in the territories.  In
connection with exclusive undertakings of PMUSA and PMPSA not to exploit the
capillary aerosolization technology for all licensed uses, we are obligated to
pay royalties on all product sales, including sales of aerosol devices and
related components that are not based on the capillary aerosolization
technology; provided, however, that no royalties are payable to the extent that
we exercise our right to terminate the license with respect to a specific
indication.  We also agreed in the future to pay minimum royalties,
but are entitled to a reduction of future royalties in an amount equal to the
excess of any minimum royalty paid over royalties actually earned in prior
periods.





Capillary Aerosolization
Technology Patents and Patent Rights





Under our
license agreements with PMUSA and PMPSA, we hold exclusive licenses to the
capillary aerosolization technology for use with pulmonary
surfactants  (alone or in combination with any other pharmaceutical
compound(s)) for all respiratory diseases.  Under the U.S.
License Agreement, our license to use the capillary aerosolization technology
includes other (non-surfactant) drugs to treat a wide range of pediatric and
adult respiratory indications in hospitals and other health care
institutions. The aerosolization technology patents expire on various dates
beginning in May 2016 and ending in 2023, or, in some cases, possibly
later. Our license will expire as to each licensed product in a each
country on the latest of: (a) the 10th
anniversary of the date of the first commercial sale in such country; (b) the
date on which the sale of such licensed product ceases to be covered by a valid
patent claim in such country, or (c) the date a generic form of the product
is introduced in such country.  The license agreements provide for
monitoring inventions and seeking patent protection for innovations related to
both capillary aerosolization technology and our surfactant
technology.  Our license rights extend to innovations to the capillary
aerosolization technology that are made under the license
agreements.  With these proprietary rights, we believe that our
aerosolized KL4 surfactant
can be developed to potentially address a broad range of serious respiratory
conditions.


21





See,“Item 1A – Risk Factors
– If we cannot protect our intellectual property, other companies could use our
technology in competitive products.  Even if we obtain patents to
protect our products, those patents may not be sufficiently broad or they may
expire and others could then compete with us”; “ – Intellectual property rights
of third parties could limit our ability to develop and market our products”;
and “ – If we cannot meet requirements under our license agreements, we could
lose the rights to our products.”





Other
Regulatory Designations





New Drug Product
Exclusivity





KL4
(sinapultide), our proprietary peptide that serves as the important base of our
precision-engineered surfactant platform technology, including Surfaxin, is a
new chemical entity.  Upon approval, Surfaxin is expected to receive
either five years or three years of marketing exclusivity depending on FDA’s
determination whether Surfaxin drug product qualifies for new chemical entity
exclusivity or supplemental exclusivity, respectively.





Orphan Drug and Orphan
Medicinal Product Designations





“Orphan
Drugs” are pharmaceutical products that are intended to treat diseases affecting
fewer than 200,000 patients in the United States.  The Office of
Orphan Product Development of the FDA grants certain advantages to the sponsors
of Orphan Drugs including, but not limited to, seven years of market exclusivity
upon approval of the drug, certain tax incentives for clinical research and
grants to fund testing of the drug.  The FDA has granted Orphan Drug
designation for Surfaxin for the treatment of RDS in premature
infants.  However, as our proposed indication for Surfaxin is for the
prevention, rather than treatment, of RDS, it is not certain whether the FDA
will apply this regulatory exclusivity to our proposed initial indication for
Surfaxin.  Accordingly, we are in the process of applying to the FDA
to amend this exclusivity designation to include the prevention
indication.  Alternatively, as we believe that in the context of
neonatal RDS, prevention and treatment are nearly identical, we plan to request
a meeting with the FDA following approval of Surfaxin, if approved, to clarify
the application of this designation to Surfaxin.  The FDA has also
granted Orphan Drug designation to (i) Surfaxin for the prevention of BPD in
premature infants, (ii) Surfaxin for the treatment of BPD in premature infants,
(iii) Surfaxin for the treatment of Meconium Aspiration Syndrome (MAS), and (iv)
our KL4 surfactant
for the treatment of ARDS in adults.





Similarly,
the Commission of the European Communities grants “Orphan Medicinal Product”
designation, which provides for exclusive marketing rights for indications in
Europe for 10 years (subject to revision after six years) following marketing
approval by the EMEA.  In addition, the designation would enable us to
receive regulatory assistance in the further development process, and to access
reduced regulatory fees throughout its marketing life. We have received
Orphan Medicinal Product designation for (i) Surfaxin for the prevention and
treatment of RDS in premature infants (ii) Surfaxin for the treatment of MAS in
newborn infants, and (ii) our KL4 surfactant
for the treatment of ALI in adults (which in this circumstance encompasses
ARDS).





Fast Track
Designations





Designation
as a “Fast Track” product means that the FDA has determined that the drug is
intended for the treatment of a serious or life-threatening condition and
demonstrates the potential to address unmet medical needs, and that the FDA will
facilitate and expedite the development and review of the application for the
approval of the product.  The FDA generally will review an NDA for a
drug granted Fast Track designation within six months.





The FDA
has granted “Fast Track” designation for (i) Surfaxin for the treatment and
prevention of BPD in premature infants, and (ii) our KL4 surfactant
for the treatment of ARDS in adults.


22





COMPETITION





We are
engaged in highly competitive fields of pharmaceutical research and development.
Competition from numerous existing companies and others entering the fields in
which we operate is intense and expected to increase. We expect to compete with,
among others, conventional pharmaceutical companies. Most of these companies
have substantially greater research and development, manufacturing, marketing,
financial, technological personnel and managerial resources than we do.
Acquisitions of competing companies by large pharmaceutical or health care
companies could further enhance such competitors’ financial, marketing and other
resources. Moreover, competitors that are able to complete clinical trials,
obtain required regulatory approvals and commence commercial sales of their
products before we do may enjoy a significant competitive advantage over us.
There are also existing therapies that may compete with the products we are
developing. See,“Item
1A – Risk Factors – Our industry is highly competitive and we have less capital
and resources than many of our competitors, which may give them an advantage in
developing and marketing products similar to ours or make our products
obsolete.”





Currently,
the FDA has approved surfactants as replacement therapy only for the prevention
and treatment of RDS in premature infants. The most commonly used of these
approved surfactants are Curosurf®(poractant
alfa), which is derived from a chemical extraction porcine (pig) lung, and
Survanta® (beractant),
which is derived from a chemical extraction process of bovine (cow)
lung.  Curosurf is marketed in Europe by Chiesi Farmaceutici S.p.A.,
and in the United States by Cornerstone Therapeutics Inc.  Survanta is
marketed by the Abbott Nutritionals, Inc.  ONY, Inc.
markets  Infasurf®, a
surfactant derived from calf lung surfactant extract in the United
States.  The only approved synthetic surfactant available in the
United States was Exosurf®;
however, this product does not contain any surfactant proteins and the
manufacturer, GlaxoSmithKline, plc., has discontinued marketing this
product.





GOVERNMENT
REGULATION





The
development, manufacture, distribution, marketing and advertising of drug
products are subject to extensive regulation by federal, state and local
governmental authorities in the United States, including the FDA, and by similar
agencies in other countries.  Any product that we develop must receive
all relevant regulatory approvals or clearances before it may be marketed in a
particular country.  Gaining regulatory approval of a drug product
candidate requires the expenditure of substantial resources over an extended
period of time.  As a result, larger companies with greater financial
resources will likely have a competitive advantage over us.





Development
Activities:  To gain regulatory approval of our KL4 surfactant
technology pipeline products, we must demonstrate, through experiments,
preclinical studies and clinical trials that each of our drug product candidates
meets the safety and efficacy standards established by the FDA and other
international regulatory authorities.  In addition, we and our
suppliers and contract manufacturers must demonstrate that all
development-related laboratory, clinical and manufacturing practices comply with
regulations of the FDA, other international regulators and local
regulators.  Regulations establish standards for such things as drug
substances, materials and excipients; medical device components, subassemblies
and device manufacture; drug manufacturing operations and facilities and
analytical laboratories and medical device development laboratories processes
and environments; in each instance, in connection with research, development,
testing, manufacture, quality control, labeling, storage, record keeping,
approval, advertising and promotion, and distribution of product candidates, on
a product-by-product basis.  See,“Item 1A – Risk Factors
– The regulatory approval process for our products is expensive and
time-consuming and the outcome is uncertain.  We may not obtain
required regulatory approvals for the commercialization of our
products.”





Pre-clinical Studies and
Clinical Trials:  Development testing generally begins with
laboratory testing and experiments, as well as research studies using animal
models to obtain preliminary information on a product’s efficacy and to identify
any safety issues.  The results of these studies are compiled along
with other information in an investigational new drug (IND) application, which
is filed with the FDA.  After resolving any questions raised by the
FDA, which may involve additional testing and animal studies, clinical trials
may begin.  Regulatory agencies in other countries generally require a
Clinical Trial Application (CTA) to be submitted and approved before each trial
can commence in each country.


23





Clinical
trials normally are conducted in three sequential phases and may take a number
of years to complete.  Phase 1 consists of testing the drug
product in a small number of humans, normally healthy volunteers, to determine
preliminary safety and tolerable dose range.  Phase 2 usually
involves studies in a limited patient population to evaluate the effectiveness
of the drug product in humans having the disease or medical condition for which
the product is indicated, determine dosage tolerance and optimal dosage and
identify possible common adverse effects and safety
risks.  Phase 3 consists of additional controlled testing at
multiple clinical sites to establish clinical safety and effectiveness in an
expanded patient population of geographically dispersed test sites to evaluate
the overall benefit-risk relationship for administering the product and to
provide an adequate basis for product labeling.  Phase 4 clinical
trials may be conducted after approval to gain additional experience from the
treatment of patients in the intended therapeutic indication.





The
conduct of clinical trials are subject to stringent medical and regulatory
requirements.  The time and expense required to establish clinical
sites, provide training and materials, establish communications channels and
monitor a trial over a long period of time is substantial.  The
conduct of clinical trials at institutions located around the world is subject
to foreign regulatory requirements governing human clinical trials, which vary
widely from country to country.  Delays or terminations of clinical
trials could result from a number of factors, including stringent enrollment
criteria, slow rate of enrollment, size of patient population, having to compete
with other clinical trials for eligible patients, geographical considerations
and others.  Clinical trials are monitored by the regulatory agencies
as well as medical advisory and standards boards, which could determine at any
time to reevaluate, alter, suspend, or terminate a trial based upon accumulated
data, including data concerning the occurrence of adverse health events during
or related to the treatment of patients enrolled in the trial, and the
regulator’s or monitor’s risk/benefit assessment with respect to patients
enrolled in the trial.  If they occur, such delays or suspensions
could have a material impact on our KL4 surfactant
technology development programs.  See,“Item 1A–Risk Factors
– Our research and development activities involve significant risks and
uncertainties that are inherent in the clinical development and regulatory
approval processes”,  and “–Our ongoing clinical trials may be
delayed, or fail, which will harm our business.”





Regulatory
Review:  The results of preclinical and clinical trials are
submitted to the FDA in an NDA, with comparable filings submitted to other
international regulators.  After the initial submission, the FDA has a
period of time in which it must determine if the NDA is complete.  If
an NDA is accepted for filing, following the FDA’s review, the FDA may grant
marketing approval, request additional information, or deny the application if
it determines that the application does not provide an adequate basis for
approval.  If the FDA grants approval, the approval may be conditioned
upon the conduct of post-marketing clinical trials or other studies to confirm
the product’s safety and efficacy for its intended use.  Until the FDA
has issued its approval, no marketing activities can be conducted in the United
States.  Similar regulations apply in other countries.





After an
NDA is submitted, although the statutory period provided for the FDA’s review is
less than one year, dealing with questions or concerns of the agency and, taking
into account the statutory timelines governing such communications, may result
in review periods that can take several years.  For example, the FDA
has issued to us three Approvable Letters and a Complete Response Letter,
indicating that our Surfaxin drug product may be approved if we satisfy certain
conditions.  Although in many cases applicants are required to
consider additional clinical trials, which may have the effect of termination a
development program, the approvable letters and the Complete Response Letter
that we received did not require additional clinical trials demonstrating safety
and efficacy.  Our development programs have, however, been
substantially delayed as the FDA has required us to develop additional data to
respond to the issues it has raised.





Manufacturing
Standards:  The FDA and other international regulators
establish standards and routinely inspect facilities and equipment, analytical
and quality laboratories and processes used in the manufacturing and monitoring
of products.  Prior to granting approval of a drug product, the agency
will conduct a pre-approval inspection of the manufacturing facilities, and the
facilities of suppliers, to determine that the drug product is manufactured in
accordance with cGMP regulations and product specifications. Following
approval, the FDA will conduct periodic inspections.  If, in
connection with a facility inspection, the FDA determines that a manufacturer
does not comply with cGMP, the FDA will issue an inspection report citing the
potential violations and may seek a range of remedies, from administrative
sanctions, including the suspension of our manufacturing operations, to seeking
civil or criminal penalties.  In March 2008, the FDA completed a
pre-approval inspection of our manufacturing facility in Totowa and issued an
Establishment Inspection Report (EIR) indicating an approval recommendation for
our Surfaxin NDA.  The FDA may determine to re-inspect our Totowa
facility or our laboratory facilities located at Warrington, Pennsylvania, at
any time. See,“Item 1A – Risk Factors – The manufacture of our drug products is a
highly exacting and complex process, and if we, our contract manufacturers or
any of our materials suppliers encounter problems manufacturing our products or
the drug substances used to make our products, this could potentially cause us
to delay development or clinical programs or, following approval, product
launch, or cause us to experience shortages of products
inventories.”


24







International
Approvals:  If we
succeed in gaining regulatory approval to market our products in the United
States, we will still need to apply for approval with other international
regulators.  Regulatory requirements and approval processes are similar in
approach to that of the United States.  With certain exceptions,althoughthe approval of the FDA carries
considerable weight, international regulators are not boundbythe findings of the FDAandthere is a risk that foreign regulators
will not accept a clinical trial design or may require additional data or other
information not requested by the FDA.  In Europe, there is a centralized
procedureavailableunder which the EMEA will
conduct the application review and recommend marketing approval to the European
Commission, or not, for the sale of drug products in the EU
countries.





Post-approval
Regulation:  Following the grant of
marketing approval, the FDA
regulates the marketing and promotion of drug products.  Promotional claims
are generally limited to the information provided in the product package insert
for each drug product, which is negotiated with the FDA during the NDA review
process.  In addition, the FDA enforces regulations designed to guard
against conflicts of interest, misleading advertising and improper compensation
of prescribing physicians.  The FDA will review, among other things,
direct-to-consumer advertising, prescriber-directed advertising and promotional
materials, sales representative communications to healthcare professionals,
promotional programming and promotional activities on the Internet.  The
FDA will also  monitor scientific and educational activities.  If
the FDA determines that a company has promoted a product for an unapproved use
(“off-label”), or engaged in other violations, it may issue a regulatory letter
and may require corrective advertising or other corrective communications to
healthcare professionals.  Enforcement actions may also potentially include
product seizures, injunctions and civil or criminal penalties.  The
consequences of such an action and the related adverse publicity could have a
material adverse effect on a developer’s ability to market its drug and its
business as a whole.





Following approval,the FDA and other international
regulators will continue to monitor data to assess the safety and efficacy of an
approved drug.  A post-approval discovery of previously unknown problems or
failure to comply with the applicable regulatory requirements may result in
restrictions on the marketing of a product or a recall or withdrawal of the
product from the market, as well as possible civil or criminal sanctions. 
Similar oversight is provided by international regulators.





Combination
drug-device products. 
Combination drug products, such as our aerosolizedKL4surfactant, which consists of our proprietaryKL4surfactantadministered through our novel
capillary aerosolization systems, are similarly subject to extensive regulation
by federal, state and local governmental authorities in the United States and in
other countries.  Combination products involve review of two or more
regulated components that might normally be reviewed by regulatory authorities
having different expertise and may involve more complicated and time-consuming
regulatory coordination, approvals and clearances than a drug product
alone.  In the United States, our aerosolizedKL4surfactantcombination drug-device product will be
reviewed by the Center for Drug Evaluation and Research (CDER) of the FDA, with
input from the division that approves medical devices.  Among other things,
we will have to demonstrate compliance with both cGMP, to ensure that the drug
possesses adequate strength, quality, identity and purity, and applicable
Quality System (QS) regulations, to ensure that the device is in compliance with
applicable performance standards.  Although cGMP and QS overlap in many
respects, each is tailored to the particular characteristics of the types of
products to which they apply, such that compliance with both cGMP and QS may
present unique problems and manufacturing challenges.




None of
our products under development has been approved for marketing in the United
States or elsewhere. We may not be able to obtain regulatory approval for any of
our products under development. If we do not obtain the requisite governmental
approvals or if we fail to obtain approvals of the scope we request, we or our
licensees or strategic alliance or marketing partners may be delayed or
precluded entirely from marketing our products, or the commercial use of our
products may be limited. Such events would have a material adverse effect on our
business, financial condition and results of operations. See, “Item 1A – Risk
Factors – Our technology platform is based solely on our proprietary KL4
surfactant technology and capillary aerosolization technology”; “ – Our research
and development activities involve significant risks and uncertainties that are
inherent in the clinical development and regulatory approval processes”, “– Our
ongoing clinical trials may be delayed, or fail, which will harm our business”,
“–We may not successfully develop and market our products, and even if we do, we
may not become profitable,” and “ – The regulatory approval process for our
products is expensive and time-consuming and the outcome is uncertain. We may
not obtain required regulatory approvals for the commercialization of our
products,” and “ – Even assuming that we gain regulatory approval to market our
drugs, if the FDA and foreign regulators later withdraw their approval or
otherwise restrict marketing, our business would be materially
harmed.”


25




Certain
of our product candidates may qualify for Fast Track and/or Orphan Drug
designation.  Fast Track designation means that the FDA has determined that
the drug is intended to treat a serious or life-threatening condition and
demonstrates the potential to address unmet medical needs.  An important
feature is that it provides for accelerated approval and the possibility of
rolling submissions and emphasizes the critical nature of close, early
communication between the FDA and sponsor to improve the efficiency of product
development.  The FDA generally will review an NDA for a drug granted Fast
Track designation within six months instead of the typical one to three
years.  Orphan Drug designation is granted to pharmaceutical products that
are intended to treat diseases affecting fewer than 200,000 patients in the
United States and provides certain advantages to the Orphan Drugs sponsors,
including, but not limited to, seven years of market exclusivity upon approval
of the drug, certain tax incentives for clinical research and grants to fund
testing of the drugs. See,“Item 1A – Risk
Factors – Even though some of our product candidates have qualified for
expedited review, the FDA may not approve them at all or any sooner than other
product candidates that do not qualify for expedited review,” and  “–
Licensing, Patents and Other Proprietary Rights and Regulatory Designations
–Patents and
Proprietary Rights.”




EMPLOYEES




As of
March 1, 2010, we have approximately 77 full-time employees, all employed in the
United States.  In connection with our manufacturing operations in Totowa,
New Jersey, we have 15 employees subject to a collective bargaining arrangement
which expires on December 3, 2010.
  As of
December 31, 2009, we had employment agreements with 12 officers that expire in
May 2010.  These agreements provide for automatic one-year renewal at the
end of each term, unless otherwise terminated by either party.  In February
2010, we provided notice of non-renewal with respect to all but the agreements
that we maintain with the
following officers: Chief Financial Officer, General Counsel, and the senior
officers in charge of Manufacturing, Corporate Development, and Human Resources.The employment of the officers whose agreements will not be renewed were
not terminated and they will remain as at-will employees and, in lieu of the
benefits provided under their employment agreements, will be entitled to certain
severance benefits. The loss
of services from these executives could significantly adversely affect our
ability to develop and market our products and obtain necessary regulatory
approvals. See,
“Item 1A – Risk Factors – We depend upon key employees and consultants in a
competitive market for skilled personnel.  If we are unable to attract and
retain key personnel, it could adversely affect our ability to develop and
market our products.”




AVAILABLE
INFORMATION





We file annual, quarterly and current
reports, proxy statements and other information with the Securities and Exchange
Commission.  You may read and copy anymaterials thatwe file with theSEC at the SEC’s Public Reference Room
at 100 FStreet,
N.E., Washington, D.C.
20549.  You may obtain information on the operation of the Public Reference
Room by calling the SEC at 1-800-SEC-0330.  Many of our SECfilings are also available to the public
from theSEC’s website at
“http://www.sec.gov.”  We make available for download free of charge
through our website our annual report on Form 10-K, our quarterly reports on
Form 10-Q and current reports on Form 8-K, and amendments to those reports filed
or furnished pursuant to Section 13(a) or 15(d) the Exchange Act as soon as
reasonably practicable after we have filed it electronically with, or furnished
it to, the SEC.





We maintain a website at
“http://www.DiscoveryLabs.com”.  Our website and the information contained
therein or connected thereto are not incorporated into this Annual Report on
Form 10-K.


26


ITEM 1A.
            RISK FACTORS.





You should carefully consider the
following risks and any of the other information set forth in this Annual Report
onForm 10-K and in the
documents incorporated herein by reference, before deciding to invest in shares
of our common stock.  The risks described below are not the only ones that
we face.  Additional risks not presently known to us or that we currently
deemimmaterial may also impair our business
operations.  The following risks, among others, could cause our actual
results, performance, achievements or industry results to differ materially from
those expressed in our forward-looking statements contained herein and presented elsewhere by management
from time to time.  If any of the following risks actually occurs, our
businessprospects, financial
condition or results of operationscould be materially harmed.In such case, the market price of our
common stockwould likely
decline due to the occurrence of any of these risks, and youcouldlose all or part of your
investment.





We may notsuccessfully develop and market our
products, and even if we do, we may not become profitable.





We currently have no productsapproved for marketing and
sale and are conducting research and development on our product
candidates.  As a result, we have not begun to market or generate revenues
from the commercialization of any of our products.  Our long-term viability
will be impaired if we are unable to obtain regulatory
approval for, or successfully market, our product candidates.  Even if we
successfully develop and gain regulatory approval for our products, we still may
not generate sufficient or sustainable revenues or we may not becomeprofitable.





To date, we have generated revenues
primarily from investments, research grants and collaboration agreements. 
We need to continue to engage in significant, time-consuming and costly
research, development, pre-clinical studies, clinical testing and regulatory approval
activities for our products under development beforewe can commercialize them.  In addition,after making significant investments,
the development,pre-clinical or clinical studies may
show that our products are not effective or safe for one or more of their
intended uses.  We may fail in the development and commercialization of our
products.





As of December 31, 2009, we have an accumulated deficit of
approximately $357.6million and we expect to continue to
incur significant
increasing operating losses over the next severalyears.As a result of our financial position as
of December 31, 2009, the audit opinion we received from our independent
auditors, which is included in our financial statements in this report,
contained a notation
related to ourability to
continue as a going concern, which contemplates the realization of assets
and satisfaction of liabilities in the normal course of business.  Our
ability to continue as a going concern is dependent on our ability to raise
additional capital, to fund our research and development and commercial programs
and meet our obligations on a timely basis.  If we are unable to
successfully raise sufficient additional capital, through strategic alliances
and other financing alternatives, we will likely not have sufficient cash flow
and liquidity to fund our business operations, forcing us to curtail our
activities and, ultimately, potentially cease operations.  Even if we are
able to raise additional capital, such financings may only be available on
unattractive terms, or could result in significant dilution of stockholders’
interests and, in such event, the market price of our common stock may
decline.





In
addition, we may face significant challenges if conditions in the global
financial markets do not significantly improve, including an inability to access
the capital markets at a time when we would like or require, and an increased
cost of capital.  Except for our CEFFs (which are subject to certain
limitations), we currently do not have arrangements to obtain additional
financing.  Any such financing could be difficult to obtain or only
available on unattractive terms and could result in significant dilution of
stockholders’ interests.  In any such event, the market price of our common
stock may decline.  In addition, failure to secure any necessary financing
in a timely manner and on favorable terms could have a material adverse effect
on our business plan, financial performance and stock price and could delay new
product development and clinical trial plans.





The regulatoryapproval process for our products is
expensive and time-consuming and the outcome is uncertain.  We may not
obtain required regulatory approvals for the commercialization of our
products.





Totest, make and sellour products under development,
including Surfaxin, we must receive regulatory approvals for each product. 
The FDA and foreign regulators, such as the EMEA, extensively and rigorously
regulate the testing, manufacture, distribution, advertising,
pricingand marketing of drug products. 
This approval process includes (i) preclinical studies and clinical trials
of each drug product candidate andactive pharmaceutical
ingredientto establishitssafety and effectiveness, and (ii)
confirmation by the FDA andforeign regulators that we maintain good
laboratory and manufacturing practices during testing and manufacturing. 
Even if favorable data are generated by clinical trials, the FDA or foreign
regulator may not accept or approve an NDA or MAA filed fora drugproducton a timely basis or at all.


27





In particular, we filed an NDA with the FDA for Surfaxin
for the prevention of RDS in premature infants.OnApril 17, 2009,we received aComplete Response Letterfor this NDA.We met with the FDA in June 2009 and
September 2009 to discuss proposals for resolving the sole remaining issue
regarding our BAT.We arecurrentlydeveloping a comprehensive preclinical
program that will consist of a series of prospectively-designed, side-by-side
preclinical studies employing an optimized and revalidatedBATand the well-established preterm lamb
model of RDS.See,“Item 1 – Business – Surfactant
Replacement Therapy for Respiratory Medicine –Respiratory Distress Syndrome in
Premature Infants (RDS)–Surfaxin for the Prevention
of RDS in Premature Infants.”The FDA indicated that to gain approval
of Surfaxin, data generated from the preterm lamb model and BAT studies must
demonstrate, in a point-to-point analysis, the same relative changes in
respiratory compliance betweenboth models over time.  Even if our
current efforts to optimize and revalidate the BAT are successful, we may not
succeed with our side-by-side studies or, even if we do succeed with our
side-by-side studies, the FDA may not accept the results or may interpret the data in a different manner such
that, ultimately, the FDA may not approve Surfaxin for RDS in premature
infants.Any failure
to secure FDA approval or further delay associated with the FDA’s review processwith respect to Surfaxincould potentially delay or prevent the approval of our
other products and would have a material adverse effect on our
business.





Even assuming that we gain regulatory
approval to market our drugs, if the FDA and foreign regulatorslater withdraw their approval or
otherwise restrict
marketing, our business would be materially harmed.





The FDA and foreign regulators have not
yet approved any of our products under development for marketing in the United
States or elsewhere.Without regulatory approval, we will not
be able to market our
products.Even if we were to succeed in gaining
regulatory approvals for any of our products, the FDA or a foreign regulator
could at any time withdraw any approvals granted if there is a later discovery
of previously unidentified problems orif we fail to comply with other
applicable regulatory requirements at any stage in the regulatory process, or
the FDA or a foreign regulator may restrict or delay our marketing of a product
or force us to make product recalls.  In addition, the FDA couldimpose other sanctions such as fines,
injunctions, civil penalties or criminal prosecutions.  Any withdrawalof our regulatory approvalor significant restriction
on our ability to market our products after approval would have a material
adverse effect on our
business.





The
April 2009 Complete Response Letter and the resulting delay in our gaining
approval of Surfaxin have caused us to make fundamental changes in our business
strategy, which now focuses on securing strategic alliances, and take additional
steps to conserve our financial resources, which may subject us to unanticipated
risks and uncertainties.





Following
receipt of the April 2009 Complete Response Letter from the FDA, to conserve our
cash resources, we implemented cost containment measures and reduced our
workforce.





Because
of the delay in our gaining approval of Surfaxin, we also made fundamental
changes in our business strategy.  To secure capital and develop and, if
approved, commercialize our KL4 surfactant
pipeline programs and products, we are now seeking to enter into strategic
alliances, development agreements or other collaboration arrangements in all
markets, including the United States, and are reviewing various otherfinancial alternatives that would
provide infusions of capitaland other resourcesneeded to advance our KL4respiratory pipeline
programsand meet our
capital requirements, including potentially satisfying our loan with
Quintiles, and continue our operations.  Although we are consideringseveral potential opportunities, there
can be no assurance that any strategic alliance or other financing alternatives
will be successfully concluded.





Assuming
that we are able to identify strategic partners andsecure such strategic
alliances, our ability to execute our current operating plan will be dependent
on numerous factors, including, the performance of third-party strategic
partners and collaborators with whom we may contract.  Under these
arrangements, our partners may control key decisions relating to the
development, and assuming approval, commercialization, of our products. 
The rights of our partners would limit our flexibility in considering
development strategies and in the alternatives for the commercialization of our
products.  In addition, if we breach or terminate our strategic alliance
agreements or if our strategic partners otherwise fail to conduct their
activities in a timely manner, or if there is a dispute about our respective
obligations, we may need to seek other partners or we may have to develop our
own internal sales and marketing capabilities to commercialize our products in
the United States.  If we fail to successfully develop these relationships,
or if we or our partners fail to successfully develop or commercialize any of
our products, it may delay or prevent us from developing or commercializing our
products in a competitive and timely manner and would have a material adverse
effect on the commercialization of our products.


28





For
example, our collaboration
arrangement with Esteve for Surfaxin and certain other of our drug product candidates
is focused on key southern European markets.  If we or Esteve should fail
to conduct our respective collaboration-related activities in a timely manner,
or otherwise breach or terminate the agreements that make up ourcollaboration arrangements, or if a
dispute should arise under our collaboration arrangements, such events could
impair our ability to commercialize or develop our products for the Esteve
territory in Europe.  Inthatevent, we may need to seek other
partners and collaborationarrangement, or we may have to develop our own
internal capabilities to market the covered products in the Esteve territory
without a collaboration arrangement.





As we
continue to manage our cash resources and work towards securing potential
strategic alliances, wehave also
reassessed the level of investment and the pace of our research and development
programs, including for Aerosurf, BPD, ARF and new formulations of ourKL4surfactant, including Surfaxin
LS.  Reductions in
investment will cause us to
experience delays in the progress of some of our programs.Also, as
we reassess our regulatory position and financial resources, at any time
we may implement additional and potentially significant changes to our
development plans and our operations as we seek to strengthen our financial and
operational position.  Such changes, if adopted, could prove to be
disruptive and detrimental to our development programs.  Moreover, consideration and planning of
such strategic changes diverts management’s attention and other resources from
day-to-day operations, which may subject us to further risks and
uncertainties.





Even thoughsome of our product candidates have
qualified for expedited review, the FDA may not approve them at all or any
sooner than other product
candidates that do not qualify for expedited review.





The FDA has notified us that two of our
intended indications of ourKL4surfactant technologypipeline, BPD in premature infants and ARDS in
adults, have been granted designation as “Fast Track”products under provisions of the Food
and Drug Administration Modernization Act of 1997.  We believe that other
potential products in ourKL4surfactant technologypipeline may also qualify for Fast
Track designation.  Fast Track designation does not accelerate clinical trials nor
does it mean that the regulatory requirements are less stringent.  Our
products may cease to qualify for expedited review and our other product
candidates may fail to qualify for Fast Track designation or expedited
review.  Moreover, even if we are
successful in gaining Fast Track designation, other factors could result in
significant delays in our development activities with respect to our Fast Track
products.





Our research anddevelopment activities involve
significantrisks and
uncertainties that are inherent in the clinical development and regulatory
approval processes.





Development risk factors include, but
are not limited to,whether we, or our third-party
collaborators, drug substances and materials suppliers and third-party contract
manufacturers, will be able to:





·
            complete our pre-clinical and
      clinical trials of ourKL4surfactantproduct candidates with
      scientific results that are sufficient to support further development and
      regulatory approval;


·
            receive the necessary regulatory
      approvals;


·
            obtain adequate supplies of
      surfactant active drug substances, manufactured to our
      specifications and on commercially reasonable
  terms;


·
            perform under agreements to supply
      drug substances, medical device components and related services necessary
      to manufacture ourKL4surfactantproduct candidates, including
      Surfaxin, Surfaxin LS andAerosurf;


·
            resolve to the FDA’s satisfaction
      the matters identified in the April 2009 Complete Response Letter for
      Surfaxin for the prevention of RDS in premature
      infants;


29


·
            provide for sufficient
      manufacturing capabilities, at our manufacturing operations in Totowa and
      with third-party contract manufacturers, to produce sufficient drug
      product, including Surfaxin, Surfaxin LS and capillary aerosolization
      systems to meet our pre-clinical and clinical development
      requirements;


·
            successfully implement a strategy
      for thedevelopment
      andmanufacture of
      capillary aerosolization systems and related materials to support clinical
      studies of Aerosurf; and


·
            obtain capital necessary to fund
      our research and development efforts, including our supportive operations,
      manufacturing and clinical trials
  requirements.





Because these factors, many of which are
outside our control, could have a potentially significant impact on our
development activities, the success, timing of completion and ultimate cost of
development of any of our product candidates is highly uncertain and cannot be
estimated with any degree of certainty.  The timing and cost to complete
drug trials alone may be impacted by, among other things:





·
            slow patient
      enrollment;


·
            long treatment time required to
      demonstrate effectiveness;


·
            lack of sufficient clinical
      supplies and material;


·
            adverse medical events or side
      effects in treated patients;


·
            lack of compatibility with
      complementary technologies;


·
            failure of a drug product
      candidate to demonstrate effectiveness;
  and


·
            lack of sufficient
      funds.





If we do not successfully complete
clinical trials, we will not receive regulatory approval to market ourKL4surfactantproducts.  Failure to obtain and
maintain regulatory approval and generate revenues from the sale of our products
would have a material adverse effect on our financial condition and results of
operations and likely reduce the market value of our common
stock.





Our ongoing clinicaltrials may be delayed, or fail, which will
harm our business.





Clinical trials generally take two to
five years or more to complete.  Like many biotechnology companies, even
after obtaining promising results in earlier trials or in preliminary findings
for such clinical trials,
we may suffer significant setbacks in late-stage clinical trials.  Data
obtained from clinical trials are susceptible to varying interpretations that
may delay, limit or prevent regulatory approval.  In addition, we may be
unable to enroll patients quickly enough to meet our
expectations for completing any or all of these trials.  The timing and
completion of current and planned clinical trials of our product candidates
depend on many factors, including the rate at which patients are enrolled.  Delays in patient
enrollment in clinical trials may occur, which would be likely to result in
increased costs, program delays, or both.





Patient enrollment is a function of many
factors, including:





·
            the number of clinical
      sites;


·
            the size of the patient
      population;


·
            the proximity of patients to the
      clinical sites;


·
            the eligibility and enrollment
      criteria for the study;


·
            the willingness of patients or
      their parents or guardians to participate in the clinical
      trial;


·
            the existence of
      competingclinical
      trials;


·
            the existence of alternative
      available products; and


·
            geographical and geopolitical
      considerations.





If we succeed in achieving our patient
enrollment targets, patients that enroll in our clinical trials could suffer
adverse medical events or
side effectsthat areknown, such as a decrease
in the oxygen level of the blood upon administration, or currently unknown to us.  It is also possible that the FDA
or foreign regulators could interrupt, delay or halt any one or more of our
clinical trials for any of
our product candidates.  If we or any regulator believe that trial
participants face unacceptable health risks, any one or more of our trials could
be suspended or terminated.  We also may not reach agreement with the FDA
or a foreignregulator on the design of any one or
more of the clinical studies necessary for approval.  Conditions imposed by
the FDA and foreign regulators on our clinical trials could significantly
increase the time required for completion of such clinical trials andthe costs of conducting the clinical
trials.


30





In addition to our efforts to gain
approval of Surfaxin for the prevention of RDS in premature infants, we are
currently conducting a Phase 2 clinical trial to evaluate the use of Surfaxin in
children up to two years of
age suffering from Acute Respiratory Failureand our aerosolized KL4surfactant isthe subject of an
investigator-initiatedPhase 2atrial assessing the safety,
tolerability and short-term effectivenessof aerosolized KL4surfactant inpatients withCF.We are also planning to initiate
clinical studies in support of other products in ourKL4surfactant technologypipeline.  All of these clinical
trials will be time-consuming and potentially costly.  Should we fail to
complete our clinical development programs or should such programs
yield unacceptable results, such failures would have a material adverse effect
on our business.





The manufactureof our drug products is a highly
exacting and complex process, and if we, our contract manufacturers
orany of our materials
suppliers encounter problems manufacturing our products orthedrug substancesused to make our products, this could potentially cause us to
delay development or clinical programs or, following approval, product launch,
or cause us toexperience
shortages of products inventories.





The manufacture of pharmaceutical
products requires significant expertise and compliance with strictly enforced
federal, state and foreign regulations.We, our contract manufacturers or our
materials and drug
substances suppliers may experience manufacturing or quality control problems
that could result in a failure to maintain compliance with the FDA’s cGMP requirements, or those of foreign
regulators, which is necessary to continue manufacturing our drug products, materials or drug
substances.  Otherproblems that may be encountered include:





·
            the need to make necessary
      modifications to qualify and validate a
  facility;


·
            difficulties with production and
      yields, including manufacturing and completing all required release testing on a timely
      basis to meet demand;


·
            availability of raw materials and
      supplies;


·
            quality control and
      assurance;


·
            casualty damage to a facility;and


·
            shortages of qualified
      personnel.





Such a failure could result in product
production and shipment
delays or an inability to obtain materials or drug substance
supplies.





Manufacturing or quality control
problems havein the pastoccurred and may again
occur at our Totowa, New Jersey facility, or may occur at the facilities of a
contract manufacturer
ofour drug substances and materials
suppliers.  Such problems may require potentially complex, time-consuming
and costly comprehensive investigations to determine the root causes of such
problems and may also require detailed and time-consuming remediation efforts, which can
further delay a return to normal manufacturing and production activities.Any failure by our own
manufacturing operations or by the manufacturing operations of any of our
suppliers to comply with cGMP requirements or other FDA orsimilarforeign regulatory requirements could
adversely affect our ability to manufacture our drug products, which in turn
would adversely affect our clinical research activities and our ability to
develop and gain regulatory approval to marketour drug products.





We manufacture ourowndrug productsat ourfacilityin Totowa, New Jersey.  We currently do not have a
back-up facility.  Any interruption in manufacturing operations at this
location couldresult in
shortage of drug supply for plannedpreclinical experiments andclinical trials, and, if approved,
commercial requirements for Surfaxin.  A number of factors could cause
interruptions, including:





·
            equipment malfunctions or
      failures;


·
            technology
      malfunctions;


·
            work stoppages or
      slowdowns;


31


·
            damage to or destruction of the
      facility;


·
            regional power shortages;
      and


·
            product
      tampering.





To assure adequate drug supplies and
continued compliance with
cGMP and other FDA or foreign regulatory requirements, we own certain
specialized manufacturing equipment, employ experienced manufacturing senior
executive and managerial personnel, and continue to investin enhanced quality systems and
manufacturing capabilities.  However, we do not have
fully-redundant systems and equipment to respond promptly in the event of a
significant loss at our manufacturing operations.  We may under certain
conditions be unable to produce Surfaxin and our otherKL4surfactantproduct candidates at the required
volumes or to appropriate standards, if at all.  If we are unable to
successfully develop and maintain our manufacturing capabilities and at all
times comply with cGMP, it will adversely affect our clinical development
activities and, potentially, the sales of
our products, if approved.





If we fail toidentify ormaintain relationships with our
manufacturers, assemblers and integrator of our capillary aerosolization
systemsor
subcomponents,the timeline
of our plans for the development and, if approved, commercialization of Aerosurf
could suffer.





In connection with the development ofthe drug-device combinationaerosol formulation of ourKL4surfactant technology, including Aerosurf, we currently plan to rely on
third-party contract
manufacturers to manufactureandassemble the subcomponents of our
capillaryaerosolization
technologyand to assemble
and integrate the component partsto support ourpreclinicalexperiments, planned clinicalstudies and potential
commercialization of Aerosurf.  Certain of these components must be
manufactured in an environmentally-controlled area and, when assembled, thecritical drug
product-contact components and patient interface systems must be packaged and
sterilized.  Eachof the aerosolization
system devices must be quality-control tested prior to release and monitored
forconformance to
designated product specification.





We have identified component
manufacturers and an integrator to manufacture and integrate our initial
prototype capillary aerosolization system that we plan to use in Phase 2
clinical trials.  However, as with many device development initiatives,
there is a risk that these manufacturers and integrator may not be able to
manufacture and integrate the subcomponents of our capillary aerosolization
systems to our specified standards.  In addition, we may not be able to
identify qualified additional or replacement manufacturers and integrators to
manufacture subcomponents and integrate our current prototype or next generation
and later development versions of our capillary aerosolization systems orwe may not be able to enter
into agreements with them on terms and conditions favorable and acceptable to
us.  In addition, the
manufacturers and assemblers and integrators that we identify may be unable to
timely comply with FDA, or other foreign regulatory agency, requirements. 
If we do not successfully identify and enter into contractual agreements
with,manufacturers, assemblers and
integrators that have the required expertise, it will adversely affect our
timeline for the development and, if approved, commercialization of
Aerosurf.





If the parties we dependon for supplying our active drug
substances,materials and
excipientsas well as manufacturing-related
servicesdo not
timely supply these
productsand
services, it may delay or
impair our ability to develop, manufacture and market our
products.





We rely on suppliers for our active drug
substances, materials and excipients,and third parties for certain
manufacturing-related services to manufacturedrug product that meets appropriate
content, quality and stability standards foruse in clinical trials and, if approved,
forcommercial
distribution.  Our
ability to manufacture depends upon receiving adequate supplies and
relatedservices, which may be difficult or
uneconomical to procure.  The manufacturing process for Aerosurf, a
combination drug-device product, includes the integration of a number of
componentparts, many of which are comprised of a large
number of subcomponent parts that we expect will be produced by
potentially alargenumber of
manufacturers.  We and our suppliersmay not be able to (i) produce our
drug substances, or manufacture materials and excipients or our drug product, or
capillary aerosolization systemssubcomponent parts or integrated
devices, to appropriate standards for use in clinical studies, (ii) comply
with manufacturing specifications under any definitive manufacturing, supply or servicesagreements with us, or
(iii) maintain relationships with our suppliers and service providers for a
sufficient time to successfully produce and market our product
candidates.


32




In some
cases, we are dependent upon a single supplier to provide all of our
requirements for one or more of our drug substances, materials and excipients or
one or more of our drug product device subcomponents, components and
subassemblies.  If we do not maintain manufacturing and service
relationships that are important to us and are not able to identify a
replacement supplier or vendor or develop our own manufacturing
capabilities, our ability to obtain regulatory approval for our products could
be impaired or delayed and our costs could substantially increase,.  Even
if we are able to find replacement manufacturers, suppliers and vendors when
needed, we may not be able to enter into agreements with them on terms and
conditions favorable to us or there could be a substantial delay before such
manufacturer, vendor or supplier, or a related new facility is properly
qualified and registered with the FDA or other foreign regulatory
authorities.  Such delays could have a material adverse effect on our
development activities and our business.




Under our restructuredlicense agreement with
PMUSA/PMPSA, we now have rights to develop thecapillaryaerosolization technology, which will require us to build
internal development capabilities or enter into future collaborationsor other arrangements to gain the
engineering expertise required to support our development
activities.





In March 2008, we restructured a strategic alliance with Philip
Morris USA, Inc. (PMUSA) d/b/a/ Chrysalis and assumed full
responsibilityfor
development of thecapillary aerosolization
technology, including
finalizing design development for the initial prototype aerosolization device
platform and disposable dose packets.  We currently plan to rely on our own
engineering expertise as well as design engineers, medical device experts and
other third-party collaborators to advance the development of ourcapillary aerosolization
technology.





Under our restructured arrangement with
PMUSA, we now have rights to develop thecapillary aerosolization
technologyand have not had
development support from PMUSA since June 30, 2008.  Our development
activities are subject to certain risks anduncertainties, including, without
limitation:





·
            We may not be able to complete the
      development of the initial prototype capillary aerosolization system, if
      at all, on a timely basis and such inability may delay or prevent
      initiation of our planned Phase 2 clinical
  trials.


·
            To continue the
      development of thecapillary
      aerosolization technology, we will require access to
      sophisticated engineering capabilities.  To meet that requirement, we
      are developing our own internal medical device engineering expertise and
      plan to work with a leading engineering and design firm that has a
      successful track record of developing innovative devices for major
      companies in the medical and pharmaceutical industries.  There is no
      assurance that our efforts will be successful.Ifwe are unable to identify design
      engineersand medical
      device experts to support our development efforts, including the initial
      prototype aerosolization system and the next generation versions of the
      capillary aerosolization systems, it would impair our ability to
      commercialize or develop our aerosolizedKL4surfactantproducts.


·
            To advance the development of our
      capillary aerosolization technology, we will require additional capital
      and mayseek a
      potential strategic partner or third-party collaborator to provide financial support andthe necessary medical
      device development expertise.  There can be no
      assurance, however, that we will successfully identify or be able to enter
      into agreements with such potential partners or collaborators on terms and
      conditions that are favorable to us.  If we are unable to secure the
      necessary medical device development expertise
      to support our development program, this could impair our ability to
      commercialize or develop our aerosolized KL4surfactant.





The realization of any of the foregoing
risks would have a material adverse effect on our business.





To market, sellanddistribute our products, weplan toenter into distribution arrangements and
marketing alliances, which could require us to give up rights to our drug
product candidates.





We have limited experience in marketing
or selling pharmaceutical
products and have a limited marketing and sales team.  To market, sell and
distribute our products, we may relyon third-party distributors to
distribute, or enter into marketing alliances to sell, our products,bothinternationallyandin the United States.  We may not be
successful in identifying such third parties or finalizing such arrangements on
terms and conditions that are favorable to us.  Our failure to successfully
enter into these arrangements on favorable terms could delay or impair
our ability to commercialize our drug
product candidates and could increase our costs of commercialization.  Our
dependence on distribution arrangements and marketing alliances to commercialize
our drug product candidates will subject us to a number of risks, including:


33





·
            we may be required to relinquish
      important rights to our products or drug product
      candidates;


·
            we may not be able to control the
      amount and timing of resources that our distributors or collaborators may
      devote to the commercialization of our drug product
      candidates;


·
            our distributors or collaborators
      may experience financial
difficulties;


·
            our distributors or collaborators
      may not devote sufficient time to the marketing and sales of our products
      thereby exposing us to potential expenses in terminating such
      distribution agreements; and


·
            business combinations or
      significant changes in a collaborator’s business strategy may adversely
      affect a collaborator’s willingness or ability to
      complete its obligations under any
  arrangement.





If wefail to enter into arrangements with
third parties in a timely manner or if such parties fail to perform, it could
adversely affect sales of our products.  We and our third-party
distributors and collaborators must also market our products in compliancewith federal, state and local laws
relatedto providing incentives and
inducements.  Violation of these laws can result in substantial
penalties.





We intend to market and sell Surfaxin,
if approved, through one or more strategic partnersor other collaborators.  We currently have such an
alliance with Estevefor
distribution of ourKL4surfactantproductsin Andorra, Greece, Italy, Portugal and
Spain.We have limited influence over the
decisions made by Esteve or its sublicensees or the resources that
they may devote to the
marketing and distribution of Surfaxin products in their licensed territory, and
Esteve or its sublicensees may not meet their obligations in this regard. 
Our marketing and distribution arrangement with Esteve may not be successful,
and, as a result, we may not receive any
revenues from it.  Also, we may not be able to enter into marketing and
sales agreements for Surfaxin on acceptable terms, if at all, in territories not
covered by the Esteve agreement, or for any of our other drug product candidates.





The commercialsuccess of our product candidates will
depend upon the degree of market acceptance by  physicians, patients,
healthcare payers and others in the medical community.





Any potential products that we bring to
market may not gain or
maintain market acceptance by governmental purchasers, group purchasing
organizations, physicians, patients, healthcare payers and others in the medical
community.  If any products that we develop do not achieve an adequate
level of acceptance, wemay not generate sufficient revenues to
support continued commercialization of these products. The degree of market
acceptance of our product candidates, if approved for commercial sale, will
depend on a number of factors, including:


·
              the perceived safety and efficacy
      of our products;





·
              the potential advantages over
      alternative
treatments;


·
            the prevalence and severity of any
      side effects;


·
            the relative convenience and ease
      of administration;


·
            cost
      effectiveness;


·
            the willingness of the target patient population to
      try new products and of physicians to prescribe our
      products;


·
            the effectiveness of our marketing
      strategy and distribution support;
and


·
            the sufficiency of coverage or
      reimbursement by third
parties.





If we donot adequately forecast customer demand for our
product candidates, including Surfaxin, if approved, our business could
suffer.





The timing and amount of customer demand
and the commercial requirements to meet changing customer demandaredifficult to predict. 
 If we are successful
in gaining regulatory approval of our products, we may not be able to accurately
forecast customer demand for our drug product candidates, including Surfaxin, or
respond effectively to unanticipated increases in demand.  This could
havean adverse effect on our
business.  If we overestimate customer demand, or attempt to commercialize
products for which the market is smaller than we anticipate, we could incur
significant unrecoverable costs from creating excess
capacity.


34





We
will require significant additional capital to continue our planned research and
development activities and continue to operate as a going concern. 
Moreover, such additional financing could result in equity
dilution.





Until
such time as we are able to commercialize any of our lead products, if
approved, and generate revenues, we will need substantial additional funding to
conduct our ongoing research and product development activities and continue to
operate as a going concern.  Our operating plans require that we make
prudent investments in preclinical studies and our drug product and device
development programs, and focus our resources on being in a position to initiate
key clinical programs only after we have secured strategicand financial alternatives needed to
provide thenecessary capital.  We would prefer to accomplish our
objectives through strategic alliances.If we are unable to raise
substantial additional funds through strategic alliances or other alternatives,
including potentially, future debt and equity financings, we may be forced
to further limit many, if not all, of our programs, which could have a material
adverse impact on our business plan.In the meantime, as we
attempt to conserve our financial resources, we may experience additional delays
in certain of our development programs.





The terms ofour indebtedness may impair our ability
to conduct our business.





Our capital requirements are funded in
part by an $8.5 million loan fromQuintiles, which isdue and payable, together with
approximately$2.0 million
accrued interest, on April 30, 2010.We are pursuing a potential strategic
restructuring of this loan withQuintilesand we are also considering alternative
means of financing its payment should that become necessary.The Quintiles loan issecured by substantially all of our
assets, including our
proprietary technologies,and contains a number of covenants and restrictions that, with certain
exceptions, restricts our ability to, among other things, incur additional
indebtedness, borrow moneyor issue guarantees, use assets as
security in other transactions, and sell assets to other companies.  A
breach of any of these restrictions could result in a default under theQuintilesloan documents.  If a default were
to occur,Quintileswould have the right to declare all borrowings to be
immediately due and payable.  If we are unable to pay when due amounts owed
toQuintiles, whether at maturity or in connection
with acceleration of the loan following a default,Quintileswould have the right to
proceed against the
collateral securing the
indebtedness.





We have
financed certain acquisitions of personal property, machinery and equipment
through an equipment financing facility with GE Business Financial Services Inc.
and a loan from the Commonwealth of Pennsylvania, Department of Community and
Economic Development, Machinery and Equipment Loan Fund (MELF).  As of
December 31, 2009, an aggregate of $1.0 million was outstanding under
the facility and the loan.  If we were unable to pay our creditors when due
amounts owed, they would have the right to proceed against the collateral
securing the debt.  See, “Item 7 – Management’s
Discussion and Analysis of Financial Condition and Results of Operations –
Liquidity and Capital Resources – Debt – Equipment Financing Facilities – GE
Business Financial Services Inc.”




If we require additional funds to
support our capital programs, there can be no assurance thatwe will be able to secure alenderthatwill be willing to provide us funding or
that we will be able to secureadditional funding through the MELF or
other program of the Commonwealth.  In addition, the aggregate amount of
our indebtedness may adversely affect our financial condition, limit our
operational and financing flexibility and negatively impact our
business.





Our CommittedEquity Financing Facilitiesmay become unavailable to
us if we do not comply with their conditions.





If we are unable to meet the conditions
provided under the CEFFs, we will not be able to issue any portion of the shares
potentially available for
issuance under the CEFFs and therefore may not be able to use the CEFFs to fund
our activities,and the CEFFs could expire withoutbeingfullyutilized.  Moreover, Kingsbridge
has the right under certain circumstances to terminate the CEFFs, including in the event of a material
adverse event.  In addition, even if we meet all the conditions provided
under the CEFFs, we are dependent upon the financial ability of Kingsbridge to
perform its obligations and purchase shares of our common stock underthe CEFFs.  Any inability on our
part to use at least one of the CEFFs or any failure by Kingsbridge to perform
its obligations under the CEFFs could have a material adverse effect upon
us.


35





The marketprice of our stock may be adversely
affected by market
volatility.





The market price of our common stock,
like that of many other development stage pharmaceutical or biotechnology
companies, has been and is likely to be volatile.  In addition to general
economic, political and market conditions, the priceand trading volume of our stock could
fluctuate widely in response to many factors, including:





·
            announcements of the results of
      clinical trials by us or our
competitors;


·
            patient adverse reactions to drug
      products;


·
            governmental approvals, delays in
      expected governmental approvals or withdrawals of any prior governmental
      approvals or public or regulatory agency concerns regarding
      the safety or effectiveness of our
  products;


·
            changes in the United States or
      foreign regulatory policy during the period of product
      development;


·
            changes in the United States or
      foreign political environment and the passage of laws, including tax,
      environmental or other laws, affecting the product development
      business;


·
            developments in patent or other
      proprietary rights, including any third party challenges of our
      intellectual property
rights;


·
            announcements of
      technological
      innovations by us or our
competitors;


·
            announcements of new products or
      new contracts by us or our
competitors;


·
            actual or anticipated variations
      in our operating results due to the level of development expenses and
      other factors;


·
            changes in financial estimates by securities
      analysts and whether our earnings meet or exceed the
      estimates;


·
            conditions and trends in the
      pharmaceutical and other
industries;


·
            new accounting standards;
      and


·
            the occurrence of any of the risks
      described in these “Risk Factors”or elsewhere in this Annual
      Report on Form 10-K or our other public
  filings.





Our common stock is listed for quotation
on The Nasdaq Global Market.  During the twelve month
period ended December 31, 2009, the price of our common stock ranged
from $0.33 to $2.40.We expect the price of our common stock
to remain volatile.  The average daily trading volume in our common stock
varies significantly.  For the twelve month period ended December 31, 2009,
the average daily trading volume in our common stock was approximately 3,586,958
shares and the average number of transactions per day was approximately
4,621.  The instability observed in our daily volume and number of
transactionsper day may
affect the ability of our stockholders to sell their shares in the public market at prevailing
prices.





In the past, following periods of
volatility in the market price of the securities of companies in our industry,
securities class action litigation has often been instituted against companies
in our industry.Even
if securities class actions that we may face in the future are ultimately
determined to be meritless or unsuccessful, they involve substantial costs and a
diversion of management attention and resources, which could negatively impact
our business.





If we are unableto regain compliance with the Minimum
Bid Price Requirement of The Nasdaq Global Market prior to June 1, 2010, our
stock price may decline and our common stock may be subject to delisting from
Nasdaq.  If our stock were no longer listed onNasdaq, the liquidity of our securities
would be impaired.





On December 2, 2009, we received a
letter from The Nasdaq Stock Market indicating that for 30 consecutive business
days our common stock did not maintain a minimum closing bid price of $1.00 pershare as required by Nasdaq
Listing Rule 5450(a)(1).  Under the Nasdaq Listing Rules, if during the 180
calendar days following the date of the notification, or prior to June 1, 2010,
the closing bid price of our stock is at or above $1.00 for a minimum
of10 consecutive business days, we will
regain compliance with the minimum bid price requirement and the common stock
will continue to be eligible for listing on The Nasdaq Global
Market.


36





If we do not achieve compliance with the
minimum bid price requirement by June 1, 2010, Nasdaq will provide
us with written notification that the common stock is subject to
delisting.  We may, at that time, appeal Nasdaq’s determination to a Nasdaq Hearing
Panel. Such an appeal, if granted, would stay delisting until a ruling by the panel.  Alternatively,
if we are at that time in compliance with all initial listing standards for the
Nasdaq Capital Market other than the minimum bid price requirement, we could
apply to transfer the listing of our common stock to the NasdaqCapital Market and thereby receive an
additional grace period of 180 days to regain compliance with the minimum bid
price requirement.





If our stock price does not exceed the
minimum bid price of $1.00 within the time frames set forth above, our common
stock will be subject to
delisting.  If our common stock were no longer listed on The Nasdaq Global
Market or the Nasdaq Capital Market, investors might only be able to trade in
the over-the-counter market in the Pink Sheets®(a quotation medium operated by
Pink OTC Markets Inc.) or
on the OTC Bulletin Board®of the Financial Industry Regulatory
Authority, Inc. (FINRA).  This would impair the liquidity of our securities
not only in the number of shares that could be bought and sold at a given price,
which might be depressed by
the relative illiquidity, but also through delays in the timing of transactions
and reduction in media coverage.





Future sales and issuancesof our common stock or rights to
purchase our common stock, including pursuant to ourCEFFs,stock incentive plans and upon the exercise
of outstanding securities exercisable for shares of our common stock, could
result in substantial additional dilution of our stockholders, cause our stock
price to fall and adversely affect our ability to raise capital.





We require significant additional
capital to continue to execute our business plan and advance our research and
development efforts.  To the extent that we raise additional capital
through the issuance of additional equity securities and through theexercise of outstanding
warrants, our stockholders may experience substantial dilution.  We may
sell shares of our common stock in one or more transactions at prices that may
be at a discount to the then-current market value of our common stock and on
suchother terms and conditions as we may
determine from time to time.  Any such transaction could result in
substantial dilution of our existing stockholders.  If we sell shares of
our common stock in more than one transaction, stockholders who purchase ourcommon stock may be materially diluted by
subsequent sales.  Such sales could also cause a drop in the market price
of our common stock.  The issuance of shares of our common stock under the
CEFFs has, and the issuance
of sharesupon exercise of
the relatedwarrants we
issued to Kingsbridge will have,a dilutive impact on our other
stockholders and the issuance, or even potential issuance, of such shares could
have a negative effect on the market price of our common stock.  In
addition, if we access the CEFFs, we will issue shares of our common
stock to Kingsbridge at a discount (from6% to 15%, depending upon the market
price) to the daily volume
weighted average price of our common stockon each trading day, whichwill further dilute the interests of
otherstockholders.See,“Item 7 –Management’s Discussion and Analysis of
Financial Condition and Results of Operations – Liquidity and Capital Resources
– Committed Equity Financing Facilities(CEFFs).”Furthermore, to the extent that Kingsbridge sells to
third parties the shares of
our common stock that we sell to Kingsbridge under the CEFFs, our stock price
may decrease due to the additional selling pressure in the market.  The
perceived risk of dilution from sales of stock to or by Kingsbridge may causeholders of our common stock to sell their
shares, or it may encourage short sales of our common stock or other similar
transactions.  This could contribute to a decline in the stock price of our
common stock.





Wealso filedauniversal shelf registrationstatementwith the SEConForm S-3 (File No. 333-151654) on June
13, 2008(which was
declared effective shortly thereafter)for the proposed offering from time to
time of up to $150million ofoursecurities,including common stock, preferred stock,
varying formsofdebt and warrant
securities, or any combination of the foregoing.Wehave issued securitiespursuant to this shelf registration
statementon two prior
occasions, including in February 2010, and may do so again in the futurein response to marketconditions or other
circumstances on terms and conditions that will be determined at such
time.





As ofMarch 5, 2010, wehad 153,892,960shares of common stock issued and
outstanding.  In addition, as of December 31, 2009, approximately (i)14.8 million shares of our common stockwerereserved for potential issuance upon the
exercise of outstanding warrants, (ii)17.8 million shares of our common stockwerereserved for issuance pursuant to our
equity incentive plans, and (iii) 137,435 shares of our common stockwerereserved for issuance pursuant to our
401(k) Plan.  The exercise of stock optionsand other securities could cause our
stockholders to experience substantial dilution.  Moreover, holders of our stock options and warrants
are likely to exercise them, if ever, at a time when we
otherwise could obtain a price for the sale of our securities that is higher
than the exercise price per security of the options or warrants.  Such
exercises, or the possibility of such exercises, may impede our efforts toobtain additional financing through the
sale of additional securities or make such financing more costly.  It may
also reduce the price of our common stock.


37





If, during the term of certain of our
warrants, we declare or make any dividend or other distribution of our assets to holders of shares
of our common stock, by way of return of capital or otherwise (including any
distribution of cash, stock or other securities, property or options by way of a
dividend, spin off, reclassification, corporate rearrangement or other similar transaction), then
the exercise price of such warrants may adjust downward and the number of shares
of common stock issuable upon exercise of such warrants would increase.  As
a result, we may be required to issue more shares of commonstock than previously anticipated,
which could result in further dilution of our existing
stockholders.





Directors, executiveofficers, principal stockholders and
affiliated entities own a significant percentage of our capital stock, and they
may make decisions that you
do not consider to be in your best interest.





As of December 31, 2009, our directors, executive officers,
principal stockholders and affiliated entities beneficially owned, in the
aggregate, approximatelyseventeenpercent (17%)of the issued and outstanding shares of our common
stock.  For the purpose of computing this amount, an affiliated entity
includes any entity that is known to us to be the beneficial owner of more than
five percent (5%) of our issued and outstanding common stock. 
Asa result, if some or all of them acted
together, they would have the ability to exert substantial influence over the
election of our Board of Directors and the outcome of issues requiring approval
by our stockholders.  This concentration of ownership mayhave the effect of delaying or
preventing a change in control of our company that may be favored by other
stockholders.  This could prevent transactions in which stockholders might
otherwise recover a premium for their shares over current market
prices.





Our technologyplatform is based solely on our
proprietaryKL4surfactant technologyandcapillary aerosolization
technology.





Ourtechnologyplatform is based on the scientific
rationale of using ourKL4surfactant technologyandcapillary aerosolizationtechnologyto treat life-threatening respiratory
disorders and to serve as the foundation for the development of novel
respiratory therapies and products.  Our business is dependent upon the
successful development and approval of our drug product candidates and our drug-device combination
products based on these technologies.  Any material problems with our
technology platforms could have a material adverse effect on our
business.





If we cannotprotect our intellectual property,
other companies could use our technology in competitive
products.Even if we
obtainpatents to protect
our products, those patents may not be sufficiently broad or they may expire and
others could then compete with us.





We seek patent protection for our drug
product candidates toprevent others from commercializing
equivalent products in substantially less time and at substantially lower
expense.  The pharmaceutical industry places considerable importance on
obtaining patent and trade secret protection for new technologies,
products and processes.  Our success will
depend in part on our ability and that of parties from whom we license
technology tosuccessfully
obtain patents,defend our
patents and otherwise prevent others from infringing our proprietary
rights, including our
tradesecrets.





The patent position of companies relying
upon biotechnology is highly uncertain and involves complex legal and factual
questions for which important legal principles are unresolved.  To date,
the United States Patent and Trademark Office (USPTO) has not adopted a consistent policy
regarding the breadth of claims that it will allow in biotechnology patents or
the degree of protection that these types of patents afford.  As a result,
there are risks that we may not secure rights to products or processes that appear to be
patentable.


38





We and the parties licensing
technologies to us, have filed various United States and foreign patent
applications with respect to the products and technologies under our
development, and the USPTO and foreign patent offices have issued patents with respect
to our products and technologies.  These patent applications include
international applications filed under the Patent Cooperation Treaty.  Our
pending patent applications, those we may file in the future or those
wemay license from third parties may not
result in the USPTO or foreign patent office issuing patents.  In addition,
if patent rights covering our products are not sufficiently broad, they may not
provide us with sufficient proprietary protection or competitive advantages against competitors with
similar products and technologies.  Furthermore, even if the USPTO or
foreign patent offices were to issue patents to us or our licensors, others may
challenge the patents or circumvent the patents, or the patent office or the courts may invalidate the
patents.  Thus, any patents we own or license from or to third parties may
not provide us any protection against competitors.





The patents that we hold also have a
limited life.  We have licensed a series of patents for ourKL4surfactant technologyfrom Johnson & Johnson and its
wholly-owned subsidiary Ortho Pharmaceutical Corporation (Ortho Pharmaceutical),
which are important,bothindividuallyandcollectively, to our strategy of
commercializing ourKL4surfactantproducts.  These patents, which
include important KL4composition of matter claims and
relevant European patents,began to expireinNovember 2009, and will expireon various datesending in 2017 or, in some cases,
possibly later.Of
the patents that have expired, we have filed to extend our most
important patent one year, with further extensions possible into 2014.For our aerosolizedKL4surfactant, we hold exclusive licenses in the
United States and outside the United States to PMUSA’scapillary aerosolization
technologyfor use with
pulmonary surfactants for all respiratory diseases.  Our exclusive license
in the United States also extends toother (non-surfactant) drugs to treat a
wide range of pediatric and adult respiratory indications in hospitals and other
health care institutions.  Thecapillary aerosolization
technologypatents expire
on various dates beginning in May 2016 and ending in 2023, or, in some cases,
possibly later.We
have filed, and when possible and appropriate, will file, other patent applications with respect to our
products and processes in the United States and in foreign countries.  We
may not be able to develop enhanced or additional products or processes that
will be patentable under patent law and, if we do enhance or developadditional products that we believe are
patentable, additional patents may not be issued to us.See also,“–If we cannot meet requirements under
our license agreements, we could lose the rights to our
products.”





Intellectual propertyrights of third parties could limit our ability to develop
and market our products.





Our commercial success also depends upon
our ability to operate our business without infringing the patents or violating
the proprietary rights of others.  In certain cases, the USPTO
keeps United States patent
applications confidential while the applications are pending.  As a result,
we cannot determine in advance what inventions third parties may claim in their
pending patent applications.  We may need to defend or enforce our patent
and license rights or to determine the
scope and validity of the proprietary rights of others through legal
proceedings, which would be costly, unpredictable and time consuming.  Even
in proceedings where the outcome is favorable to us, they would likely
divert substantial resources, including
management time, from our other activities.  Moreover, any adverse
determination could subject us to significant liability or require us to seek
licenses that third parties might not grant to us or might only grant atrates that diminish or deplete the
profitability of our products.  An adverse determination could also require
us to alter our products or processes or cease altogether any product sales or
related research and development activities.





If we cannotmeet requirements under our license agreements,
we could lose the rights to our products.





We depend on licensing agreements with
third parties to maintain the intellectual property rights to our products under
development.  Presently, we have licensed rights fromJohnson & Johnson, Ortho
Pharmaceutical, PMUSA and PMPSA.  These agreements require us to make
payments and satisfy performance obligations to maintain our rights under these
licensing agreements.  All of these agreements last either throughout the
lifeof the patents or for a number of years
after the first commercial sale of the relevant product.





In addition, we are responsible for the
cost of filing and prosecuting certain patent applications and maintaining
certain issued patents licensed to us.  If we do not meet our obligations under our
license agreements in a timely manner, we could lose the rights to our
proprietary technology.





Finally, we may be required to obtain
licenses to patents or other proprietary rights of third parties in connection
with the development and
use of our products and technologies.  Licenses required under any such
patents or proprietary rights might not be made available on terms acceptable to
us, if at all.


39





We rely onconfidentiality agreements that could
be breached andmay be
difficult to enforce.





Although we take what we believe to be
reasonable steps to protect our intellectual property, including the use of
agreements relating to the non-disclosure of our confidential information to
third parties, as well as agreements that provide for disclosure and
assignment to us of all rights to the ideas, developments, discoveries and
inventions of our employees and consultants while we employ them, such
agreements can be difficult and costly to enforce.  We generally seek toenter into these types of agreements with
consultants, advisors and research collaborators; however, to the extent that
such parties apply or independently develop intellectual property in connection
with any of our projects, disputes may arise concerningallocation of the related proprietary
rights.  Such disputes often involve significant expense and yield
unpredictable results.  In addition, we also rely on trade secrets and
proprietary know-how that we seek to protect, in part, through confidentiality
agreements with our employees,
consultants, advisors or others.





Despite the protective measures we
employ, we still face the risk that:





·
            agreements may be
      breached;


·
            agreements may not provide
      adequate remedies for the applicable type of
  breach;


·
            our trade secrets or proprietary
      know-how may otherwise become
known;


·
            our competitors may independently
      develop similar technology;
or


·
            our competitors may independently
      discover our proprietary information and trade
    secrets.





We depend uponkey employees and consultants in a
competitive market for skilled personnel.  If we are unable to attract and
retain key personnel, it could adversely affect our ability to develop and market
our products.





We are
highly dependent upon the members of our executive management team and our
directors, as well as our scientific advisory board members, consultants and
collaborating scientists.  Many of these people have been involved with us
for many years, have played integral roles in our progress and we believe that
they continue to provide value to us.  A loss of any of our key personnel
may have a material adverse effect on aspects of our business and clinical
development and regulatory programs.





In August
2009, Dr. Capetola resigned his position with us as President and Chief
Executive Officer and a member of our Board of Directors.  Our Board
elected W. Thomas Amick, our Chairman of the Board, to act as Chief Executive
Officer for an interim period.  Mr. Amick, who is otherwise employed by
another biotech company as its Chief Executive Officer, is able to devote
only a  portion of his time to his duties as our interim
Chief Executive Officer. Until such time as we employ a full-time
Chief Executive Officer, our dependency on the remaining members of our
management team to exhibit strong leadership skills and effectively manage our
operations is increased. While we
expect that, once we have secured sufficient strategic and financial resources
to support the continuing development of our KL4 surfactant
technology and support our operations, we will seek to attract candidates to
lead our management team, there can be no assurances that we will be successful
in that endeavor.





As of
December 31, 2009, we had employment agreements with 12 officers that expire in
May 2010.  These agreements provide for automatic one-year renewal at the
end of each term, unless otherwise terminated by either party.  In February
2010, we provided notice of non-renewal with respect to all but the agreements
that we maintain with the
following officers: Chief Financial Officer, General Counsel, and the senior
officers in charge of Manufacturing, Corporate Development, and Human Resources.The employment of the officers whose agreements will not be renewed were
not terminated and they will remain as at-will employees and, in lieu of the
benefits provided under their employment agreements, will be entitled to certain
severance benefits. The loss
of services from these executives could significantly adversely affect our
ability to develop and market our products and obtain necessary regulatory
approvals. 40





Ourfuture success also will depend in part
on the continued service of our key scientific and management personnel and our
ability to identify, hire and retain additional personnel.  We may
experience intense competition for qualified personnel and the existence of non-competition agreements
between prospective employees and their former employers may prevent us from
hiring those individuals or subject us tolawsuits brought bytheir former employers. While we attempt
to provide competitive compensation packages to attract and retain key personnel,manyof our competitors have greater
resources and more experience than we, making it difficult for us to compete
successfully for key personnel.





Our industry ishighly competitive and we have less
capital and resources than
many of our competitors, which may give them an advantage in developing and
marketing products similar to ours or make our products
obsolete.





Our industry is highly competitive and
subject to rapid technological innovation and evolving industrystandards.  We compete with
numerous existing companies intensely in many ways.  We intend to market
our products under development for the treatment of diseases for which other
technologies and treatments are rapidly developing and, consequently, we
expect new companies to enter our industry
and that competition in the industry will increase.  Many of these
companies have substantially greater research and development, manufacturing,
marketing, financial, technological, personnel and managerial resourcesthan we have.  In addition, many of
these competitors, either alone or with their collaborative partners, have
significantly greater experience than we do in:





·
            developing
      products;


·
            undertaking preclinical testing
      and human clinical trials;


·
            obtaining FDA and other regulatory
      approvals or products; and


·
            manufacturing and marketing
      products.





Accordingly, our competitors may succeed
in obtaining patent protection, receiving FDA or comparable foreign approval or
commercializing products before us.  Ifwe commence commercial product sales, we
will compete against companies with greater marketing and manufacturing
capabilitiesthatmay successfully develop
and commercialize products that are more effective or less expensive than
ours.  These are areas inwhich, as yet, we have limited or no
experience.  In addition, developments by our competitors may render our
drug product candidates obsolete or noncompetitive.





We also face, and will continue to face,
competition from colleges, universities, governmental agencies and other public and private
research organizations.  These competitors frequently aggressively seek
patent protection and licensing arrangements to collect royalties for use of
technology that they have developed.  Some of these technologies
may compete directly with the technologies
that we are developing.  These institutions will also compete with us in
recruiting highly qualified scientific personnel.  We expect that
therapeutic developments in the areas in which we are active may occur at
arapid rate and that competition will
intensify as advances in this field are made.  As a result, we need to
continue to devote substantial resources and efforts to research and development
activities.





If productliability claims are brought against
us,it may result in
reduced demand for our products or damages that exceed our insurance coverage
and we may incur substantial costs.





The clinical testing, marketing and use
of our products exposes us to product liability claims if the use or misuse of
our products causes injury,
disease or results in adverse effects.  Use of our products in clinical
trials, as well as commercial sale, if approved, could result in product
liability claims.  In addition, sales of our products through third party
arrangementscould also subject us to product
liability claims.  We presently carry product liability insurance withannualcoverage of up to $10 million per
occurrence and $10 million in the aggregate.  However, this insurance
coverage includes various deductibles, limitations and exclusions from coverage,
and in any event might not fully cover any potential claims.  We may need
to obtain additional product liability insurance coverage, including by
locally-authorized insurers licensed in countries where we conduct
ourclinical trials, before initiating
clinical trials.  We expect to obtain product liability insurance coverage
before commercializing any of our drug product candidates; however, such
insurance is expensive and may not be available when we need
it.


41





In the future, we may not be able to obtain
adequate insurance, with acceptable limits and retentions, at an acceptable
cost.  Any product liability claim, even one that is within the limits of
our insurance coverage or one that is meritless and/or unsuccessful, could adversely affect the
availability or cost of insurance generally and our cash available for other
purposes, such as research and development.  In addition, such claims could
result in:





·
            uninsured expenses related to
      defense or payment of substantial monetary awards to
      claimants;


·
            a decrease in demand for our drug
      product candidates;


·
            damage to our reputation;
      and


·
            an inability to complete clinical
      trial programs or to commercialize our drug product candidates, if
      approved.





Moreover, the existence of a product
liability claim could affect the market price of our common
stock.





Our corporatecompliance program cannot ensure that
we are in compliance with all applicable laws and regulations affecting our activities in
the jurisdictions in which we may sell our products, if approved, and a failure
to comply with such regulations or prevail in litigation related to
noncompliance could harm our business.





Many of our activities,
including the research,
development, manufacture, sale and marketing of our products, are subject to
extensive laws and regulation, including without limitation, health care "fraud
and abuse" laws, such as the federal false claims act, the federal
anti-kickbackstatute, and other state and federal
laws and regulations.  We have developed and implemented a corporate
compliance policy and oversight program based upon what we understand to be
current industry best practices, but we cannot assure you that this
program will protect us from governmental
investigations or other actions or lawsuits stemming from a failure to be in
compliance with such laws or regulations.If any such investigations, actions or
lawsuits are instituted against us, and if we are not successful in defending or disposing of them
without liability, such investigations, actions or lawsuits could result in the
imposition of significant fines or other sanctions and could otherwise have a
significant impact on our business.





We expect toface uncertainty over reimbursement and
healthcare reform.





In both the United States and other
countries, sales of our products will depend in part upon the availability of
reimbursement from third-party payers, which include governmental health
administration authorities,
managed care providers and private health insurers.  Third party payers
increasingly challenge the price and examinethe cost effectiveness of medical
products and services.  Moreover, the current political environment in the
United States and abroad
may result in the passage of significant legislation that could, among other
things, restructure the markets in which we operate and restrict pricing
strategies of drug development companies.  If, for example, price
restrictions were placed on the distribution of our drugs, we may be
forced to curtail development of our pipeline products and this could havea material adverse effect
on our business, results of operations and financial condition.  Even if we succeed in
commercializing our drug products, uncertainties regarding health care
policy, legislation and regulation, as well as private market practices, could
affect our ability to sell our products in quantities or at prices that will
enable us to achieve profitability.





To obtain reimbursementfrom a third party payer, it must
determine that our drug product is a covered benefit under its health plan,
which is likely to require a determination that our product
is:





·
            safe, effective and medically
      necessary;


·
            appropriate for the specific
      patient;


·
            cost-effective;
      and


·
            neither experimental nor
      investigational.





Obtaining a determination that a product
is a covered benefit may be a time-consuming and costly process that could require us to provide
supporting scientific, clinical and cost-effectiveness data about our products
to each payer.  We may not be able to provide sufficient data to gain
coverage.


42





Even when a payer determines that a
product is covered, the payer may impose limitations that preclude
payment for some uses that are approved by the FDA or other regulatory
authorities. Moreover, coverage does not imply that any product will be covered
in all cases or that reimbursement will be available at a rate that would permit a health care provider
to cover its costs of using our product.





Provisions ofour Restated Certificate of
Incorporation, as amended, our Amended and Restated By-Laws, our Shareholder
Rights Agreement and Delaware law could defer a change of our management and thereby discourage
or delay offers to acquire us.





Provisions of ourAmended andRestated Certificate of Incorporation,
as amended, our Amended and Restated By-Laws, our Shareholder Rights Agreement
and Delaware law may make it moredifficult for someone to acquire control
of us or for our stockholders to remove existing management, and might
discourage a third party from offering to acquire us, even if a change in
control or in management would be beneficial to our stockholders. 
Forexample, our Restated Certificate of
Incorporation, as amended, allows us to issue shares of preferred stock without
any vote or further action by our stockholders.  Our Board of Directors has
the authority to fix and determine the relative rights and preferences of preferred stock.  Our
Board of Directors also has the authority to issue preferred stock without
further stockholder approval.  As a result, our Board of Directors could
authorize the issuance of a series of preferred stock that would grant
toholders the preferred right to our
assets upon liquidation, the right to receive dividend payments before dividends
are distributed to the holders of common stock and the right to the redemption
of the shares, together with a premium, before the redemptionof our common stock.  In addition,
our Board of Directors, without further stockholder approval, could issue large
blocks of preferred stock.  We have adopted a Shareholder Rights Agreement,
which under certain circumstances would significantly impair theability of third parties to acquire
control of us without prior approval of our Board of Directors thereby
discouraging unsolicited takeover proposals.  The rights issued under the
Shareholder Rights Agreement would cause substantial dilution to a
personor group that attempts to acquire us on
terms not approved in advance by our Board of Directors.





The failure
toprevail in litigation or the costs of litigation, including securities class
action and patent claims, could harm our financial performance and business
operations.





We are potentially susceptible to
litigation.  For example, as a public company, we may be subject to claims
asserting violations of securities laws.Even if such actions are found to be
without merit, the potential impact of such actions, which generally seek
unquantified damages and attorneys’fees and expenses, is uncertain. 
There can be no assurance that an adverse result in any future proceeding would
not have a potentially material adverse effect on our business, results of
operations and financial
condition.





We have from time to time been involved
in disputes and proceedings arising in the ordinary course of business,
including in connection with the conduct of clinical trials.  Such claims,
with or without merit, if not resolved, could be time-consuming and
result in costly litigation.  Although we believe such claims are unlikely
to have a material adverse effect on our financial condition or results of
operations, it is impossible to predict with certainty the eventual
outcome of such claims and there can be no
assurance that we will be successful in any proceeding to which we may be a
party.





In addition, as the USPTO keeps United
States patent applications confidential in certain cases while the applications
are pending, we cannot ensure that our products or methods do not infringe upon
the patents or other intellectual property rights of third parties.  As the
biotechnology and pharmaceutical industries expand and more patents are applied
for and issued, the risk increases that our patents or patent applications for
ourKL4surfactantproduct candidates may give rise to a
declaration of interference by the USPTO, or to administrative proceedings in
foreign patent offices, or that our activities lead to claims of patent
infringement by other companies, institutions or individuals.  These
entities or persons could bring legal proceedings against us seeking to
invalidate our patents, obtain substantial damages or enjoin us from conducting
research and development activities.


43





ITEM 1B.
            UNRESOLVED STAFF
      COMMENTS.





There are no unresolved written comments
that were received from the SEC staff 180 days or more before the end of our
fiscal year relating to our periodic or current reports under the Exchange
Act.





ITEM 2.
            PROPERTIES.





We maintain our principal executive
offices at 2600 Kelly Road, Suite 100, Warrington, Pennsylvania 18976-3622,
which consists of 39,594 square feet of space that we lease at an annual rent of
approximately $0.9 million.  In April 2007, the lease, which originally
expired in February 2010 with total aggregate payments of $4.6 million, was
extended through February 2013, with additional payments of $3.0 million over
the three-year extension period.  We do not own any real
property.





In October 2007, we completed
construction of ananalytical and development laboratory
within our Warrington, Pennsylvania headquarters location.Our analytical testing activities
predominantly involve release and stability testing of raw materials as well as
commercial and clinical drug product supply.  We also perform at this
location development work with respect to our aerosolizedKL4surfactantand novel formulations of our product
candidates.





In February 2010, we completed
construction of a new medical device development laboratorywithin our Warrington, Pennsylvania
headquarters locationthat
will support the further development of our capillary aerosolization
systems.  The facility includes capabilities to assemble disposable dose
packets in a controlled environment in two class 10,000 hoods following clean
room procedures.  We also use this laboratory for component parts and
finished assembly inspection and storage.  Having this new laboratory
greatly enhances our ability to leverage our internal development engineering
resources and manage ongoing preclinical development activities for Aerosurf,
while at the same time controlling the related expense and conserving our
financial resources.




We lease
approximately 21,000 square feet of space for our manufacturing operations in
Totowa, New Jersey, at an annual rent of $150,000.  This space is
specifically designed for the manufacture and filling of sterile pharmaceuticals
in compliance with cGMP and is our only manufacturing facility.  The lease
for our Totowa facility expires in December 2014.  In addition to customary
terms and conditions, the lease is subject to the landlord’s right,
upon two years’ prior notice, to terminate the lease early.  This
early termination right is subject to certain conditions, including that
the master tenant, a related party of the landlord, must have ceased all
activities at the premises, and, depending upon the timing of the notice, if we
satisfy certain financial conditions, the landlord would be obligated
to make early termination payments to us.  At the present time,
we understand that the master tenant continues to be active in the
premises.  As this early termination option could require us to move out of
our Totowa facility as early as March 2012, we are developing a long-term
manufacturing strategy that includes (i) potentially renegotiating our current
lease to amend the termination and other provisions, (ii) building or acquiring
additional manufacturing capabilities to support product development and, if
approved, commercial production of our KL4 surfactant
product candidates, and (iii) potentially using contract
manufacturers.




ITEM 3.
            LEGAL PROCEEDINGS.





We are
not aware of any pending or threatened legal actions to which we are a
party or of which our property is the subject that would, if
determined adversely to us, have a material adverse effect on our business and
operations.




We have from time to time been involved
in disputes and proceedings arising in the ordinary course of business,
including in connection with the conduct of our clinical trials.  In
addition, as a public
company, we are alsopotentially susceptible to
litigation, such as claims asserting violations of securities laws.  Any
such claims, with or
without merit, if not resolved, could be time-consuming and result in costly
litigation.There can be no
assurance that anadverse
result in any future proceeding would not have a potentially material adverse
effect on our business, results of operationsorfinancial
condition.


44





ITEM 4.
            RESERVED.





PART II





ITEM
5.            MARKET FOR REGISTRANT’S COMMON EQUITY,
RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES.





Market Information





Our common stock is traded on The Nasdaq
Global Market under the symbol “DSCO.”  As of March1, 2010, the number of stockholders of record
of shares of our common stock wasapproximately 142and the number of beneficial owners of
shares of our common stock was approximately25,924.  As of March5, 2010, there were153,892,950shares of our common stock issued and
outstanding.





The following table sets forth the
quarterly sales price ranges of our common stock for the periods indicated, as
reported by Nasdaq.





Low
                  
                  
                  HighFirst Quarter
      2008
                  
                  $
                  1.75
                  
                  
                  $
                  2.63Second Quarter
      2008
                  
                  $
                  1.29
                  
                  
                  $
                  3.02Third Quarter
      2008
                  
                  $
                  1.48
                  
                  
                  $
                  2.19Fourth Quarter
      2008
                  
                  $
                  0.77
                  
                  
                  $
                  2.00First Quarter
      2009
                  
                  $
                  0.91
                  
                  
                  $
                  1.48Second Quarter
      2009
                  
                  $
                  0.71
                  
                  
                  $
                  2.40Third Quarter
      2009
                  
                  $
                  0.33
                  
                  
                  $
                  1.69Fourth Quarter
      2009
                  
                  $
                  0.61
                  
                  
                  $
                  1.38





We have not paid dividends on our common
stockand do not expect to
declare and paydividends
on our common stock in the foreseeable future.





Sales of Unregistered
Securities




During
the 12 months ended December 31, 2009, we did not issue any unregistered shares
of common stock pursuant to the exercise of outstanding warrants and
options.  There were no stock repurchases in the 12 months ended December
31, 2009. During 2009, we completed nine draw downs under our CEFFs with
Kingsbridge and issued an aggregate of 10,732,615 shares of our common stock in
connection with these draw downs. The
shares of common stock issued under our CEFFs were issued pursuant to the
exemption from registration under the Securities Act of 1933, as amended,
provided by Section 4(2) of such act for transactions not involving a public
offering.See,
“Item 7 – Management’s Discussion and Analysis of Financial Condition and
Results of Operations – Liquidity and Capital Resources – Committed Equity
Financing Facilities (CEFFs).”


45


ITEM 6.
            SELECTED FINANCIAL
      DATA





The selected consolidated financial data
set forth below with respect to our consolidated statement of operations for the
years ended December 31, 2009, 2008and 2007and with respect to the Consolidated
Balance Sheets as of December 31, 2009and 2008have been derived from audited
consolidated financial statements included as part of this Annual Report on Form
10-K.  The statement of operations data for the years ended December 31,
2006and 2005and the balance sheet data as of
December 31, 2007and 2006and 2005are derived from audited financial
statements not included in this Annual Report.  The following selected
consolidated financial data should be read in conjunction with the consolidated
financial statements and notes theretoand the information disclosed in “Item 7
- Management’s Discussion and Analysis of Financial Condition and Results of
Operations,”included
elsewhere in this Annual Report.





Consolidated Statement of Operations
Data:


(in thousands, except per share
data)





For the year ended December
      31,2009
                                  
                                  
                                  2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006
                                  
                                  
                                  2005Revenues from collaborative
      agreements
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  4,600
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  134Operating
      Expenses:Research and
      development
                                  
                                  
                                  19,077
                                  
                                  
                                  
                                  26,566
                                  
                                  
                                  
                                  26,200
                                  
                                  
                                  
                                  23,716
                                  
                                  
                                  
                                  24,137General and
      administrative
                                  
                                  
                                  10,120
                                  
                                  
                                  
                                  16,428
                                  
                                  
                                  
                                  13,747
                                  
                                  
                                  
                                  18,386
                                  
                                  
                                  
                                  18,505Restructuring
      charges
                                  
                                  
                                  –
                                  
                                  
                                  
                                  –
                                  
                                  
                                  
                                  –
                                  
                                  
                                  
                                  4,805
                                  
                                  
                                  
                                  –In-process research and
      development
                                  
                                  
                                  –
                                  
                                  
                                  
                                  –
                                  
                                  
                                  
                                  –
                                  
                                  
                                  
                                  –
                                  
                                  
                                  
                                  16,787Total expenses(1)
                                  
                                  
                                  29,197
                                  
                                  
                                  
                                  42,994
                                  
                                  
                                  
                                  39,947
                                  
                                  
                                  
                                  46,907
                                  
                                  
                                  
                                  59,429Operating
    loss
                                  
                                  
                                  (29,197
                                  )
                                  
                                  
                                  (38,394
                                  )
                                  
                                  
                                  ( 39,947
                                  )
                                  
                                  
                                  (46,907
                                  )
                                  
                                  
                                  (59,295
                                  )Other(expense) /income
                                  
                                  
                                  (1,043
                                  )
                                  
                                  
                                  (712
                                  )
                                  
                                  
                                  (58
                                  )
                                  
                                  
                                  574
                                  
                                  
                                  
                                  391Net loss
                                  
                                  $
                                  (30,240
                                  )
                                  
                                  $
                                  ( 39,106
                                  )
                                  
                                  $
                                  ( 40,005
                                  )
                                  
                                  $
                                  (46,333
                                  )
                                  
                                  $
                                  (58,904
                                  )Net loss per common share - basic
      and diluted
                                  
                                  $
                                  (0.26
                                  )
                                  
                                  $
                                  ( 0.40
                                  )
                                  
                                  $
                                  (0.49
                                  )
                                  
                                  $
                                  (0.74
                                  )
                                  
                                  $
                                  (1.09
                                  )Weighted average number of
      commonshares
      outstanding
                                  
                                  
                                  115,200
                                  
                                  
                                  
                                  98,116
                                  
                                  
                                  
                                  81,731
                                  
                                  
                                  
                                  62,767
                                  
                                  
                                  
                                  54,094




(1)Included
in the net loss for the years ended December 31, 2009, 2008, 2007 and
2006 were non-cash charges for stock-based compensation for employees in
accordance with ASC Topic 718 of $2.7 million, $4.6 million, $5.3 million
and $5.5 million, respectively.


Consolidated Balance Sheet
      Data:(in
    thousands)
                
                December
31,2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005Cash and
      investments
                
                $
                15,741
                
                
                $
                24,792
                
                
                $
                53,007
                
                
                $
                26,402
                
                
                $
                50,908Working
    capital
                
                
                176
                
                
                
                15,551
                
                
                
                43,149
                
                
                
                18,999
                
                
                
                33,860Total
assets
                
                
                21,403
                
                
                
                32,889
                
                
                
                62,744
                
                
                
                34,400
                
                
                
                56,008Long-term obligations, less
      current potion
                
                
                1,118
                
                
                
                12,090
                
                
                
                13,494
                
                
                
                12,110
                
                
                
                3,562Total stockholder’s
      equity
                
                $
                4,487
                
                
                $
                10,933
                
                
                $
                38,781
                
                
                $
                14,322
                
                
                $
                34,838


46


ITEM 7.
            MANAGEMENT’S DISCUSSION AND
      ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





INTRODUCTION





Management’s
discussion and analysis of financial condition and results of operations
(MD&A) is provided as a supplement to the accompanying consolidated
financial statements and footnotes to help provide an understanding of our
financial condition, the changes in our financial condition and our results of
operations.  This item
should be read in connection with our Consolidated Financial
Statements.See,“Item 15 –Exhibits and Financial Statement
Schedules.”Our discussion is organized as
follows:





·
              Company
      Overview and Business Strategy:  this section provides
      a general description of our company and business
      plans.





·
              Critical
      Accounting Policies:this section contains
      a discussion of the accounting policies that we believe are important to
      our financial condition and results of operations and that require the
      exercise of judgment and use of estimates on the part of management in
      their application.  In addition, all of our significant
      accounting policies, including the critical accounting policies and
      estimates, are discussed in Note 3 to the accompanying consolidated
      financial statements.





·
              Results of
      Operations:  this section provides
      an analysis of our results of operations presented in the accompanying
      consolidated statements of operations, including comparisons of the
      results for the years ended December 31, 2009, 2008and 2007.





·
              Liquidity and
      Capital Resources:  this section provides
      a discussion on our capital resources, future capital requirements, cash
      flows, committed equity financing facilities, historical financing
      transactions, outstanding debt arrangements and
      commitments.





OVERVIEW





Discovery Laboratories, Inc. (referred
to as “we,” “us,” or the “Company”) isabiotechnology company developingour novel KL4proprietary technology, whichproduces a synthetic, peptide-containing
surfactant (KL4surfactant) that is structurally
similar to pulmonary surfactant, a substance produced naturally in the lung and
essential for survival and normal respiratory function.  In addition,
our proprietary capillary
aerosol-generating
technology (capillaryaerosolizationtechnology) produces a dense aerosol with
a defined particle size, to potentially deliver our aerosolized KL4surfactant to thelung.  As many respiratory
disorders are associated with surfactant deficiency or surfactant degradation,
we believe that our proprietary technology platform makes it possible, for the
first time, to develop a significant pipeline of surfactant products targeted to
treat a wide range of respiratory problems.


We are
developing our lead products, Surfaxin®(lucinactant),
Surfaxin LSTM and Aerosurf®, to
address the most significant respiratory conditions affecting pediatric
populations.  Our research and development efforts are currently
focused on the management of RDS in premature infants.  We believe
that the RDS market represents a significant opportunity from both a medical and
a business perspective. We further believe that Surfaxin, Surfaxin LS
and Aerosurf, have the potential to greatly improve the management of RDS and,
collectively, represent the opportunity, over time, to significantly expand the
current RDS worldwide annual market.




In addition to our lead products,
we plan over time to
develop our KL4surfactant technologyinto abroad productpipeline that potentially will address a
variety of debilitating respiratory conditions for which there currently areno orfew approved therapies,in patient populationsrangingfrom premature infants to
adults.Our
KL4surfactant is in clinical development
to potentially address pediatric patients with Acute Respiratory Failure (ARF)
and patients with Cystic Fibrosis (CF). We are conducting research and
preclinical development with our KL4surfactant potentially to address Acute
Lung Injury (ALI), and, potentially in the future, other diseases associated
with inflammation of the lung, such as Asthma and Chronic Obstructive Pulmonary
Disease (COPD).  We have also initiated exploratory preclinical
studies to assess the feasibility of using our KL4surfactant in combination with small
and large molecule therapeutics to efficiently and effectively deliver therapies
to the lung to treat a range of pulmonary conditions and
disease.


47





An importantpriority is to secure strategicand financial resourcestopotentiallymaximize the inherent value in our
KL4surfactant
technology.  We would prefer to accomplish our objectives through
strategic alliances.With respect to our lead
products,we are actively
engaged in discussions with potential strategic and/orfinancial partners,althoughthere can be no assurance that any
strategic alliance or other financing transaction will be successfully
concluded.With
respect to our early stage exploratory programs, our plans include potentially
taking these initiatives through a Phase 2 proof-of-concept phase and, if
successful, thereafter determining whether to seek strategic alliances or
collaboration arrangements or to utilize other financial alternatives to fund
their further development.




We have
focused our current resources on our lead products, primarily to address the
requirements to gain the potential approval of Surfaxin in the United
States.    Until such time as we secure sufficient strategic
and financial resources to support the continuing development of our KL4 surfactant
technology and support our operations, we will continue to conserve our
resources, predominantly by curtailing and pacing investments in our pipeline
programs.





The reader isreferred to, and encouraged to read in
its entirety “Item 1 – Business” of this Annual Report on Form 10-K, which
contains a discussion of our Business and Business Strategy, as well as
information concerning our proprietary technologies and our current and planned
KL4pipeline programs.





As of December 31, 2009, we had cash and
cash equivalents of $15.7 million.  In February 2010, we completed a
public offering resulting in gross proceeds of $16.5 million ($15.1 million
net).  Also, as of December 31, 2009, our $10.5 million loan withQuintilesis classified as a current liability,
payable in April 2010.  We are pursuing a potential strategic
restructuring of this loan: however, there can be no assurance that any such
restructuring will occur. Currently, under our two CommittedEquityFinancingFacilities (CEFFs), we may potentially raise (subject to
certain conditions, including minimum stock price and volume limitations) up to
an aggregate of $69.5 million.  However, as of March 1, 2010, neither
CEFF was available because the market price of our common stock price was below
the minimum price required to utilize the facility.  During 2009, we
raised aggregate gross proceeds of $22.0 million.  In May 2009, we
completed a registered direct public offering in resulting in gross proceeds of
$11.3 million ($10.5 million net), and, throughout 2009, we raised an aggregate
of $10.7 million from 10 draw-downs under our CEFFs.See,”– Committed Equity Financing
Facilities(CEFFs)”, and “–Financings Pursuant to
Common Stock Offerings.”





Our future capital requirements depend
upon many factors, including the success of our efforts to secure one or more
strategic alliances or other collaboration arrangements to support our product
development activities and, if approved, commercialization plans.  We
are currently focused on developing our lead KL4surfactant products, Surfaxin LS,
Aerosurf and Surfaxin, to address the most significant respiratory conditions
affecting pediatric populations.  However, there can be no assurance
that we will be able to secure strategic partners or collaborators to support
and advise our activities, that our research and development projects will be
successful, that products developed will obtain necessary regulatory approval,
that any approved product will be commercially viable, that any CEFF will be
available for future financings, or that we will be able to obtain additional
capital when needed on acceptable terms, if at all.  In addition to
multiple strategic alternatives, we continue to consider potential additional
financings and other similar opportunities to meet our capital requirements and
continue our operations.  Even if we succeed in securing strategic
alliances, raising additional capital and developing and subsequently
commercializing product candidates, we may never achieve sufficient sales
revenue to achieve or maintain profitability.





CRITICAL ACCOUNTING
POLICIES





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


48





We believe the following accounting
policies are the most critical for an understanding of our financial condition
and results of operations.  For further discussion of our accounting
policies,see“Note 3–Summary of Significant Accounting
Policies” in the Notes to Consolidated Financial Statementsfor the year ended December 31,
2009,  in Part IV to this Annual Report on Form 10-K.





Revenue recognitionunderstrategic alliances and collaboration
agreements





Revenue under strategic alliances and
our collaboration agreements is recognized based on the performance requirements
of the contract.  Grant revenue is recorded upon receipt of
funds.





Research and development
expenses





Research and development costs consist
primarily of expenses associated with our personnel, facilities, manufacturing
operations, formulation development, research, clinical, regulatory, other
preclinical and clinical activities and medical affairs.  Research and
development costs are charged to operations as incurred.





RESULTS OF
OPERATIONS





The net loss for the years ended
December 31, 2009, 2008and 2007was$30.2 million (or $0.26 per share),$39.1 million (or $0.40 per
share),and$40.0 million (or $0.49 per share),
respectively.  Included in the net loss for the years ended December
31, 2009, 2008and 2007were stock-based compensation expenses
of$2.7 million (or $0.02
per share),$4.6 million
(or $0.05 per share),and
$5.3million (or $0.06 per
share), respectively.





Revenue





The company did not record any revenues
in 2009 and 2007.





In March 2008, werestructured ourDecember 2005strategicalliance with Philip Morris USA Inc. (PMUSA),
d/b/a Chrysalis Technologies (Chrysalis), and assumed full
responsibilityfrom
Chrysalisfor the further
development of thecapillary aerosolization
technology.As part of therestructuring, Chrysalis completed a
technology transferto
us, provided development
support through June 30, 2008, and also paid us $4.5 million to support our
future development activities, which we recognized as revenue in
2008.See,“Item 1 – Business –Licensing, Patents and Other Proprietary
Rights and Regulatory Designations –Patents and Proprietary Rights – Philip
Morris USA Inc. andPhilip
Morris Products S.A.”





Research and Development
Expenses





Research and development expenses for
the years ended December 31, 2009, 2008 and 2007were $19.1 million, $26.6 million and
$26.2million,
respectively.  These costs are charged to operations as incurred and
are tracked by category, as follows:


49





(Dollarsinthousands)
                    
                    YearEndedDecember31,Research and Development
      Expenses:
                    
                    2009
                    
                    
                    2008
                    
                    
                    2007Manufacturing
      development
                    
                    $
                    9,118
                    
                    
                    $
                    14,165
                    
                    
                    $
                    11,888Development
      operations
                    
                    
                    7,100
                    
                    
                    
                    9,113
                    
                    
                    
                    10,196Direct pre-clinical and clinical
      programs
                    
                    
                    2,859
                    
                    
                    
                    3,288
                    
                    
                    
                    4,116Total Research and Development
      Expenses(1)
                    
                    $
                    19,077
                    
                    
                    $
                    26,566
                    
                    
                    $
                    26,200





For a description of the clinical
programs included in research and development,see“– Surfactant Replacement Therapy for
Respiratory Medicine.”





Manufacturing
Development





Manufacturing development
includesthe cost of ourmanufacturing operations,
quality assurance and analytical chemistry capabilities to assure adequate
production of clinical and potential commercial drug supply for ourKL4surfactantproducts, in conformance with current
good manufacturing practices (cGMP).  These costs include employee expenses,
facility-related costs, depreciation, costs of drug substances (including raw
materials), supplies, quality control and assurance activities and analytical
services, etc.Additionally, in 2008 costs
includedactivities to
address issues identified inanApprovable Letterthat we received from the FDA with
respect to Surfaxin in May 2008 (May 2008 Approvable Letter).





The decrease in manufacturing
development expenses in 2009 as compared to 2008 is primarily due to our efforts
in 2009 to conserve financial resources following receipt of the April 2009
Complete Response Letter.





The increase in manufacturing
development expenses in 2008 as compared to 2007 is primarily due to:
(i) expenditures in 2008 to support our quality assurance and analytical
chemistry capabilities, including implementation and validation of analytical
methods and quality testing of drug product for our development programs; (ii)
activities related to preparation of the Complete Response to the May 2008
Approvable Letter; and (iii) purchases of active ingredients for the production
of Surfaxin.





Manufacturing development expenses
included charges of $0.4 million, $0.8 million and $0.7 million associated with
stock-based employee compensation for the years ended December 31, 2009, 2008,
and 2007, respectively.





Development
Operations





Development operations includes:
(i) medical, scientific, clinical, regulatory, data management and
biostatistics activities in support of our KL4surfactant development programs;
(ii) medical affairs activities to provide scientific and medical education
support in connection with our KL4surfactant technology pipeline
programs; (iii) design and development for the manufacture of our novel
capillary aerosolization systems, including an aerosol generating device, the
disposable dose delivery packets and patient interface system necessary to
administer Aerosurf for our planned Phase 2 clinical trials and;
(iv) pharmaceutical development activities, including development of a
lyophilized (dry powder) formulation of our KL4surfactant.  These costs
include personnel, expert consultants, outside services to support regulatory,
data management and device development activities, symposiums at key neonatal
medical meetings, facilities-related costs, and other costs for the management
of clinical trials.





The decrease in development operations
expenses in 2009 as compared to 2008 is primarily due to our efforts in 2009 to
conserve financial resources and limit investment in our KL4respiratory pipeline programs following
receipt of the April 2009 Complete Response Letter.  The decrease in
development operations expenses in 2008 as compared to 2007 is primarily due to
cost reductions resulting from the relocation of our analytical testing and
pharmaceutical development activities previously performed at our laboratories
located in Doylestown, Pennsylvania,and Mountain View, California,and consolidation of those
activities intoour new
laboratory space in Warrington, Pennsylvania,in the fourth quarter of
2007.The
decrease in 2008 from 2007 was partially offset by expenditures
in  2008 associated with our medical affairs capabilities, including
medical science liaisons and symposiums at key pediatric medical meetings in
anticipation ofthe
potential approval and commercial launch of Surfaxin in May
2008.  Expenses associated with medical affairs activities were $0.6
million, $2.0 million and $0.8 million for the years ended December 31, 2009,
2008 and 2007, respectively.


50





Development operations expenses included
charges of $0.3 million, $0.7 million and $0.9 million associated with
stock-based employee compensation for the years ended December 31, 2009, 2008,
and 2007, respectively.





Direct
Pre-Clinical and Clinical Programs





Direct pre-clinical and clinical
programs include: (i) pre-clinical activities, including toxicology studies
and other pre-clinical studies to obtain data to support potential
Investigational New Drug (IND) and NDA filings for our product candidates;
(ii) activities associated with conducting human clinical trials, including
patient enrollment costs, external site costs, clinical drug supply and related
external costs such as contract research consultant fees and expenses;
(iii) activities related to addressing the items identified in the April
2009 Complete Response Letter; and (iv) activities related to preparation
of the Complete Responses (submitted in November 2007 and October 2008,
respectively) to an Approvable Letter received from the FDA with respect to
Surfaxin in April 2006 (April 2006 Approvable Letter) and the May 2008
Approvable Letter.





Direct pre-clinical and clinical
programs expenses in 2009 included: (i) costs associated with activities to
address issuesidentified in the April 2009 Complete
Response Letter; (ii) activities associated with the ongoing Phase 2
clinical trial evaluating the use of Surfaxin in children up to two years of age
suffering with ARF; and (iii) pre-clinical and preparatory activities for
anticipated Phase 2 clinical trials for Surfaxin LS and Aerosurf for RDS in
premature infants.





Direct pre-clinical and clinical
programs expenses in 2008 and 2007 included: (i) costs associated with
preparation of the Complete Responses to the May 2008 Approvable Letter and the
April 2006 Approvable Letter; (ii) activities associated with the ongoing
Phase 2 clinical trial evaluating the use of Surfaxin in children up to two
years of age suffering with ARF; and (iii) pre-clinical and preparatory
activities for anticipated Phase 2 clinical trials for Aerosurf for RDS in
premature infants.  The decrease in expenses in 2008 as compared to
2007 is primarily due to our efforts to conserve financial resources following
receipt of the May 2008 Approvable Letter.





The decrease indirect pre-clinical and clinical programexpensesin2009compared to 2008 and 2007is primarily due to our efforts to
conserve financial resourcesand limit our investment in research and
development programsin
anticipation of potentially securing a strategic or financial alternative to
fund our research and development activities.





Research and
Development Expenses by Category





We also track ourresearch and development
expensesin major categories asshown in the following
table:





2009
                    
                    
                    2008
                    
                    
                    2007Salaries &
      Benefits
                    
                    $
                    8,693
                    
                    
                    $
                    11,651
                    
                    
                    $
                    9,808Contracted
      Services
                    
                    
                    4,832
                    
                    
                    
                    6,378
                    
                    
                    
                    8,522Rents &
      Utilities
                    
                    
                    1,310
                    
                    
                    
                    1,628
                    
                    
                    
                    2,105Depreciation
                    
                    
                    1,235
                    
                    
                    
                    1,511
                    
                    
                    
                    1,135Raw Materials&
    Supplies
                    
                    
                    1,466
                    
                    
                    
                    2,241
                    
                    
                    
                    1,091Stock-Based
      Compensation
                    
                    
                    694
                    
                    
                    
                    1,503
                    
                    
                    
                    1,681All Other
                    
                    
                    847
                    
                    
                    
                    1,654
                    
                    
                    
                    1,858Total
                    
                    $
                    19,077
                    
                    
                    $
                    26,566
                    
                    
                    $
                    26,200





Year-to-year changes in salaries,
benefits and stock-based compensation generally reflect changes in the size and
mix of our employee base over time.  In the second half of 2007, we
increased our workforce in anticipation of the potential commercial launch of
Surfaxin in 2008and, with
the prospect of generating revenues, a potential acceleration of our investment
in our pipeline programs.  We maintained our employee
base at approximately the same level throughout 2008.Following receipt ofthe April 2009Complete Response Letter for Surfaxin,
we reduced our workforceand restructured certain functions in
research and development, primarily medical affairs.See,“– Results of Operations – General and
Administrative Expenses.”


51





Contracted services include the cost of
pre-clinical studies, clinical trial activities,certain componentsour manufacturing operations, quality
control and analytical testing of our drug product, biological activity testing,
consulting services, aerosol device design and engineering services,
etc.  Contracted services decreased over the three-year period
primarily due to limiting our investment in our KL4pipeline programs to conserve financial
resources following receipt of the May 2008 Approvable
Letter.





Rents and utilities are associated with
ourleased manufacturing,
laboratory and relatedfacilities, including our manufacturing
operationsin Totowa, New
Jersey.The decreasein rents and utilitiesover the three-year period is due to
termination of leasesforoffice and analytical laboratory space
in Doylestown, Pennsylvania,and Mountain View,
California,in mid-2008.The activities performed at these
locations wereconsolidatedin the fourth quarter of
2007into ournewanalytical and development
laboratoryatcorporate headquartersat, in Warrington,
Pennsylvania.





Depreciation isassociated with manufacturing and
laboratory equipment, as well as leasehold improvements at our manufacturing
operations in Totowa and our laboratories and related space at our headquarters
in Warrington, Pennsylvania.The increasein depreciation from 2007 to 2008 is
associated with investments made tocompletethenew analytical and development
laboratory inWarrington,
Pennsylvania,at the end of
2007.Approximately $300,000 of
depreciation in2008 (and
2009)representsa full year of
depreciationwith respect
to the new laboratory.  The decline from 2008 to 2009 is
due toourlimiting purchases of equipment during
2008 and 2009 to conserve
financial resources.In addition, certain older assetsbecamefully depreciatedin this period, resulting in a decrease in
depreciation expense.





Raw materials and supplies consist of
purchases of our active pharmaceutical ingredients for the manufacture of our
KL4product candidates and supplies to
support our manufacturing and laboratory operations, including component parts
for the disposable dose delivery packets and patient interface system necessary
to administer Aerosurf via our  novel capillary aerosolization
systems.





All other includes the cost of employee
travel, insurances, shipping and taxes.





General and Administrative
Expenses





General and administrative expenses
consist primarily of the costs of executive management, business and commercial
development, finance and accounting, intellectual property and legal, human
resources, information technology, facility and other administrative
costs.





General and administrative expenses for
the years ended December 31, 2009, 2008, and 2007 were $10.1 million, $16.4
million, and $13.7 million, respectively.  General and administrative
expenses included charges of $2.2 million, $3.1 million and $3.6 million
associated with stock-based employee compensation for the years ended December
31, 2009, 2008, and 2007, respectively.





Expenses for pre-launch commercial
activities for the years ended December 31, 2009, and 2008  and 2007
were $0.7, $5.0 million, and $2.2 million, respectively.  A
significant component of 2008 and 2007 general and administrative expenses is
associated with pre-launch commercial activities to prepare for the potential
approval and commercial launch of Surfaxin in May 2008.  These
activities began in the second half of 2007 and were accelerated in early 2008
up to receipt of the May 2008 Approvable Letter.  Following receipt of
the May 2008 Approvable Letter, we scaled back our commercial
activities.  Throughout the remainder of 2008 and into 2009, we made
limited investments in our commercial capabilities in anticipation of the
potential approval of Surfaxin in the United States.  Following
receipt of the April 2009 Complete Response Letter, we have reassessed our
business strategy and have curtailed investment in commercial
capabilities.We no longer plan toestablish our own specialty pulmonary
commercial organizationto
launch our KL4surfactant products in the Unites
States and arenow seeking
to enter into strategic alliances to support our research and development
programs and, if approved, to commercialize our products in all markets,
including the United States.   Although we are actively engaged
in discussions with potential strategic and/orfinancial partners, there can be no
assurance that any strategic alliance or other financing transaction will be
successfully concluded.


52





In addition, following receipt in April
2009 Complete Response Letter, to conserve our cash resources, we implemented
cost containment measures and reduced our workforce from 115 to 91
employees.  The workforce reduction was focused primarily in our
commercial and corporate administrative groups.  We incurred a
one-time charge of $0.6 million ($0.4 million in general and administrative
expenses and $0.2 million in research and development expenses) in 2009 related
to the workforce reduction.As of December 31, 2009, we had 77 full-time employees, the
majority of which are devoted to research and development.





We believe our existing general and
administrative resources, including legal, finance, business development,
information technologies, human resources and general management capabilities,
are sufficient to support our business operations for the foreseeable
future.  We may make additional investments in the future to enhance
these capabilities as and when required to meet the needs of our
business.





To sustain and perfect our potential
competitive position, we
expect to invest inmaintaining our existing patent
portfolio, trademarks, trade secrets and regulatory exclusivity designations,
including potential orphan drug and new drug product exclusivities, andwhen appropriate,patent
extensions,new patents,new trademarks, andnewregulatory exclusivity designations,
when available.See,“Item 1 –Business –Licensing, Patents and Other Proprietary
Rights and Regulatory Designations.”





Other Income /
(Expense)





Other income / (expense), net was ($1.0) million, ($0.7) million and ($0.1) million for the
years ended December 31, 2009, 2008and 2007, respectively, as summarized in the
chart below:





(Dollars in
      thousands)
                      
                      Year Ended December
      31,2009
                      
                      
                      2008
                      
                      
                      2007Interest
    income
                      
                      $
                      48
                      
                      
                      $
                      842
                      
                      
                      $
                      1,794Interest
      expense
                      
                      
                      (1,096
                      )
                      
                      
                      (1,614
                      )
                      
                      
                      (1,906
                      )Other income /
      (expense)
                      
                      
                      5
                      
                      
                      
                      60
                      
                      
                      
                      54Other income / (expense),
      net
                      
                      $
                      (1,043
                      )
                      
                      $
                      (712
                      )
                      
                      $
                      (58
                      )





Interest income consists of interest
earned on our cash and marketable securities.  The decrease in
interest income in2009 and2008 is due to a general
decline in market interest rates and in our average cash andmarketable securities
balance.





Interest expense consists of interest
accrued on the outstanding balance of our loan withQuintilesand under our equipment financing
facilities.  In addition, interest expense includes $0.5million, $0.5 million and
$0.5million for the years ended December
31, 2009, 2008and 2007, respectively, associated with the
amortization of deferred financing costs for warrants issued toQuintilesin October 2006 as consideration forrestructuring our loan in 2006.The decrease in interest expense in2009 and2008 is due to a decline in the variable
interest rate on ourQuintilesloan, which is equal to the U.S. prime
rate.





Other income / (expenses) primarily
consists of proceeds from the sale of our Commonwealth of Pennsylvania research
and development tax creditsof$5,000, $0.1million, and $0.2millionfor the years2009, 2008and 2007, respectively.  The decrease
in proceeds from the sale of these tax credits is due to more credits being
available for sale in 2007and 2008as compared to 2009.


53


LIQUIDITY AND CAPITAL
RESOURCES





We have incurred substantial losses
since inception due to investments in research and development, manufacturing
and potential commercialization activities and we expect to continue to incur
substantial losses over the next several years.  Historically, we have
funded our business operations through various sources, including public and
private securities offerings, draw downs under our CEFFs, capital equipment and
debt facilities, and strategic alliances.  We expect to continue to
fund our business operations through a combination of these sources, as well as
sales revenue from our product candidates, beginning with Surfaxin forthe prevention ofRDS,if approved.





Following receipt of the April 2009
Complete Response Letter for Surfaxin, we made fundamental changes in our
business strategy.We nowbelievethatit is inourbest interest financially toseek to develop andcommercializeour KL4technology through strategic alliances
or othercollaboration
arrangements.However, therecan be no assurance that any strategic
alliance or otherarrangementwill be successfully
concluded.





The accompanying financial statements
have been prepared assuming that we will continue as a going concern, which
contemplates the realization of assets and satisfaction of liabilities in the
normal course of business.As a result of ourcashposition as of December 31, 2009, the
audit opinion we received from our independent auditors, which is included in
our financial statements in this report, containsa notation related to ourability tocontinue as a going
concern.Our ability to continue as a going
concern is dependent on our ability to raise additional capital, to fund our
research and development and commercial programs and meet our obligations on a
timely basis.  If we are unableto successfully raise sufficient
additional capital,through
strategic and collaborativearrangementswith potential partners
and/orfuture debt and
equity financings, we will
likely not have sufficient cash flows and liquidity to fund our business
operations, which could significantly limit our ability to continue as a going
concern.  In that event,we may be forced to further limitdevelopment ofmany, if not all, of our programsand consider other means of
creating value for our stockholders, such as licensing the development and/or commercializationof products that we
consider valuable andmightotherwiseplan todevelop ourselves.  If we are
unable to raise the necessary capital, we may be forced tocurtail all of our activities and,
ultimately, cease operations.  Even if we are able
to raise additional capital, such financings may only be available on
unattractive terms, or could result in significant dilution of
stockholders’interests and, in such event, the
market price of our common stock may decline.Our December 31, 2009 financial
statementsdo not include
any adjustments relating to recoverability and classification of recorded asset
amounts or the amounts and classification of liabilities that might be necessary
shouldwebe unable to continue in
existence.





Our future capital requirements depend
upon many factors, including the success of our efforts to secure one or more
strategic alliances to support our product development activities and
commercialization plans, and the ultimate success of our product development and
commercialization plans.Currently, we are focused on developing
our lead KL4surfactant products to address the most
significant respiratory conditions affecting pediatric populations.However, there can be no assurance that
we will be able to secure strategic partners to support our activities, that our
research and development projects will be successful, that products developed
will obtain necessary regulatory approval, that any approved product will be
commercially viable, that any CEFF will be available for future financings, or
that we will be able to obtain additional capital when needed on acceptable
terms, if at all.  In addition to multiple strategic alternatives, we
continue to consider potential additional financings and other similar
opportunities to meet our capital requirements and continue our
operations.  Even if we succeed in raising additional capital and
developing and subsequently commercializing product candidates, we may never
achieve sufficient sales revenue to achieve or maintain
profitability.





As ofDecember 31, 2009, we had cash and cash equivalents
of $15.7million.In February 2010, we completed a public
offering resulting in gross proceeds of $16.5 million ($15.1 million
net).Also, as
of December 31, 2009, our $10.5 million loan withQuintilesis classified as a current liability,
payable in April 2010.We arepursuing a potential strategic
restructuring of this loan:however, there can be no assurance that
any such restructuring will occur.Currently, under our two CEFFs, we may
potentially raise (subject to certain conditions, including minimum stock price
and volume limitations) up to an aggregate of $69.5million.However, as of March5,2010,neitherthe May 2008 CEFFnor the December 2008 CEFFwas available becausethe market price ofourcommonstock was below the minimum
pricerequired($1.15 and $0.60, respectively) to
utilize the facility.During 2009, we raised aggregate gross
proceeds of $22.0 million.  In May 2009, wecompleted a registered direct public
offeringinresulting in gross proceeds of $11.3
million ($10.5 million net), and, throughout 2009, weraised an aggregate of $10.7millionfrom10draw-downs under our CEFFs.See,“– Committed Equity Financing
Facilities(CEFFs),”and “–Financings Pursuant to Common Stock
Offerings.”


54





To meet our capital requirements, we
continue to consider multiple strategic alternatives, including, but not limited
to potential business alliances, commercial and development
partnerships,additional financings and other similar opportunities, although
there can be no assurance that we will take any further specific actions or
enter into any transactions.Untilsuch timeas we secure the necessary
capital,weplan tocontinue conservingour financial resources,predominantlybylimiting investments in our pipelineprograms.See,“Item 1A –Risk Factors –We will
require significant additional capital to continue our planned research and
development activities and continue to operate as a going concern. 
Moreover, such additional financing could result in equity dilution,”and“–The terms of our indebtedness may impair
our ability to conduct our business,”“–Future sales and issuances of our common
stock or rights to purchase our common stock, including pursuant to our CEFFs, stock
incentive plans and upon the exercise of outstanding securities exercisable for
shares of our common stock, could result in substantial additional dilution of
our stockholders, cause our stock price to fall and adverselyaffect our ability to raise
capital.”





Cash Flows





We had cash, cash equivalents and
marketable securities of $15.7million, $24.8million and $53.0million as of December 31,
2009, 2008and 2007, respectively.  The decrease
of $9.1million in 2009is primarily due to $30.0million used in operating activities,
capital expenditures and principal payments on equipment loans, partially offset
by proceeds of $10.4million from financings under our CEFFs
and $10.5million from ourMay 2009 Registered Direct
Offering.See,“– Committed Equity Financing
Facilities(CEFFs)”, and “–Financings Pursuant to
Common Stock Offerings.”





Cash Flows Used in Operating
Activities





Cash flows used in operating activities
were $27.4million, $31.8million and $29.4million for the years ended December
31, 2009, 2008and 2007,respectively.





Our cash flows used in operating
activities are a result of our net operating losses adjusted for non-cash
expenses associated with stock-based compensation, depreciation and changes in
our accounts payable and accrued liabilities.See,“– Results of Operations.”  Cash flows from operating
activities in 2008 alsoinclude $4.5million received fromChrysalisto support development of our capillary
aerosolization technology.





Cash FlowsFrom / (Used in)Investing
Activities





Cash flowsfrom / (used in)investing activities include capital
expenditures of $0.1million, $0.6million and $3.8million for the years ended December
31, 2009, 2008and 2007, respectively.  Capital
expenditures were primarily for laboratory and manufacturing equipment to
support analytical, quality, manufacturing and development
activities.  In 2007, we completed construction of a new analytical
and development laboratory in our headquarters in Warrington, Pennsylvania, for
a total cost of approximately $3.0 million andconsolidated at this location the
analytical, quality and development activities previouslyconducted at locationsin Doylestown, Pennsylvania,and Mountain View,
California.The
new laboratoryexpanded our
capabilities by providing additional capacity to conduct analytical testing as
well as opportunities toexploitourinternalprofessional expertise across a broad
range of projects, improving both operational efficiency and financial
economics.The leases for ourDoylestown, Pennsylvania,and Mountain View,
California,locations either expired orterminatedin 2008.See,“– Contractual Obligations.”





Cash flows from / (used in) investing
activities also include cash used to purchase short-term marketable securities
and cash received from the sale and/or maturity of short-term marketable
securities.  When assessing our cash position and managing our
liquidity and capital resources, we do not consider cash flows between cash and
marketable securities to be meaningful.  Cash used to purchase
marketable securities is subject to an investment policy that is approved by the
Board of Directors and provides for the purchase of high-quality marketable
securities, while ensuring preservation of capital and fulfillment of liquidity
needs.As of
December 31, 2009, the company did not have any available-for-sale marketable
securities.





55




Cash Flows from Financing
Activities





Cash flows from financing activities
were $18.3million, $4.2million and $59.7million for the years ended December 31,
2009, 2008and 2007, respectively, as summarized in the
chart below:





(Inmillions)
                      
                      YearEndedDecember31,2009
                      
                      
                      2008
                      
                      
                      2007Financings under
      CEFFs
                      
                      $
                      10.3
                      
                      
                      $
                      6.3
                      
                      
                      $
                      7.0Financings pursuant to common
      stock offerings
                      
                      
                      10.5
                      
                      
                      
                      –
                      
                      
                      
                      51.7Proceeds from equipment financing
      facilities
                      
                      
                      –
                      
                      
                      
                      0.9
                      
                      
                      
                      2.9Debt service
      payments
                      
                      
                      (2.5
                      )
                      
                      
                      (3.0
                      )
                      
                      
                      (1.9
                      )Cash flows from financing
      activities, net
                      
                      $
                      18.3
                      
                      
                      $
                      4.2
                      
                      
                      $
                      59.7





The following sections provide a more
detailed discussion of our cash flows from financing
activities.





Committed Equity Financing Facilities
(CEFFs)





We have
entered into four Committed Equity Financing Facilities (CEFFs) with Kingsbridge
Capital Limited (Kingsbridge), a private investment group, under which
Kingsbridge is committed to purchase, subject to certain conditions,
newly-issued shares of our common stock.  The CEFFs allow us, at our
discretion, to raise capital at the time and in amounts deemed suitable to us,
to support our business plans.  We are not obligated to utilize any of
the funds available under the CEFFs.  Each CEFF is available for a
period of two or three years from inception.  Should we choose to
utilize any of the CEFFs, our ability to access the funds available under the
CEFFs is subject to certain conditions, including stock price and volume
limitations.





As of December 31, 2009,we hadtwoCEFFsavailablefor future financings as follows: the
CEFF dated December 12, 2008 (December 2008 CEFF)andthe CEFF dated May 22, 2008 (May 2008
CEFF).  A third
CEFF entered in April 2006 expired on May 12, 2009 and is no longer
available.The
following table sets forth an overview of the “draw down” requirements and
availability under each CEFF:




(inmillions,exceptper
                                sharedataandtradingdays)
                              
                              
                              
                              Minimum
      Price
                              
                              Minimum
                              
                              #of
                                Trading
                                Days
                              
                              
                              Amountper
                                Contract
                              
                              
                              PotentialAvailability
                                at
                                December31,2009Expiration
                              
                              to
      Initiate
                                  Draw
                                  Down(1)
                              
                              VWAP
      for
                                Daily
                                Pricing(2)
                              
                              In
      Each
                                Draw
                                Down(2)
                              
                              
                              Shares
                              
                              
                              Maximum
                                Proceeds
                              
                              
                              Shares
                              
                              
                              Maximum
                                ProceedsMay 2008 CEFF
                              
                              June 18, 2011
                              
                              $
                              1.15
                              
                              90% of the
                                closing market
                                price on the
                                day preceding
                              
                              
                              8
                              
                              
                              
                              19.3
                              
                              
                              $
                              60.0
                              
                              
                              
                              12.8
                              
                              
                              $
                              51.8Dec. 2008 CEFF
                              
                              Feb. 6, 2011
                              
                              $
                              0.60
                              
                              the first day of
                                draw down
                              
                              
                              6
                              
                              
                              
                              15.0
                              
                              
                              $
                              25.0
                              
                              
                              
                              7.1
                              
                              
                              $
                              17.7





(1)
            To initiate a draw down, the
      closing price of our common stock on the trading day immediately preceding
      the first trading day of the draw downperiodmust be at least equal to the
      minimum price set forth
above.


(2)
            If on any trading day, the daily
      volume-weighted average of our common stock (VWAP) is less than the
      minimum VWAP set forth above, no shares are purchased on that trading day
      and the aggregate amount that we originally designatedfor the overalldraw down is reduced for each such
      dayby1/8thin the case of theDecember2008 CEFF, and1/6thin the case of the May2008 CEFF, respectively.  Unless we and
      Kingsbridge agree otherwise, a minimum of three trading days must elapse
      between the expiration of any draw-down pricing period and the beginning
      of the next draw-down pricing
period.


56


Each draw down is limited in amount as
follows:





·
            May 2008 CEFF – the lesser of 3.0
      percent of the closing price market value of the outstanding shares of our
      common stock at the time of the draw down or $10 million;
      and


·
            December 2008 CEFF – the lesser of
      1.5 percent of the closing price market value of the outstanding shares of
      our common stock at the time of the draw down or $3
      million.





The
purchase price of shares sold to Kingsbridge under the CEFFs is at a discount to
the VWAP (as defined in the applicable agreement) for each of the trading days
following our initiation of a “draw down” under the CEFF, as
follows:





DailyVWAP
                        
                        %ofVWAP
                        
                        
                        ApplicableDiscountMay 2008 CEFFGreater
      than $7.25 per share
                        
                        
                        94
                        %
                        
                        
                        6
                        %Less
      than or equal to $7.25 but greater than $3.85 per share
                        
                        
                        92
                        %
                        
                        
                        8
                        %Less
      than or equal to $3.85 but greater than $1.75 per share
                        
                        
                        90
                        %
                        
                        
                        10
                        %Less
      than or equal to $1.75 but greater than or equal to $1.15 per
      share
                        
                        
                        88
                        %
                        
                        
                        12
                        %December
      2008 CEFFGreater
      than $7.25 per share
                        
                        
                        94
                        %
                        
                        
                        6
                        %Less
      than or equal to $7.25 but greater than $3.85 per
      share
                        
                        
                        92
                        %
                        
                        
                        8
                        %Less
      than or equal to $3.85 but greater than $1.75 per
      share
                        
                        
                        90
                        %
                        
                        
                        10
                        %Less
      than or equal to $1.75 but greater than or equal to $1.10 per
      share
                        
                        
                        88
                        %
                        
                        
                        12
                        %Less
      than or equal to $1.10
      but greater than or equal to $.60
                        
                        
                        85
                        %
                        
                        
                        15
                        %





In addition, Kingsbridge may terminate
the CEFFs under certain circumstances, including if a material adverse event
relating to our business continues for 10 trading days after notice of the
material adverse event.





In
connection with the December 2008 CEFF, we issued a warrant to Kingsbridge on
December 22, 2008 to purchase up to 675,000 shares of our common stock at an
exercise price of $1.5132 per share.  The warrant expires in May 2014
and is exercisable, in whole or in part, for cash, except in limited
circumstances, with expected total proceeds to us, if exercised, of
approximately $1.0 million.  As of December 31, 2009, this warrant had
not been exercised.





In
connection with the May 2008 CEFF, we issued a warrant to Kingsbridge on May 22,
2008 to purchase up to 825,000 shares of our common stock at an exercise price
of $2.506 per share.  The warrant expires in November 2013 and is
exercisable, in whole or in part, for cash, except in limited circumstances,
with expected total proceeds to us, if exercised, of approximately $2.1
million.  As of December 31, 2009, this warrant had not been
exercised.





In
connection with the 2006 CEFF, we issued a Class C Investor Warrant to
Kingsbridge on April 17, 2006 to purchase up to 490,000 shares of our common
stock at an exercise price equal to $5.6186 per share.  The warrant
expires in October 2011 and is exercisable, in whole or in part, for cash,
except in limited circumstances, with expected total proceeds to us, if
exercised, of approximately $2.8 million.  As of December 31, 2009,
this Class C Investor Warrant had not been exercised.





In
connection with a CEFF that we entered in 2004, we issued a Class B Investor
Warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at
an exercise price equal to $12.0744 per share.  The warrant expired
unexercised in January 2010.


57


CEFF
Financings





The financings that wecompleted under theDecember2008 CEFF
are:





(inthousands, exceptper share data)


CompletionDate
                  
                  SharesIssued
                  
                  
                  GrossProceeds
                  
                  
                  Discounted
                    AveragePrice
                    PerShareApril 8,
    2009
                  
                  
                  806
                  
                  
                  $
                  1,000
                  
                  
                  $
                  1.24May 7, 2009
                  
                  
                  1,273
                  
                  
                  
                  1,000
                  
                  
                  
                  0.79September 23,
      2009
                  
                  
                  1,793
                  
                  
                  
                  1,583
                  
                  
                  
                  0.88October 13,
      2009
                  
                  
                  1,909
                  
                  
                  
                  1,800
                  
                  
                  
                  0.94October 21,
      2009
                  
                  
                  2,101
                  
                  
                  
                  1,900
                  
                  
                  
                  0.90





The
financings that we completed under the May 2008 CEFF are:





(inthousands, exceptper share data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareJuly 11,
    2008
                    
                    
                    1,105
                    
                    
                    $
                    1,563
                    
                    
                    $
                    1.41July 31,
    2008
                    
                    
                    992
                    
                    
                    
                    1,500
                    
                    
                    
                    1.51October 17,
      2008
                    
                    
                    914
                    
                    
                    
                    1,313
                    
                    
                    
                    1.44November 20,
      2008
                    
                    
                    221
                    
                    
                    
                    250
                    
                    
                    
                    1.13January2, 2009
                    
                    
                    479
                    
                    
                    
                    500
                    
                    
                    
                    1.04January16, 2009
                    
                    
                    419
                    
                    
                    
                    438
                    
                    
                    
                    1.04February 18,
      2009
                    
                    
                    857
                    
                    
                    
                    1,000
                    
                    
                    
                    1.17March 31,
    2009
                    
                    
                    1,015
                    
                    
                    
                    1,094
                    
                    
                    
                    1.08October 13,
      2009
                    
                    
                    559
                    
                    
                    
                    606
                    
                    
                    
                    1.09





The financings that we completed under
thenow expired2006 CEFF
are:





(inthousands, exceptper share data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareMay 29,
2006
                    
                    
                    1,079
                    
                    
                    $
                    2,188
                    
                    
                    $
                    2.03October 11,
      2006
                    
                    
                    1,205
                    
                    
                    
                    2,300
                    
                    
                    
                    1.91November 10,
      2006
                    
                    
                    1,372
                    
                    
                    
                    3,000
                    
                    
                    
                    2.19February 22,
      2007
                    
                    
                    943
                    
                    
                    
                    2,000
                    
                    
                    
                    2.12October 12,
      2007
                    
                    
                    1,909
                    
                    
                    
                    5,000
                    
                    
                    
                    2.62September 9,
      2008
                    
                    
                    676
                    
                    
                    
                    1,250
                    
                    
                    
                    1.85





Financings Pursuant to Common Stock
Offerings





Historically, we havefunded, and expect to continue to
fund,our business operations through various
sources, including financings pursuant to common stock
offerings.


58





2008 Universal Shelf





In June 2008,we filed a universal shelf registration
statement on Form S-3 (No.333-151654) (2008 Universal Shelf) with the SEC
for the proposed offering from time to time of up to $150 million of our
securities, including common stock, preferred stock, varying forms of debt and
warrant securities, or any combination of the foregoing, on terms and conditions
that will be determined at that time.





In February 2010, we completed a public
offering of 27,500,000 shares of our common stock and warrants to purchase
13,750,000 shares of our common stock, sold as units, with each unit consisting
of one share of common stock and a warrant to purchase 0.50 of a share of common
stock, at a public offering price of $0.60 per unit, resulting in gross and net
proceeds to us of $16.5 million andapproximately$15.1 million,
respectively.  The warrants expire in February 2015 and are
exercisable, subject to an aggregate share ownership limitation, at a price per
share of $0.85, for cash or, in the event that the related registration
statement or an exemption from registration is not available for the resale of
the warrant shares, on a cashless basis.





In May 2009, we completed a registered
direct offering of 14,000,000 shares of our common stock and warrants to
purchase 7,000,000 shares of our common stock, sold as units to select
institutional investors, with each unit consisting of one share of common stock
and a warrant to purchase 0.50 of a share of common stock, at an offering price
of $0.81 per unit, resulting in gross and net proceeds to us of $11.3 million
and $10.5 million, respectively.  The warrants expire in May 2014 and
are exercisable, subject to an aggregate share ownership limitation, at a price
per share of $1.15, for cash or, in the event that the related registration
statement or an exemption from registration is not available for the resale of
the warrant shares, on a cashless basis.




As of
December 31, 2009 and March 1, 2010, respectively, up to $138.7 million and
$122.2 million of our securities are potentially available for issuance pursuant
to the 2008 Universal Shelf.





2005 Universal Shelf





In October 2005, we filed a universal
shelf registration statement onForm S-3 (File No. 333-128929)(2005 Universal Shelf)with the SEC for the proposed offering,
from time to time, of up to $100 million of our debt or equity
securities.





In December 2007, we completed a
registered direct offering of 10,000,000 shares of our common stock to select
institutional investors.  The shares were priced at $2.50 per share
resulting in gross and net proceeds to us of $25.0 million and $23.6 million,
respectively.





In April 2007, we completed a registered
direct offering of 14,050,000 shares of our common stock to select institutional
investors.  The shares were priced at $2.15 per share resulting in
gross and net proceeds to us of $30.2 million and $28.1 million,
respectively.





The October 2005 universal shelf
registration statement expired in December 2008 and is no longer
available.





Debt





Historically, we havefunded, and expect to continue tofund, our business operations through
various sources, including debt arrangements such as credit facilities and
equipment financing facilities.





Loan withQuintiles





Quintilesextended to us a secured, revolving
credit facility, which we
restructured in October
2006.The outstanding principal balance
ofthe loan,$8.5 million,is due and payable onApril 30, 2010, together with all unpaid interestaccrued sinceJuly 1, 2006.  Since October
2006, interest is calculatedat the prime rate, compounded
annually.  We may repay the loan, in whole or in part, at any time
without prepayment penalty or premium.  In addition, our obligations
toQuintilesunder the loanagreementaresecured by asecurityinterest in substantially all of our
assets, subject to limited exceptions set forth in therelated securityagreement.


59





Also in October 2006, in consideration
ofQuintiles’s agreement to restructure the loan, we
entered into a Warrant Agreement withQuintiles, pursuant to whichQuintileshas the right to purchase 1.5 million
shares of our common stock at an exercise priceof$3.5813 per share.  The
warrants have a seven-year term and are exercisable, in whole or in part, for
cash, cancellation of a portion of our indebtedness under theQuintilesloan agreement, or a combination of the
foregoing, in an amount equal to the aggregate purchase price for the shares
being purchased upon any
exercise.





As of December 31, 2009, the outstanding balance under the loan
was $10.5million ($8.5 million principal and
$2.0million accrued interest) and was
classified as acurrent
liabilityon the
Consolidated Balance Sheetsas of such date.





For the years ended December 31,
2009, 2008and 2007, we incurred interest expense
associated with theQuintilesloan of $0.3million, $0.5million and $0.7million,
respectively.The decrease in interest expense in 2009
and 2008 is due to declines in the prime rate during 2008 ranging from 7.25% to
3.25%.During
2009, the prime rateremained at 3.25%.In addition, for the years
endedDecember 31, 2009,
2008 and 2007, we incurred interest expense associated with the amortization of
deferredfinancing costs in
connection with warrants issued toQuintilesin October 2006 of $0.5million, $0.5 million and
$0.5million,
respectively.





Equipment Financing
Facilities





Historically, we havefundedour purchases of capital expenditures
through the use of equipment financing facilities, although we currently do not have a
facility available.  The outstanding principal
balanceof
thesefacilities as of
December 31, 2009and 2008was as follows:





(in
    thousands)
                  
                  2009
                  
                  
                  2008GE Business Financial Services,
      Inc.Short-term
                  
                  $
                  538
                  
                  
                  $
                  2,385Long-term
                  
                  
                  65
                  
                  
                  
                  664Total
                  
                  
                  603
                  
                  
                  
                  3,049Pennsylvania Machinery and
      Equipment LoanShort-term
                  
                  
                  59
                  
                  
                  
                  57Long-term
                  
                  
                  363
                  
                  
                  
                  428Total
                  
                  
                  422
                  
                  
                  
                  485Total
      Short-term
                  
                  
                  597
                  
                  
                  
                  2,442Total
    Long-term
                  
                  
                  428
                  
                  
                  
                  1,092Total
                  
                  $
                  1,025
                  
                  
                  $
                  3,534





GE Business Financial Services
Inc.





In May 2007, we entered into a Credit
and Security Agreement (Credit Agreement) with GE Business Financial Services
Inc. (formerly Merrill Lynch Business Financial Services Inc.) (GE), as Lender,
pursuant to which GE agreed to provide us a $12.5 million facility (Facility) to
fund our capital programs.  The right to draw under this Facility
expired on November 30, 2008.  Over the term of the Facility, we
received $7.2 million, $4.0 million of which was applied to prepayment of a
prior facility and $2.3 million of which was associated with construction
and equipment for the analytical and development laboratory that we built in our
Warrington, Pennsylvania headquarters in 2007.


60





Proceeds received under the Facility
were $0.0 million, $0.4 million and $6.8 million for the years ended December
31, 2009, 2008 and 2007, respectively.  Advances under the Facility to
finance the acquisition of property and equipment are amortized over a period of
36 months and all other equipment and related costs are amortized over a
period of 24 months.  The advance to prepay our prior facility is
amortized over a period of 27 months.  Interest on each advance
accrues at a fixed rate per annum equal toone-monthLIBOR plus 6.25%, determined on the
funding date of such advance.  Principal and interest on all advances
are payable in equal installments on the first business day of each
month.  We may prepay advances, in whole or in part, at any time,
subject to a prepayment penalty, which, depending on the period of time elapsed
from the closing of the Facility, will range from 4% to 1%.





Principal payments under the Facility
were $2.4 million, $3.0 million and $1.2 million for the years ended December
31, 2009, 2008 and 2007, respectively.  Interest expense under the
Facility was $0.2 million, $0.5 million and $0.7 million for the years ended
December 31, 2009, 2008 and 2007, respectively.  The remaining
outstanding loan balance under the Facility was $0.6 million as of December 31,
2009, which will be paid over the next 21 months, with the final payment in
September 2011.





Our obligations under the Facility are
secured by a security interest in (i) the financed property and equipment, and
(ii) all of our intellectual property (Supplemental Collateral), subject to
limited exceptions set forth in the Loan Agreement.  The Supplemental
Collateral will be released on the earlier to occur of (a) receipt by us of FDA
approval of our NDA for Surfaxinfor the prevention of RDS in premature
infants, or (b) the date on which we shall have maintained over a continuous
12-month period ending on or after March 31, 2008, measured at the end of each
calendar quarter, a minimum cash balance equal to our projected cash
requirements for the following 12-month period.  In addition, we, GE
andQuintilesentered into an Intercreditor Agreement
under which GE agreed to subordinate its security interest in the Supplemental
Collateral (which does not include financed property and equipment) to the
security interest in the same collateral that we previously granted toQuintiles(asdiscussed above).





Pennsylvania–Department of Community and Economic
Development – Machinery and Equipment Loan Fund





We entered into a Loan Agreement and
Security Agreement with the Commonwealth of Pennsylvania, Department of
Community and Economic Development (Department)inSeptember 2008,pursuant to which the Department made a
loan to us from the Machinery and Equipment Loan Fund in the amount of $500,000
(MELF Loan) to fund the purchase and installation of new machinery and equipment
and the upgrade of existing machinery and equipment at our analytical and
development laboratory in Warrington, Pennsylvania.  Principal and
interest on the MELF Loan is payable in equal monthly installments over a period
of seven years.  Interest on the principal amount accruesat a fixed rateof five percent (5.0%)per annum.  We may prepay the
MELF Loan at any time
without penalty.





In addition to customary terms and
conditions, the MELF Agreement provides that we must meet certain criteria
regarding retention and creation of new jobs within a three-year
period.  In the event that we fail to comply with this requirement,
the interest rate on the Promissory Note, except in limited circumstances, will
be adjusted to a fixed rate equal to two percentage points above the current
prime rate for the remainder of the term.





Off-Balance Sheet
Arrangements





We did not have any material off-balance
sheet arrangements at December 31, 2009, 2008 or 2007, or for the periods then
ended.


61





Contractual
Obligations





Payments due under contractual debt
obligations at December 31, 2009, including principal and interest, are
as follows:





(in
      thousands)
                      
                      2010
                      
                      
                      2011
                      
                      
                      2012
                      
                      
                      2013
                      
                      
                      2014
                      
                      
                      There-after
                      
                      
                      TotalLoan payable(1)
                      
                      $
                      10,573
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      –
                      
                      
                      $
                      10,573Equipment
      loan obligations(1)
                      
                      
                      722
                      
                      
                      
                      152
                      
                      
                      
                      85
                      
                      
                      
                      85
                      
                      
                      
                      85
                      
                      
                      
                      70
                      
                      
                      
                      1,199Operating
      lease obligations
                      
                      
                      1,127
                      
                      
                      
                      1,146
                      
                      
                      
                      1,166
                      
                      
                      
                      320
                      
                      
                      
                      150
                      
                      
                      
                      –
                      
                      
                      
                      3,909CEO
      severance
      obligations
                      
                      
                      1,211
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      1,211Total
                      
                      $
                      13,633
                      
                      
                      $
                      1,298
                      
                      
                      $
                      1,251
                      
                      
                      $
                      405
                      
                      
                      $
                      235
                      
                      
                      $
                      70
                      
                      
                      $
                      16,892





(1)See, “–Liquidity and Capital Resources -
Debt.”For the
purposes of this table, we have assumed that theQuintilesLoan will accrue interest through
maturity at an average rate that is equal to the current prime rate of
3.25%.





Operating Lease
Agreements





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




We lease
approximately 21,000 square feet of space for our manufacturing facility in
Totowa, New Jersey, at an annual rent of $150,000.  This space is
specifically designed for the manufacture and filling of sterile pharmaceuticals
in compliance with cGMP and is our only manufacturing facility. The lease
expires in December 2014, subject to the landlord’s right, upon
two years’ prior notice, to terminate the lease early.  This early
termination right is subject to certain conditions, including that the master
tenant, a related party of the landlord, must have ceased all activities at the
premises, and, depending upon the timing of the notice, if we satisfy certain
financial conditions, the landlord would be obligated to make early
termination payments to us.  At the present time, we understand
that the master tenant continues to be active in the premises. The total
aggregate payments over the term of the lease are $1.4 million.  In
connection with our manufacturing operations in Totowa, New Jersey, we have 15
employees subject to a collective bargaining arrangement which expires on
December 3, 2010. See,“Item 1 – Business
– Business Operations – Manufacturing and Distribution,” and “Item 2 –
Properties.”





Our lease for 5,600 square feet of
office and analytical laboratory space in Doylestown, Pennsylvania was
terminated effective July 31, 2008 and all activities at this location have been
consolidated into our laboratory space in Warrington,
Pennsylvania.  Our lease for 16,800 square feet of office and
laboratory space at our facility in Mountain View, California, expired without
renewal or extension on June 30, 2008.  In December 2007, we
consolidated these activities into our laboratory space in Warrington,
Pennsylvania.





Rent expense under all leases for the
years ended December 31, 2009, 2008, and 2007 was $1.1 million, $1.2 million and
$1.5 million respectively.


62




Former CEO
Commitment





Effective August 13, 2009, Dr. Robert J.
Capetola resigned his positions as our President and Chief Executive Officer and
as a member of our Board.  The Board elected Mr. W. Thomas Amick,
Chairman of the Board, to serve as Chief Executive Officer on an interim
basis.  We entered into a separation agreement and general release
(Separation Agreement) with Dr. Capetola providing for (i) an upfront severance
payment of $250,000, and (ii) periodic payments in an amount equal to his base
salary (calculated at a rate of $490,000 per annum), in accordance with our
payroll practices and less required withholdings.  The periodic
payments will end the earlier of (x) May 3, 2010 or (y) the date, if ever, that
a Corporate Transaction (as defined below) occurs.  In addition, Dr.
Capetola will be entitled to (A) continuation of medical benefits and insurance
coverage for a period of 24 or 27 months, depending upon circumstances, and (B)
accelerated vesting of all outstanding restricted shares and options, which
shall remain exercisable to the end of their stated
terms.





The Separation Agreement provides
further that, upon the occurrence of a Corporate Transaction prior to May 4,
2010, Dr. Capetola will receive a payment of up to $1,580,000(the “Additional Severance”)or, if any such Corporate
Transaction also constitutes a Change of Control (as such term is defined in the
Separation Agreement), a payment of up to $1,777,500; provided, however, that,
in each case, any such payment will be reduced by the sum of the amounts
described in clauses (i) and (ii) of this paragraph that theretofore have been
paid.  A “Corporate Transaction” is defined in the Separation
Agreement as (1) one or more corporate partnering or strategic alliance
transactions, Business Combinations or public or private financings that (A) are
completed during the Severance Period (as defined in the Separation Agreement)
and (B) result in cash proceeds (net of transaction costs) to the Company of at
least $20 million received during the Severance Period or within 90 calendar
days thereafter, or (2) an acquisition of the Company, by business combination
or other similar transaction, that occurs during the Severance Period and the
consideration paid to stockholders of the Company, in cash or securities, is at
least $20 million.  For this purpose, net proceeds will be calculated
without taking into account any amounts received by the Company as reimbursement
for costs of development and research activities to be performed in connection
with any such transaction.





Since August 13, 2009, we have raised
approximately $5.89 million in gross proceeds utilizing our CEFFs (see,“– Committed Equity Financing
Facilities(CEFFs)”).  In addition, on February 23, 2010, we completed a public
offering that resulted in net proceeds to us of approximately $15.1 million
(see,“–Financings Pursuant to Common Stock
Offerings.”).As the receipt from
financings of more than $20 million qualifies as a Corporate Transaction, our
obligation under the Separation Agreement to make payment to Dr. Capetola of the
Additional Severance has matured.  Therefore, in accordance with the
Separation Agreement, on March 5, 2010, we issued a payment to Dr. Capetola in
the amount of approximately$1.06million (less withholding),
representing his Additional Severance payment, reduced by the payments
previously made to him under the Severance Agreement, which total approximately$0.52million.  Our obligation to
make periodic payments under the Separation Agreement has been satisfied and no
further payments are due at this time.





Future Milestone
Commitment





In addition to the contractual
obligations above, we have certain milestone and royalty payment obligations to
Johnson & Johnson related to our product licenses.  To date,of the$2,500,000aggregate potential milestone
payments,we have paid $450,000formilestonesthat have been achieved.





ITEM 7A.
            QUANTITATIVE AND QUALITATIVE
      DISCLOSURES ABOUT MARKET RISK.





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





ITEM 8.
            FINANCIAL STATEMENTS AND
      SUPPLEMENTARY DATA.





See,Index to Consolidated Financial
Statements on Page F-1 attached hereto.


63





ITEM 9.
            CHANGES IN AND DISAGREEMENTS WITH
      ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.





Not applicable.





ITEM 9A.
            CONTROLS AND
      PROCEDURES.




(a) Evaluation of disclosure controls
and procedures





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





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




(b) Management’s
Report on our Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rule 13a-15(f)
promulgated under the Exchange Act.  Our internal control system is
designed to provide reasonable assurance to our management and board of
directors regarding the preparation and fair presentation of published financial
statements.  All internal control systems, no matter how well
designed, have inherent limitations.  Therefore, even those systems
determined to be effective can provide only reasonable assurance with respect to
financial statement preparation and presentation.





Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, our management
conducted an evaluation of the effectiveness of our internal control over
financial reporting as of December 31, 2009.  In making this
assessment, our management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal
Control-Integrated Framework.  Based on our assessment, our management
believes that our internal control over financial reporting is effective based
on those criteria, as of December 31, 2009.


64





Our independent registered public
accounting firm has audited management’s assessment of our internal controlover financial reporting,
and issued an unqualified opinion dated March 10, 2010 on such assessment and on
ourinternal control over
financial reporting, which opinion is included herein.





(c)
            Changes in internal
      controls





There were no changes in our internal
controlover financial
reportingidentified in connection with the
evaluation described above that occurred during the quarter ended December 31,
2009 that has materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting.


65


Report
of Independent Registered Public Accounting Firm





The
Board of Directors and Stockholders


Discovery
Laboratories, Inc. and Subsidiary





We have
audited Discovery Laboratories, Inc. and subsidiary’s internal control over
financial reporting as of December 31, 2009, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Discovery
Laboratories, Inc. and subsidiary’s management is responsible for maintaining
effective internal control over financial reporting, and for its assessment of
the effectiveness of internal control over financial reporting included in the
accompanying Management’s
Report on our Internal Control over Financial Reporting. Our
responsibility is to express an opinion on the company’s internal control over
financial reporting based on our audit.





We
conducted our audit 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 effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, testing
and evaluating the design and operating effectiveness of internal control based
on the assessed risk, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.





A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





In our opinion, Discovery Laboratories,
Inc. and subsidiary maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2009, based onthe COSO criteria.





We also have audited, in accordance with
the standards of the Public Company Accounting Oversight Board (United States),
theconsolidated balance
sheets ofDiscovery
Laboratories, Inc. and subsidiaryas of December 31, 2009 and 2008, and
the related consolidated statements of operations, stockholders’ equity, and
cash flows for each of the three years in the period ended December 31,
2009of Discovery
Laboratories, Inc. and subsidiary and our report datedMarch 10, 2010 expressedan unqualified opinion
thereon.




/s/ Ernst
& Young LLP





Philadelphia,
Pennsylvania


March 10,
2010


66


ITEM 9B.
            OTHER
      INFORMATION.





Not
applicable.





PART III





The information required by Items 10
through 14 of Part III is incorporated herein by reference to our definitive
proxy statement to be filed with the Securities and Exchange Commission within
120 days after the end of our 2009 fiscal year.





We have adopted a Code of Ethics that
applies to our officers, including our principal executive, financial and
accounting officers, and our directors and employees.  We have posted
the Code of Ethics on our Internet website at“http://www.DiscoveryLabs.com”under the “Investors” tab
in the Corporate Policies section.  We intend to make all required
disclosures on a Current Report on Form 8-K concerning any amendments to, or
waivers from, our Code of Ethics with respect to our executive officers and
directors.Our
website and the information contained therein or connected thereto are not
incorporated into this Annual Report on Form 10-K.





PART IV





ITEM 15.
            EXHIBITS AND FINANCIAL STATEMENT
      SCHEDULES.





The consolidated financial statements
required to be filed in this Annual Report on Form 10-K are listed on the Index
to Consolidated Financial Statements on page F-1 hereof.





Exhibits are listed on the Index to
Exhibits at the end of this Annual Report on Form 10-K.  The exhibits
required to be filed pursuant to Item 601 of Regulation S-K, which are listed on
the Index in response to this Item, are incorporated herein by
reference.


67


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.





DISCOVERY LABORATORIES,
      INC.Date:March10, 2010
            
            By:
            /s/ W. Thomas
      AmickW. Thomas Amick, Chairman of the
      Boardand Principal Executive
      Officer





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
                    
                    Name &
      Title
                    
                    Date/s/ W. Thomas
      Amick
                    
                    W. Thomas
    Amick
                    
                    March 10,
    2010Chairman of the Board and
      Principal Executive Officer/s/ John G.
      Cooper
                    
                    John G.
    Cooper
                    
                    March 10,
    2010Executive Vice President and Chief
      Financial Officer(Principal Accounting
      Officer)/s/ Herbert H. McDade,
      Jr.
                    
                    Herbert H. McDade,
      Jr.
                    
                    March 10,
    2010Director/s/ Antonio
      Esteve
                    
                    Antonio Esteve,
      Ph.D.
                    
                    March 10,
    2010Director/s/ Max E.
    Link
                    
                    Max E. Link,
      Ph.D.
                    
                    March 10,
    2010Director/s/ Marvin E.
      Rosenthale
                    
                    Marvin E. Rosenthale,
      Ph.D.
                    
                    March 10,
    2010Director


68


INDEX TO EXHIBITS


The following exhibits are included with
this Annual Report on Form 10-K.  All management contracts or
compensatory plans or arrangements are marked with an
asterisk.




Exhibit No.
                        
                        Description
                        
                        Method of
      Filing3.1
                        
                        Amended and Restated Certificate
      of Incorporation of Discovery Laboratories, Inc. (Discovery), dated
      December 9, 2009.
                        
                        Incorporated by reference to
      Exhibit 3.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on December 9, 2009.3.2
                        
                        Certificate of Designations,
      Preferences and Rights of Series A Junior Participating Cumulative
      Preferred Stock of Discovery, dated February 6,
    2004.
                        
                        Incorporated by reference to
      Exhibit 2.2 to Discovery’s Form 8-A, as filed with the SEC on February 6,
      2004.3.3
                        
                        Amended and Restated By-Laws of
      Discovery, as amended effective September 3, 2009.
                        
                        Incorporated by reference to
      Exhibit 3.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on September 4, 20094.1
                        
                        Shareholder Rights Agreement,
      dated as of February 6, 2004, by and between Discovery and Continental
      Stock Transfer & Trust Company.
                        
                        Incorporated by reference to
      Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on February 6, 2004.4.2
                        
                        Form of Class A Investor
      Warrant.
                        
                        Incorporated by reference to
      Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on June 20, 2003.4.3
                        
                        Class B Investor Warrant dated
      July 7, 2004, issued to Kingsbridge Capital
Limited.
                        
                        Incorporated by reference to
      Exhibit 4.1 to Discovery’s Current Report on Form 8-K as filed with the
      SEC on July 9, 2004.4.4
                        
                        Warrant Agreement, dated as of
      November 3, 2004, by and between Discovery and QFinance,
      Inc.
                        
                        Incorporated by reference to
      Exhibit 4.1 of Discovery’s Quarterly Report on Form 10-Q for the quarter
      ended September 30, 2004, as filed with the SEC on November 9,
      2004.4.5
                        
                        Class C Investor Warrant, dated
      April 17, 2006, issued to Kingsbridge Capital
    Limited
                        
                        Incorporated by reference to
      Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on April 21, 2006.4.6
                        
                        Second Amended and Restated
      Promissory Note, dated as of October 25, 2006, issued to PharmaBio
      Development Inc. (“PharmaBio”)
                        
                        Incorporated by reference to
      Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on October 26, 2006.4.7
                        
                        Warrant Agreement, dated as of
      October 25, 2006, by and between Discovery and
      PharmaBio
                        
                        Incorporated by reference to
      Exhibit 4.2 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on October 26, 2006.4.8
                        
                        Warrant Agreement, dated November
      22, 2006
                        
                        Incorporated by reference to
      Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on November 22,
2006.




69





Exhibit
      No.
                                            
                                            Description
                                            
                                            Method
      of Filing4.9
                                            
                                            Warrant
      Agreement dated May 22, 2008 by and between Kingsbridge Capital Limited
      and Discovery.
                                            
                                            Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K as
      filed with the SEC on May 28, 2008.4.10
                                            
                                            Warrant
      Agreement dated December 12, 2008 by and between Kingsbridge Capital
      Limited and Discovery.
                                            
                                            Incorporated
      by reference to Exhibit 4.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.4.11
                                            
                                            Form of Stock Purchase Warrant issued in May
      2009
                                            
                                            Incorporated by reference to Exhibit 10.3 to
      Discovery’s Current Report on Form 8-K, as filed with the SEC on May 8,
      2009.4.12
                                            
                                            Form of Stock Purchase Warrant issued
      in February 2010
                                            
                                            Incorporated by reference to Exhibit 4.1 to
      Discovery’s Current Report on Form 8-K, as filed with the SEC on February
      18, 2010.10.1+
                                            
                                            Sublicense
      Agreement, dated as of October 28, 1996, between Johnson & Johnson,
      Ortho Pharmaceutical Corporation and Acute Therapeutics,
    Inc.
                                            
                                            Incorporated
      by reference to Exhibit 10.6 to Discovery’s Registration Statement on Form
      SB-2, as filed with the SEC on January 7, 1997 (File No.
      333-19375).10.2
                                            
                                            Registration
      Rights Agreement, dated June 16, 1998, among Discovery, Johnson &
      Johnson Development Corporation and The Scripps Research
      Institute.
                                            
                                            Incorporated
      by reference to Exhibit 10.28 to Discovery’s Annual Report on Form 10-KSB
      for the fiscal year ended December 31, 1998, as filed with the SEC on
      April 9, 1999.10.3*
                                            
                                            Restated
      1993 Stock Option Plan of Discovery.
                                            
                                            Incorporated
      by reference to Discovery’s Registration Statement on Form SB-2 (File No.
      33-92-886).10.4*
                                            
                                            1995
      Stock Option Plan of Discovery.
                                            
                                            Incorporated
      by reference to Discovery’s Registration Statement on Form SB-2 (File No.
      33-92-886).10.5*
                                            
                                            Amended
      and Restated 1998 Stock Incentive Plan of Discovery (amended as of May 13,
      2005).
                                            
                                            Incorporated
      by reference to Exhibit 4.1 to Discovery’s Registration Statement on Form
      S-8, as filed with the SEC on August 23, 2005 (File No.
      333-116268).10.6*
                                            
                                            Form
      of Notice of Grant of Stock Option under the 1998 Stock Incentive
      Plan.
                                            
                                            Incorporated
      by reference to Exhibit 10.2 to Discovery’s Quarterly Report on Form
      10-QSB for the quarter ended September 30, 1999, as filed with the SEC on
      November 17, 1999.10.7*
                                            
                                            Discovery’s
      2007 Long Term Incentive Plan
                                            
                                            Incorporated
      by reference to Exhibit 1.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on June 28, 2007.10.8*
                                            
                                            Form
      of 2007 Long-Term Incentive Plan Stock Option Agreement
                                            
                                            Incorporated
      by reference to Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended June 30, 2007, as filed with the SEC on August 9,
      2007.




70





Exhibit No.
              
              Description
              
              Method of
      Filing10.9*
              
              Form of Stock Issuance Agreement,
      dated as of October 30, 2007, between the Discovery and the
      Grantees
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on November 5, 2007.10.10+
              
              Amended and Restated Sublicense
      and Collaboration Agreement made as of December 3, 2004, between Discovery
      and Laboratorios del Dr. Esteve, S.A.
              
              Incorporated by reference to
      Exhibit 10.28 to Discovery’s Annual Report on Form 10-K for the year ended
      December 31, 2004, as filed with the SEC on March 16,
      2005.10.11+
              
              Amended and Restated Supply
      Agreement, dated as of December 3, 2004, by and between Discovery and
      Laboratorios del Dr. Esteve, S.A.
              
              Incorporated by reference to
      Exhibit 10.29 to Discovery’s Annual Report on Form 10-K for the year ended
      December 31, 2004, as filed with the SEC on March 16,
      2005.10.12
              
              Assignment of Lease and
      Termination and Option Agreement, dated as of December 30, 2005, between
      Laureate Pharma, Inc. and Discovery.
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Annual Report on Form 10-K for the fiscal year
      ended December 31, 2005, as filed with the SEC on March 16,
      2006.10.13
              
              Common
      Stock Purchase Agreement, dated April 17, 2006, by and between Discovery
      and Kingsbridge Capital Limited.
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on April 21, 2006.10.14
              
              Second
      Amended and Restated Loan Agreement, dated as of December 10, 2001,
      amended and restated as of October 25, 2006, by and between Discovery and
      PharmaBio
              
              Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on October 26, 2006.10.15*
              
              Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Robert J. Capetola, Ph.D.
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Quarterly Report on Form 10-Q for the quarter
      ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.16*
              
              Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Robert J. Capetola and Discovery Laboratories,
Inc.
              
              Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3, 200810.17*
              
              Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and John G. Cooper.
              
              Incorporated by reference to
      Exhibit 10.2 to Discovery’s Quarterly Report on Form 10-Q for the quarter
      ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.18*
              
              Amendment to the Amended and
      Restated Employment Agreement dated as of May 4, 2006 between John G.
      Cooper and Discovery Laboratories, Inc.
              
              Incorporated
      by reference to Exhibit 10.3 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3, 200810.19*
              
              Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and David L.
      Lopez, Esq., CPA
              
              Incorporated by reference to
      Exhibit 10.3 to Discovery’s Quarterly Report on Form 10-Q for the quarter
      ended March 31, 2006, as filed with the SEC on May 10,
      2006.




71





Exhibit No.
              
              Description
              
              Method of
      Filing10.20*
              
              Amendment
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between David L. Lopez and Discovery Laboratories, Inc.
              
              Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on January 3, 2008.10.21*
              
              Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Robert Segal,
      M.D.
              
              Incorporated by reference to
      Exhibit 10.4 to Discovery’s Quarterly Report on Form 10-Q for the quarter
      ended March 31, 2006, as filed with the SEC on May 10,
      2006.10.22*
              
              Amendment to the Amended and
      Restated Employment Agreement dated as of May 4, 2006 between Robert
      Segal, M.D., F.A.C.P., and Discovery
              
              Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on July 15, 2008.10.23*
              
              Amendment dated December 12, 2008
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Robert Segal, M.D., F.A.C.P., and Discovery
              
              Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 18, 2008.10.24*
              
              Amended
      and Restated Employment Agreement, dated as of May 4, 2006, by and between
      Discovery and Charles Katzer.
              
              Incorporated
      by reference to Exhibit 10.31 to Discovery’s Annual Report on Form 10-K
      for the fiscal year ended December 31, 2006, as filed with the SEC on
      March 16, 2007.10.25*
              
              Amendment to the Amended and
      Restated Employment Agreement dated as of May 4, 2006 between Charles F.
      Katzer and Discovery
              
              Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on July 15, 2008.10.26*
              
              Amendment dated December 12, 2008
      to the Amended and Restated Employment Agreement dated as of May 4, 2006
      between Charles F. Katzer and Discovery Laboratories,
      Inc.
              
              Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 18, 2008.10.27
              
              Lease
      Agreement dated May 26, 2004, and First Amendment to Lease Agreement,
      dated April 2, 2007, by and between TR Stone Manor Corp. and Discovery
      Laboratories, Inc.
              
              Incorporated
      by reference to Exhibits 10.1 and 10.2 to Discovery’s Current Report on
      Form 8-K, as filed with the SEC on April 6, 2007.10.28
              
              Credit and Security Agreement,
      dated as of May 21, 2007, by and between Discovery and Merrill Lynch
      Capital, a division of Merrill Lynch Business Financial Services,
      Inc.
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC on May 24, 2007.10.29
              
              First
      Amendment to Credit and Security Agreement (the “Amendment”) dated May 30,
      2008, between the Company and GE Business Financial Services Inc.
      (formerly Merrill Lynch
      Business Financial Services, Inc.)
              
              Incorporated by reference to
      Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as filed with the
      SEC onJune 2,
      2008.




72






Exhibit
      No.
                    
                    Description
                    
                    Method
      of Filing10.30
      +
                    
                    Amended
      and Restate License Agreement by and between Discovery and Philip Morris
      USA Inc., d/b/a/ Chrysalis Technologies, dated March 28,
    2008
                    
                    Incorporated
      by reference to Exhibit 10.4 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2008, as filed with the SEC on May 9,
      2008.10.31
      +
                    
                    License
      Agreement by and between and Philip Morris Products S.A., dated March 28,
      2008
                    
                    Incorporated
      by reference to Exhibit 10.5 to Discovery’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2008, as filed with the SEC on May 9,
      2008.10.32
                    
                    Common
      Stock Purchase Agreement, dated as of May 22, 2008, by and between
      Kingsbridge Capital and Discovery
                    
                    Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 27, 2008.10.33
                    
                    Registration
      Rights Agreement, dated as of December 12, 2008, by and between
      Kingsbridge Capital and Discovery
                    
                    Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on May 27, 2008.10.34
                    
                    Common
      Stock Purchase Agreement, dated December 12, 2008, by and between
      Discovery and Kingsbridge Capital Limited.
                    
                    Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.10.35
                    
                    Registration
      Rights Agreement, dated as of December 12, 2008, by and between
      Kingsbridge Capital and Discovery
                    
                    Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on December 15, 2008.10.36*
                    
                    Agreement,
      dated as of August 13, 2009, by and between Discovery and W. Thomas Amick
      Regarding Service as CEO on a Part-Time, Interim Basis
                    
                    Incorporated
      by reference to Exhibit 10.1 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on September 4,2009.10.37*
                    
                    Separation
      of Employment Agreement and General Release, dated as of August 13, 2009,
      by and between Discovery and Robert J. Capetola
                    
                    Incorporated
      by reference to Exhibit 10.2 to Discovery’s Current Report on Form 8-K, as
      filed with the SEC on September 4, 2009.21.1
                    
                    Subsidiaries
      of Discovery.
                    
                    Incorporated
      by reference to Exhibit 21.1 to Discovery’s Annual Report on Form 10-KSB
      for the fiscal year ended December 31, 1997, as filed with the SEC on
      March 31, 1998.23.1
                    
                    Consent
      of Ernst & Young LLP, independent registered public accounting
      firm.
                    
                    Filed
      herewith.31.1
                    
                    Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange
      Act.
                    
                    Filed
      herewith.31.2
                    
                    Certification
      of Chief Financial Officer and Principal Accounting Officer pursuant to
      Rule 13a-14(a) of the Exchange Act.
                    
                    Filed
      herewith.





73





Exhibit No.
              
              Description
              
              Method of
      Filing32.1
              
              Certification of Chief Executive
      Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.
              
              Filed
    herewith.





+           Confidential treatment requested as to
certain portions of these exhibits.  Such portions have been redacted
and filed separately with the Commission.





*           A management contract or compensatory
plan or arrangement required to be filed as an exhibit to this annual report
pursuant to Item 15(b) of Form 10-K.




74




DISCOVERY LABORATORIES,
INC. AND SUBSIDIARY




Contents


PageConsolidated Financial
      StatementsReport of Independent Registered
      Public Accounting Firm
                      
                      
                      F-2Balance Sheets as of December 31,
      2009 and December 31, 2008
                      
                      
                      F-3Statements of Operations for the
      years endedDecember 31, 2009, 2008 and
      2007
                      
                      
                      F-4Statements of Changes in
      Stockholders’ Equity for the years endedDecember 31, 2009, 2008 and
      2007
                      
                      
                      F-5Statements of Cash Flows for the
      years endedDecember 31, 2009, 2008 and
      2007
                      
                      
                      F-6Notes to consolidated financial
      statements
                      
                      
                      F-7




F-1




DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY




Report of Independent Registered Public
Accounting Firm





The Board of Directors and
Stockholders


Discovery Laboratories,
Inc.





We have audited the accompanying
consolidated balance sheets of Discovery Laboratories, Inc. and subsidiary (the
“Company”) as of December 31, 2009 and 2008, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 2009.  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 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our
opinion.





In our opinion, the financial statements
referred to above present fairly, in all material respects, the consolidated
financial position of Discovery Laboratories, Inc. and subsidiary at December
31, 2009 and 2008, and the consolidated results of their operations and their
cash flows for each of the three years in the period ended December 31, 2009, in
conformity with U.S. generally accepted accounting
principles.





The accompanying financial statements
have been prepared assuming that the Company will continue as a going concern.
As more fully described in Note 2, the Company has incurred recurring operating
losses and has generated negative cash flows from operations since inception and
expects such results to continue for the foreseeable future.  In
addition, there is uncertainty as to the Company’s ability to raise additional
capital sufficient to meet its obligations on a timely basis.  These
conditions raise substantial doubt about the Company’s ability to continue as a
going concern. Management’s plans in regard to these matters also are described
in Note 2.  The December 31, 2009 consolidated financial statements do
not include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from the outcome of this
uncertainty.





We also have audited, in accordance with
the standards of the Public Company Accounting Oversight Board (United States),
the Company’s internal control over financial reporting as of December 31, 2009,
based on criteria established in Internal Control-Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission and our
report datedMarch
10, 2010 expressed an
unqualified opinion thereon.








March 10, 2010


Philadelphia, PA




F-2




DISCOVERY LABORATORIES,
INC. AND SUBSIDIARY




Consolidated Balance
Sheets





(In thousands, except per share
data)





December
31,
                
                
                December
31,2009
                
                
                2008ASSETSCurrent
    Assets:Cash and cash
      equivalents
                
                $
                15,741
                
                
                $
                22,744Available-for-sale marketable
      securities
                
                
                –
                
                
                
                2,048Prepaid expenses and other current
      assets
                
                
                233
                
                
                
                625Totalcurrent
    assets
                
                
                15,974
                
                
                
                25,417Property and equipment,
      net
                
                
                4,668
                
                
                
                5,965Restricted
    cash
                
                
                400
                
                
                
                600Other assets
                
                
                361
                
                
                
                907Total
assets
                
                $
                21,403
                
                
                $
                32,889LIABILITIES &
      STOCKHOLDERS’EQUITYCurrent
      Liabilities:Accounts
      payable
                
                $
                1,294
                
                
                $
                2,111Accrued
      expenses
                
                
                3,446
                
                
                
                5,313Loan payable, including accrued
      interest
                
                
                10,461
                
                
                
                –Equipment loan, current
      portion
                
                
                597
                
                
                
                2,442Total current
      liabilities
                
                
                15,798
                
                
                
                9,866Loan payable, including accrued
      interest
                
                
                –
                
                
                
                10,128Equipment loan, non-current
      portion
                
                
                428
                
                
                
                1,092Other
      liabilities
                
                
                690
                
                
                
                870Total
      liabilities
                
                
                16,916
                
                
                
                21,956Stockholders’Equity:Preferred stock,$0.001 par value;5,000 shares authorized;
      nosharesissued or
      outstanding
                
                
                –
                
                
                
                –Common stock, $0.001 par value;380,000 and
      180,000shares authorized; 126,689and101,588shares issued,126,376and101,275shares outstandingat December 31, 2009and December 31, 2008,
    respectively
                
                
                127
                
                
                
                102Additional paid-in
      capital
                
                
                365,063
                
                
                
                341,293Accumulated
      deficit
                
                
                (357,649
                )
                
                
                (327,409
                )Treasury stock (at cost); 313
      shares
                
                
                (3,054
                )
                
                
                (3,054
                )Accumulated other comprehensive
      income
                
                
                –
                
                
                
                1Total stockholders’equity
                
                
                4,487
                
                
                
                10,933Totalliabilities &stockholders’equity
                
                $
                21,403
                
                
                $
                32,889




See
notes to consolidated financial statements





F-3


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY




Consolidated Statements of
Operations





(In thousands, except per share
data)





Year Ended December
      31,2009
                    
                    
                    2008
                    
                    
                    2007Revenue from collaborative
      arrangement and grants:
                    
                    $
                    –
                    
                    
                    $
                    4,600
                    
                    
                    $
                    –Expenses:Research &
      development
                    
                    
                    19,077
                    
                    
                    
                    26,566
                    
                    
                    
                    26,200General &
      administrative
                    
                    
                    10,120
                    
                    
                    
                    16,428
                    
                    
                    
                    13,747Total
    expenses
                    
                    
                    29,197
                    
                    
                    
                    42,994
                    
                    
                    
                    39,947Operating
    loss
                    
                    
                    (29,197
                    )
                    
                    
                    (38,394
                    )
                    
                    
                    (39,947
                    )Other income /
      (expense):Interest and other
      income
                    
                    
                    39
                    
                    
                    
                    902
                    
                    
                    
                    2,029Interest and other
      expense
                    
                    
                    (1,082
                    )
                    
                    
                    (1,614
                    )
                    
                    
                    (2,087
                    )Other income / (expense),
      net
                    
                    
                    (1,043
                    )
                    
                    
                    (712
                    )
                    
                    
                    (58
                    )Net loss
                    
                    $
                    (30,240
                    )
                    
                    $
                    (39,106
                    )
                    
                    $
                    (40,005
                    )Net loss per common share - basic
      and diluted
                    
                    $
                    (0.26
                    )
                    
                    $
                    (0.40
                    )
                    
                    $
                    (0.49
                    )Weighted average number of
      commonshares outstanding - basic and
      diluted
                    
                    
                    115,200
                    
                    
                    
                    98,116
                    
                    
                    
                    81,731




See
notes to consolidated financial statements


F-4




DISCOVERY LABORATORIES,
INC. AND SUBSIDIARY




Consolidated Statements of Changes in
Stockholders’Equity


For Years Ended December 31,
2009, 2008and 2007


(In
thousands)




Common
      Stock
                              
                              
                              Additional
                                Paid-in
                              
                              
                              Unearned
                                Portion
      of
                                Compensatory
                              
                              
                              Accumulated
                              
                              
                              Treasury
      Stock
                              
                              
                              Accumulated
                                OtherCom-
                                prehensiveShares
                              
                              
                              Amount
                              
                              
                              Capital
                              
                              
                              Stock
      Options
                              
                              
                              Deficit
                              
                              
                              Shares
                              
                              
                              Amount
                              
                              
                              Income/(Loss)
                              
                              
                              TotalBalance
      – January 1, 2007
                              
                              
                              69,871
                              
                              
                              $
                              70
                              
                              
                              $
                              265,604
                              
                              
                              $
                              –
                              
                              
                              $
                              (248,298
                              )
                              
                              
                              (313
                              )
                              
                              $
                              (3,054
                              )
                              
                              $
                              –
                              
                              
                              $
                              14,322Comprehensive
      loss:Net
      loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (40,005
                              )
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (40,005
                              )Other
      comprehensive loss – unrealized gains on
      investments
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              42
                              
                              
                              
                              42Total
      comprehensive loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (39,963
                              )Issuance
      of common stock, stock option
      exercises
                              
                              
                              62
                              
                              
                              
                              –
                              
                              
                              
                              106
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              106Issuance
      of common stock, 401(k) employer
      match
                              
                              
                              118
                              
                              
                              
                              –
                              
                              
                              
                              294
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              294Issuance
      of common stock, April 2007
      financing
                              
                              
                              14,050
                              
                              
                              
                              14
                              
                              
                              
                              28,131
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              28,145Issuance
      of common stock, December 2007
      financing
                              
                              
                              10,000
                              
                              
                              
                              10
                              
                              
                              
                              23,550
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              23,560Issuance
      of common stock, CEFF
    financings
                              
                              
                              2,852
                              
                              
                              
                              3
                              
                              
                              
                              6,997
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              7,000Stock–based
      compensation expense
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              5,317
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              5,317Balance
      – December 31, 2007
                              
                              
                              96,953
                              
                              
                              $
                              97
                              
                              
                              $
                              329,999
                              
                              
                              $
                              –
                              
                              
                              $
                              (288,303
                              )
                              
                              
                              (313
                              )
                              
                              $
                              (3,054
                              )
                              
                              $
                              42
                              
                              
                              $
                              38,781Comprehensive
      loss:Net
      loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (39,106
                              )
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (39,106
                              )Other
      comprehensive loss – unrealized gains on
      investments
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (41
                              )
                              
                              
                              (41
                              )Total
      comprehensive loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (39,147
                              )Issuance
      of common stock, stock option
      exercises
                              
                              
                              18
                              
                              
                              
                              –
                              
                              
                              
                              21
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              21Issuance
      of common stock, 401(k) employer
      match
                              
                              
                              231
                              
                              
                              
                              –
                              
                              
                              
                              380
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              380Issuance
      of common stock, CEFF
    financings
                              
                              
                              4,387
                              
                              
                              
                              5
                              
                              
                              
                              6,266
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              6,271Stock-based
      compensation expense
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              4,627
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              4,627Balance
      – December 31, 2008
                              
                              
                              101,589
                              
                              
                              $
                              102
                              
                              
                              $
                              341,293
                              
                              
                              $
                              –
                              
                              
                              $
                              (327,409
                              )
                              
                              
                              (313
                              )
                              
                              $
                              (3,054
                              )
                              
                              $
                              1
                              
                              
                              $
                              10,933Comprehensive
      loss:Net
      loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (30,240
                              )
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (30,240
                              )Other
      comprehensive loss – unrealized gains on
      investments
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (1
                              )
                              
                              
                              (1
                              )Total
      comprehensive loss
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              (30,241
                              )Issuance
      of common stock,
      restricted stock awards
                              
                              
                              21
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –Issuance
      of common stock, 401(k) employer
      match
                              
                              
                              347
                              
                              
                              
                              –
                              
                              
                              
                              290
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              290Issuance
      of common stock,May
      2009 financing
                              
                              
                              14,000
                              
                              
                              
                              14
                              
                              
                              
                              10,451
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              10,465Issuance
      of common stock, CEFF
    financings
                              
                              
                              10,732
                              
                              
                              
                              11
                              
                              
                              
                              10,346
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              10,357Stock-based
      compensation expense
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              2,683
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              –
                              
                              
                              
                              2,683Balance
      – December 31, 2009
                              
                              
                              126,689
                              
                              
                              $
                              127
                              
                              
                              $
                              365,063
                              
                              
                              $
                              –
                              
                              
                              $
                              (357,649
                              )
                              
                              
                              (313
                              )
                              
                              $
                              (3,054
                              )
                              
                              $
                              –
                              
                              
                              $
                              4,487




See
notes to consolidated financial statements


F-5


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY




Consolidated Statements of Cash
Flows





(In thousands)





Year Ended December
      31,2009
                
                
                2008
                
                
                2007Cash flow from operating
      activities:Net loss
                
                $
                (30,240
                )
                
                $
                (39,106
                )
                
                $
                (40,005
                )Adjustments to reconcile net loss
      to net cash usedinoperating
      activities:Depreciation and
      amortization
                
                
                1,992
                
                
                
                2,215
                
                
                
                2,062Stock–based compensation and
      401(k) match
                
                
                2,973
                
                
                
                5,007
                
                
                
                5,613Loss on disposal of property and
      equipment
                
                
                –
                
                
                
                110
                
                
                
                18Changes in:Prepaid expenses and other current
      assets
                
                
                392
                
                
                
                (56
                )
                
                
                (89
                )Accounts
      payable
                
                
                (817
                )
                
                
                1,353
                
                
                
                (871
                )Accrued
      expenses
                
                
                (1,867
                )
                
                
                (1,773
                )
                
                
                2,762Other
assets
                
                
                (1
                )
                
                
                3
                
                
                
                35Other liabilitiesand accrued interest on loan
      payable
                
                
                153
                
                
                
                495
                
                
                
                1,080Net cash used in operating
      activities
                
                
                (27,415
                )
                
                
                (31,752
                )
                
                
                (29,395
                )Cash flow from investing
      activities:Purchase of property and
      equipment
                
                
                (147
                )
                
                
                (632
                )
                
                
                (3,765
                )Restricted
    cash
                
                
                200
                
                
                
                -
                
                
                
                -Purchase of marketable
      securities
                
                
                –
                
                
                
                (25,765
                )
                
                
                (38,355
                )Proceeds from sale or maturity of
      marketable securities
                
                
                2,047
                
                
                
                39,754
                
                
                
                22,319Net cash provided by / (used in)
      investing activities
                
                
                2,100
                
                
                
                13,357
                
                
                
                (19,801
                )Cash flow from financing
      activities:Proceeds from issuance of
      securities, net of expenses
                
                
                20,820
                
                
                
                6,292
                
                
                
                58,809Proceeds from equipment
      loans
                
                
                –
                
                
                
                896
                
                
                
                2,862Principal payments under equipment
      loan obligations
                
                
                (2,508
                )
                
                
                (2,978
                )
                
                
                (1,948
                )Net cash provided by financing
      activities
                
                
                18,312
                
                
                
                4,210
                
                
                
                59,723Net (decrease) / increase in cash
      and cash equivalents
                
                
                (7,003
                )
                
                
                (14,185
                )
                
                
                10,527Cash and cash equivalents –
      beginning of year
                
                
                22,744
                
                
                
                36,929
                
                
                
                26,402Cash and cash equivalents – end of
      year
                
                $
                15,741
                
                
                $
                22,744
                
                
                $
                36,929Supplementary disclosure of cash
      flows information:Interest
    paid
                
                $
                208
                
                
                $
                529
                
                
                $
                676Non-cash
      transactions:Unrealized gain / (loss) on
      marketable securities
                
                
                (1
                )
                
                
                (41
                )
                
                
                42Exchange of equipment loan
      obligation
                
                
                –
                
                
                
                –
                
                
                
                3,968




See
notes to consolidated financial statements




F-6




DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Note1–The Company and Description of
Business





Discovery Laboratories, Inc. (referred
to as “we,” “us,” or the “Company”) isabiotechnology company developingsurfactanttherapies to treat respiratory disorders
and diseases for which there frequently are few or no approved
therapies.  Our novel KL4proprietary technology produces a
synthetic, peptide-containing surfactant (KL4surfactant) that is structurally
similar to pulmonary surfactant, a substance produced naturally in the lung and
essential for survival and normal respiratory function.  In addition,
our proprietary capillary
aerosol-generating
technology (capillaryaerosolizationtechnology) produces a dense aerosol with
a defined particle size, to potentially deliver our aerosolized KL4surfactant to the lung.  As
many respiratory disorders are associated with surfactant deficiency or
surfactant degradation, we believe that our proprietary technology platform
makes it possible, for the first time, to develop a significant pipeline of
surfactant products targeted to treat a wide range of previously unaddressed
respiratory problems.





We are developing our lead products, Surfaxin®(lucinactant),Surfaxin LSTM and Aerosurf®, to address the most significant
respiratory conditions affecting pediatric
populations.In
April 2009, we received a Complete Response Letter from the U.S. Food and Drug
Administration (FDA) with respect to our New Drug Application (NDA) forSurfaxinfor the prevention of Respiratory
Distress Syndrome (RDS) in premature infants,our first product based on our novel
KL4surfactant technology.The letter focused primarily oncertain aspects ofour fetal rabbit biological
activity test (BAT, a quality control and stability release test for Surfaxin
and our other KL4pipelineproducts),specificallywhether analysis of preclinical data
from both the BAT and a well-established preterm lamb model of RDS demonstrates
the degree of comparability that the FDA requires and whether the BAT can
adequately distinguish change in Surfaxin biological activity over
time.We met with the FDA at an
end-of-review meeting in June 2009 and by teleconference in September 2009 to
discuss specific proposals to resolve thissole remaining Chemistry, Manufacturing
& Control (CMC)issue,
which must be addressed to obtainapproval ofSurfaxin.Based on these and other
interactions with the FDA, we are currently implementing a protocol intended tooptimize andrevalidate the BAT.This effort is ongoing and, although not
necessarily indicative of the final results, the BATis presentlymeeting all pre-specified acceptance
criteria.  Once
the BAT is optimized and revalidated, we plan to initiate a comprehensive
preclinical program that will consist of a series of a series of side-by-side
studies comparing the results of the BAT withthoseofthewell-established preterm lamb model of
RDSinorder tosatisfy the FDA’s requirements with respect to the
BAT.If these studies are successful, we
believe that we could be in a position to file a Complete Response to the April2009 Complete Response Letter in the first
quarter of 2011, which could lead to approval ofSurfaxinfor the prevention of Respiratory
Distress Syndrome (RDS) in premature infantsin 2011.  If approved,Surfaxinwouldbethe first synthetic, peptide-containing
surfactant for use in pediatric medicine.





Surfaxin LS, our lyophilized KL4surfactant,isa dry powder formulationthat isresuspended as a liquid prior to
useandisintended to improve ease of use for
healthcare practitioners, eliminate the need for cold-chain storage, and
potentially further improve clinical performance.Aerosurf is our proprietary
KL4surfactantin aerosolized form, which we are
developing using ourcapillary aerosolization
technology,initially to
treat premature infants at risk for RDS.  Premature infants with RDS
are treated with surfactants that are administered by means of invasive
endotracheal intubation and mechanical ventilation, procedures that frequently
result in serious respiratory conditions and
complications.If approved,we believe thatAerosurf will make it possible to
administer surfactant into the lung without subjecting patients to such invasive
procedures.  We believe that Aerosurf has the potential to enable a
significant increase in the use ofsurfactant therapyin pediatric
medicine.





In addition to our lead products,
we plan over time to
develop our KL4surfactant technologyinto abroad productpipeline that potentially will address a
variety of debilitating respiratory conditions for which there currently areno orfew approved therapies,in patient populationsrangingfrom premature infants to
adults.Our
plans include potentially taking these initiatives through a Phase 2
proof-of-concept phase and, if successful, thereafter determining whether to
seek strategic alliances or collaboration arrangements or to utilize other
financial alternatives to fund their further
development.We
have an ongoing Phase 2clinicaltrialof Surfaxinto potentially address Acute Respiratory
Failure (ARF) and our KL4surfactant is the subject of an
investigator-initiatedPhase 2a clinicaltrial assessing the safety, tolerability
and short-term effectiveness (via improvement in mucociliary clearance) of
aerosolized KL4surfactant in patients with Cystic
Fibrosis (CF).We are conducting research and
preclinical development with our KL4surfactant potentiallytoaddress Acute Lung Injury (ALI),
and, potentially in the
future,other diseases
associated with inflammation of the lung, such as Asthma and Chronic Obstructive
Pulmonary Disease (COPD).We have also initiated
exploratory preclinical studies to assess the feasibility of using our
KL4surfactant in combination with small
and large molecule therapeutics to efficiently and effectively deliver therapies
to the lung to treat a range of pulmonary conditions and
disease.


F-7





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





We are actively assessing various
strategic and financial alternatives to securethenecessary capitaltoadvance our KL4respiratory pipeline
programs to maximize stockholdervalue, although we prefer to accomplish our objectives
through strategic alliances.  Weare actively engaged incurrentdiscussions with potentialstrategic and/or financialpartners,butthere can be no assurance that any
strategic alliance or other financingalternativeswill be successfully
concluded.   Until we secure an alliance or other financingalternative, wewillcontinue tofocusour financial resourceson the potential approval of
Surfaxin,while minimizinginvestments in ourotherpipeline programs.





Note 2–Liquidity Risks and
Management’s Plans





We have incurred substantial losses
since inception, due to investments in research and development, manufacturing
and potential commercialization activities and we expect to continue to incur
substantial losses over the next several years.  Historically, we have
funded our business operations through various sources, including public and
private securities offerings, draw downs under our CEFFs, capital equipment and
debt facilities, and strategic alliances.  We expect to continue to
fund our business operations through a combination of these sources, as well as
sales revenue from our product candidates, beginning with Surfaxin forthe prevention ofRDS,if approved.




Following receipt of the April 2009 FDA
Complete Response Letter for Surfaxin, we made fundamental changes in our
business strategy.We nowbelievethatit is inourbest interest financially toseek to develop andcommercializeour KL4technology through strategic alliances
or othercollaboration
arrangements.However, therecan be no assurance that any strategic
alliance or otherarrangementwill be successfully
concluded.





The accompanying financial statements
have been prepared assuming that we will continue as a going concern, which
contemplates the realization of assets and satisfaction of liabilities in the
normal course of business.As a result of ourcashposition as of December 31, 2009, the
audit opinion we received from our independent auditors, which is included in
our financial statements in this report, containsa notation related to ourability to continue as a going
concern.Our ability to continue as a going
concern is dependent on our ability to raise additional capital, to fund our
research and development and commercial programs and meet our obligations on a
timely basis.  If we are unableto successfully raise sufficient
additional capital,through
strategic and collaborativearrangementswith potential partners
and/orfuture debt and
equity financings, we will
likely not have sufficient cash flows and liquidity to fund our business
operations, which could significantly limit our ability to continue as a going
concern.  In that event,we may be forced to further limitdevelopment ofmany, if not all, of our programsand consider other means of
creating value for our stockholders, such as licensing the development and/or commercializationofproducts that we consider valuable andmightotherwiseplan todevelop ourselves.  If we are
unable to raise the necessary capital, we may be forced tocurtail all of our activities and,
ultimately, cease operations.  Even if we are able to raise
additional capital, such
financings may only be available on unattractive terms, or could result in
significant dilution of stockholders’interests and, in such event, the
market price of our common stock may decline.Our December 31, 2009 financial
statementsdo not include
any adjustments relating to recoverability and classification of recorded asset
amounts or the amounts and classification of liabilities that might be necessary
shouldwebe unable to continue in
existence.




Ourfuturecapital requirements will depend upon
many factors, includingourefforts to secure one or
more strategic alliances to support our product development activities and
commercialization plans, and the ultimate success of ourproduct development and
commercialization plans.  Currently, we are focused on developing our
lead KL4surfactant products to address the most
significant respiratory conditions affecting pediatric
populations.  However, there can be no assurance that our research and
development projects will be successful, that products developed will obtain
necessary regulatory approval, that any approved product will be commercially
viable, that any CEFF will be available for future financings, or that we will
be able tosecure strategic
alliances orobtain
additional capital when needed on acceptable terms, if at all.  Even
if we succeed insecuring
strategic alliances,raising additional capital and
developing and subsequently commercializing product candidates, we may never
achieve sufficient sales revenue to achieve or maintain
profitability.




F-8




DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY




As ofDecember 31, 2009, we had cash and cash equivalents
of $15.7million.In February 2010, we completed a public
offering resulting in gross proceeds of $16.5 million ($15.1 million
net).Also, as
of December 31, 2009, our $10.5 million loan withQuintiles (formerlyPharmaBio DevelopmentInc.and NovaQuestTM), a strategic investment group of
Quintiles Transnational Corp., is classified as a current liability, payable in
April 2010.We arepursuing a potential strategic
restructuring of this loan;however, there can be no assurance that
any such restructuring will occur.Currently, under our two CEFFs, we may
potentially raise (subject to certain conditions, including minimum stock price
and volume limitations) up to an aggregate of $69.5million.However, as of March5,2010,neitherthe May 2008 CEFFnor the December 2008 CEFFwas available becausethe market price ofourcommonstock price was below the minimum
pricerequired($1.15 and $0.60, respectively) to
utilize the facility.See,Note 10 – Stockholders’ Equity, for
details about our CEFFs. During 2009, we raised  aggregate gross
proceeds of $22.0 million.  In May 2009, wecompleted a public offeringof or common stock,resulting in gross proceeds of $11.3
million ($10.5 million net), and, throughout 2009, weraised an aggregate of $10.7millionfrom10draw-downs under our CEFFs.See,“Item 7 – Management’s Discussion and Analysis of Financial
Condition and Results of Operations – Liquidity and Capital Resources –
Committed Equity Financing Facilities(CEFFs),”and “–Financings Pursuant to Common Stock
Offerings.”




Note3–Summary of Significant Accounting
Policiesand Recent
Accounting Pronouncements





The consolidated financial statements
and accompanying notes are prepared in accordance with accounting principles
generally accepted in the United States.





Consolidation





The consolidated financial statements
include all of the accounts of Discovery Laboratories, Inc. and its inactive
subsidiary, Acute Therapeutics, Inc.  All intercompany transactions
and balances have been eliminated in consolidation.





Use of estimates





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





Cash, cash equivalents and marketable
securities





We consider all highly liquid marketable
securities purchased with a maturity of three months or less to be cash
equivalents.





Marketable securities are classified as
available-for-sale and carried at fair market value, based on quoted market
prices for these or similar instruments.  Realized gains and losses
are computed using the average cost of securities sold.  Any
appreciation/depreciation on these marketable securities is recorded as other
comprehensive income (loss) in the statements of changes in
stockholders’equity until
realized.  Realized gains (losses) on disposition of marketable
securities are recorded in the statement of operations when
disposed.





Marketable securities are purchased
pursuant to an investment policy approved byourBoard of Directors(the Board)that provides for the purchase of
high-quality marketable securities, while ensuring preservation of capital and
fulfillment of liquidity needs.





Fair Value of Financial
Instruments





Our financial instruments consist
principally of cash and cash equivalents, marketable securities and restricted
cash.   The fair values of the Company’s cash equivalents and marketable
securities are based on quoted market prices.  The carrying amount of
cash equivalents and marketable securities is equal to their respective fair
values at December 31, 2009and December 31, 2008.


F-9


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Other financial instruments, including
accounts payable and accrued expenses, are carried at cost, which the Company
believes approximates fair value.





Property and
equipment





Property and equipment are recorded at
cost and depreciated using the straight-line method over the estimated useful
lives of the assets (generally three to ten years).  Leasehold
improvements are amortized over the shorter of the estimated useful lives or the
remaining term of the lease.  Repairs and maintenance costs are
charged to expense as incurred.





Long-lived assets





Our long-lived assets, primarily
consisting of equipment, are reviewed for impairment when events or changes in
circumstances indicate the carrying amount of an asset may not be recoverable,
or its estimated useful life has changed significantly.  When an
asset’s undiscounted cash flows are less than
its carrying value, an impairment is recorded and the asset is written down to
its estimated value.  No impairment was recorded during the years
ended December 31, 2009, 2008and 2007, as management believes there are no
circumstances that indicate the carrying amount of the assets will not be
recoverable.





Revenue recognitionunderstrategic alliances and collaboration
agreements





Revenue under strategic alliances and
our collaboration agreements is recognized based on the performance requirements
of the contract.  Upfront, non-refundable license fees received in
connection with collaboration agreements are deferred and recognized as revenue
over the life of the agreement or period of performance
obligations.  Revenues derived from the achievement of milestones are
recognized when the milestone is achieved, as long as there are no further
performance obligations.  Deferred revenue results from cash received
or amounts receivable in advance of revenue recognition based upon the
performance requirements of the contract.  Grant revenue is recorded
upon receipt of funds.





Research and
development





Research and development costs consist
primarily of expenses associated with our personnel, facilities, manufacturing
operations, formulation development, research, clinical, regulatory, other
preclinical and clinical activities and medical affairs.  Research and
development costs are charged to operations as incurred.





Stock-based
compensation





Effective January 1, 2006, we adopted
the fair value recognition provisions ofAccounting Standards Codification (ASC)
Topic 718“Stock
Compensation,”using the
modified-prospective-transition method.See,Note11– Stock Options and Stock-based Employee Compensation, for a
detailed description of our recognition of stock-based compensation
expense.





Income taxes





We provide for income taxes in
accordance withAccounting
Standards Codification (ASC) Topic 740,“Accounting for
Income Taxes”.ASC Topic 740requires the recognition of deferred
tax liabilities and assets for the expected future tax consequences of temporary
differences between financial statement carrying amounts and the tax basis of
assets and liabilities.





Weuse a recognition threshold and
measurement attribute for the financial statement recognition and measurement of
a tax position taken or expected to be taken ina tax return.  The adoption of ASC
740on January 1, 2007 did
not have a material impact on the consolidated financial
statements.  Due to the fact that we have never realized a profit,
management has fully reserved the net deferred tax asset since realization is
not assured.


F-10





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Comprehensive Loss





Comprehensive loss consists of net loss
plus the changes in unrealized gains and losses on available-for-sale
securities.  Comprehensive loss for the years ended December 31,
2009, 2008and 2007are as follows:





(in
    thousands)
                            
                            December
31,2009
                            
                            
                            2008
                            
                            
                            2007Net loss
                            
                            $
                            (30,240
                            )
                            
                            $
                            (39,106
                            )
                            
                            $
                            (40,005
                            )Change in unrealized
      (losses)/gains on marketable securities
                            
                            
                            (1
                            )
                            
                            
                            (41
                            )
                            
                            
                            42Comprehensive
      loss
                            
                            $
                            (30,241
                            )
                            
                            $
                            (39,147
                            )
                            
                            $
                            (39,963
                            )





Net loss per common
share





Basic net loss per common share is
computed by dividing the net loss by the weighted average number of common
shares outstanding for the periods.  For the years ended December 31,
2009, 2008and 2007,30.9million,25.1million and20.3 million shares of common stock,
respectively, were potentially issuable upon the exercise of certain stock
options and warrants and vesting of restricted stock awards.  Due to
our net loss, these potentially issuable shares were not included in the
calculation of diluted net loss per share as the effect would be anti-dilutive,
therefore basic and dilutive net loss per share are the
same.





Business segments





We currently operate in one business
segment, which is the research and development of products focused on surfactant
replacement therapies for respiratory disorders and diseases. We are managed and
operated as one business. A single management team that reports to the Chief
Executive Officer comprehensively manages the entire business. We do not operate
separate lines of business with respect to our product
candidates.





Recent
Accounting Pronouncements





In
June 2009, the Financial Accounting Standards Board (FASB) issued the Accounting Standards
CodificationTM(the Codification).  The Codification now is the
single source of authoritative accounting principles recognized by FASB to be
applied by nongovernmental entities in the preparation of financial statements
in conformity with Generally Accepted Accounting Principles (GAAP), in the
United States.  The Codification became effective for interim and
annual periods ending after September 15, 2009.  All other
accounting literature not included in the Codification will be nonauthoritative,
except for additional authoritative rules and interpretive releases issued by
the United States Securities Exchange Commission (SEC).  The
Codification is not intended to change GAAP; instead, it reorganizes the
thousands of US GAAP pronouncements into approximately 90 Accounting
Topics.  Adoption of the Codification did not have an impact on our
consolidated financial statements.





In May
2009, FASB issued new guidance for accounting for subsequent
events.  The new guidance, which is now part of Accounting Standards
Codification (ASC) Topic 855, Subsequent Events, is
consistent with existing auditing standards in its definition of subsequent
events, but requires disclosure of the date through which an entity has
evaluated subsequent events and the basis for that date.  There are
two types of subsequent events: (1) events that provide additional evidence
about conditions that existed at the balance sheet date, and are recognized in
the financial statements, and (2) events that provide evidence about
conditions that did not exist at the balance sheet date, but arose before the
financial statements are issued or are available to be issued, and are not
recognized at the balance sheet date.  The adoption of the new
guidance had no impact on our consolidated financial statements.  We
evaluated all events or transactions that occurred after December 31, 1009 up
through March 10, 2010, the date these financial statements were issued and
filed with the SEC.  During this period we had three material
nonrecognized subsequent events, which are described in Note
18.


F-11





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





In December 2007, FASB issued new
guidance for accounting for collaborative arrangements.  The new
guidance, which is now part of ASCTopic 808,Collaborative
Arrangements, is effective
for fiscal years beginning after December 15, 2008.  The scope of the new
guidance is limited to collaborative arrangements where no separate legal entity
exists and in which the parties are active participants and are exposed to
significant risks and rewards that depend on the success of the
activity.  The new guidance requires certain income statement
presentation of transactions with third parties and of payments between parties
to the arrangement, along with disclosure about thenature and purpose of the
arrangement.  The adoption of the new guidance on January 1, 2009 did
not have a material impact on our consolidated financial
statements.





In
December 2007, FASB issued new guidance for accounting for business
combinations.  The new guidance, which is now part of ASC topic 805,
Business Combinations,
is effective for financial statements issued for fiscal years beginning on or
after December 15, 2008.  The new guidance establishes principles
and requirements for how an acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, any
noncontrolling interest in the acquiree, and the goodwill acquired in the
business combination.  ASC Topic 805 also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. We adopted the new guidance on January 1, 2009, which had
no immediate impact on our financial statements; however, it may have an impact
on the accounting for any potential future business combinations.





Note4–Fair Value
Measurements





ASC Topic 820, Fair Value Measurements
and Disclosures establishes a framework for measuring fair value under GAAP and
enhances disclosures about fair value measurements.





Fair value is defined as the exchange
price that would be received for an asset or paid to transfer a liability in the
principal or most advantageous market for the asset or liability in an orderly
transaction between market participants on the measurement
date.





Valuation techniques used to measure
fair value must maximize the use of observable inputs and minimize the use of
unobservable inputs.  The fair value hierarchy is based on three
levels of inputs, of which the first two are considered observable and the last
unobservable, as follows:





·
            Level 1 – Quoted prices in active
      markets for identical assets and liabilities.  Level 1 is
      generally considered the most reliable measurement of fair value under ASC
      820.


·
            Level 2 – Inputs other than Level
      1 that are observable, either directly or indirectly, such as quoted
      prices for similar assets or liabilities, quoted prices in markets that
      are not active, or other inputs that are observable or can be corroborated
      by observable market data for substantially the full term of the assets or
      liabilities.


·
            Level 3 – Unobservable inputs that
      are supported by little or no market activity and that are significant to
      the fair value of the assets or
  liabilities.





Fair Value on a Recurring
Basis





Assets measured at fair value on a
recurring basis are categorized in the table below based upon the lowest level
of input(Level
1)as of December 31,
2009:


F-12





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Fair Value
                  
                  
                  Fair value measurement using(in
    thousands)
                  
                  December 31, 2009
                  
                  
                  Level 1
                  
                  
                  Level 2
                  
                  
                  Level 3Money markets(1)
                  
                  $
                  14,690
                  
                  
                  $
                  14,690
                  
                  
                  $
                  –
                  
                  
                  $
                  –U.S. treasury
      notes
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  –
                  
                  
                  
                  –Certificate of
      deposit
                  
                  
                  600
                  
                  
                  
                  600
                  
                  
                  
                  –
                  
                  
                  
                  –Total
                  
                  $
                  15,290
                  
                  
                  $
                  15,290
                  
                  
                  $
                  –
                  
                  
                  $
                  –





(1) Dreyfus Treasury & Agency Cash
Management Fund.





Note5–Marketable
Securities





We did not hold any available-for-sale
marketable securities as of December 31, 2009.The following is a summary of
available-for-sale marketable securities as of December 31, 2008 and
2007:





(inthousands)
                      
                      Amortized
                        CostBasis
                      
                      
                      Gross
                        Unrealized
                        Holding
                        Gains
                      
                      
                      Gross
                        Unrealized
                        Holding
                        Losses
                      
                      
                      Aggregate
                        FairValueDecember 31,
      2008U.S. treasury
      notes
                      
                      $
                      2,047
                      
                      
                      $
                      1
                      
                      
                      $
                      –
                      
                      
                      $
                      2,048Total
                      
                      $
                      2,047
                      
                      
                      $
                      1
                      
                      
                      $
                      –
                      
                      
                      $
                      2,048December 31,
      2007Commercial
      paper
                      
                      $
                      16,010
                      
                      
                      $
                      42
                      
                      
                      $
                      –
                      
                      
                      $
                      16,052Certificates of
      deposit
                      
                      
                      26
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      26Total
                      
                      $
                      16,036
                      
                      
                      $
                      42
                      
                      
                      $
                      –
                      
                      
                      $
                      16,078





Available-for-sale marketable securities
consist of United States treasury notes, certificates of deposits, and
high-quality commercial paper with a maturity of greater than three
months.  All available-for-sale marketable securities have a maturity
period of less than one year.  These assets are measured at fair
market value at each reporting period.  The fair market value is
recorded using quoted prices from active markets.





Marketable securities are purchased
pursuant to an investment policy approved byourBoard that provides for the purchase of
high-quality marketable securities, while ensuring preservation of capital and
fulfillment of liquidity needs.





Note6–Restricted Cash





Restricted cash consists of a security depositheld by our bankin the amount of $600,000tosecurea letter of credit in the samenotionalamountheld by our landlord to secure our
obligations under ourLease
Agreement dated May 26, 2004 for our headquarters location in Warrington,
Pennsylvania(See,Note14– Commitments,for further discussion on our
leases).Under
the terms of our Lease, beginning in March 2010, the letter of
credit(and the related
security deposit)will be
reduced to $400,000 and will remain in effectat that levelthrough the remainder of the lease
term.  Subject to certain conditions, upon expiration of the lease in
February 2013, the letter of credit will expireand the security deposit will be
released.




F-13





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Note7–Property and
Equipment





Property and equipment as of December
31, 2009and 2008was comprised of the
following:





December
31,(in
    thousands)
                      
                      2009
                      
                      
                      2008Equipment
                      
                      $
                      7,265
                      
                      
                      $
                      7,143Furniture
                      
                      
                      791
                      
                      
                      
                      791Leasehold
      improvements
                      
                      
                      2,838
                      
                      
                      
                      2,813Subtotal
                      
                      
                      10,894
                      
                      
                      
                      10,747Accumulated
      depreciationand
      amortization
                      
                      
                      (6,226
                      )
                      
                      
                      (4,782
                      )Property and equipment,
      net
                      
                      $
                      4,668
                      
                      
                      $
                      5,965





Equipment primarily consists of: (i)
manufacturing equipment to produce our KL4surfactantproducts, including Surfaxin and
Aerosurf, for use in ourpreclinical studies,clinicaltrials andpotential commercial needs;
(ii)laboratory
equipment for manufacturing, analytical, research and development activities;
and (iii)computers and office equipment to
support our overall business activities.





Leasehold improvements primarily
consists ofconstruction of
a new analytical and development laboratory in our Warrington, Pennsylvania
headquarters, which was completed in 2007 and where weconsolidated the analytical, quality
and development activities previously located in Doylestown,
Pennsylvania,and Mountain View,
California.  The activities conducted in our laboratory include
release and stability testing of raw materials as well aspreclinical,clinical and, if approved, commercial
drug product supply.  We also perform development work with respect to
our aerosolizedKL4surfactantand novel formulations of ourKL4surfactant technology.The laboratory will be amortized through
the end ofthelease term for our Warrington,
Pennsylvaniaheadquarters in 2013.  In
addition, in 2007, we built a microbiology laboratory at our manufacturing
facility in Totowa, NewJersey,to support production of our drug
product candidates.  The microbiology laboratorywill beamortized through the end ofthelease term for our Totowa,
NewJerseyfacility in 2014.




Depreciationand amortizationexpenseon property and equipmentfor the years ended December 31,
2009, 2008, and 2007was $1.4million, $1.6million, and $1.5million,
respectively.





Note8–Accrued Expenses





Accrued expenses as of December 31,
2009and 2008were comprised of the
following:





December
31,(in
    thousands)
                      
                      2009
                      
                      
                      2008Accrued compensation(1)
                      
                      $
                      1,763
                      
                      
                      $
                      2,390Accrued
      manufacturing
                      
                      
                      568
                      
                      
                      
                      1,174Accrued research and
      development
                      
                      
                      332
                      
                      
                      
                      374All other accrued
      expenses
                      
                      
                      783
                      
                      
                      
                      1,375Total accounts payable and accrued
      expenses
                      
                      $
                      3,446
                      
                      
                      $
                      5,313


(1)
            Accrued
      compensation consists of potential employee incentive arrangements
      (pursuant to plans approved by our Board), contractual future severance
      arrangements for our former President and Chief Executive Officer
      (see,Note 14 –
      Commitments, for further discussion of this arrangement)  and
      existing union employees at our manufacturing operations, and
      employees’unused earned
      vacation.




F-14





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Note9–Debt





Loan Payable
–Quintiles





Quintiles (formerly PharmaBio
Development, Inc. andNovaQuestTM)in 2001extended to us a secured, revolving
credit facility, which we
restructured in October
2006.The outstanding principal balance
ofthe loan,$8.5 million,is due and payable onApril 30, 2010, together with all unpaid interestaccrued sinceJuly 1, 2006.  Since October
2006, interest is calculatedat the prime rate, compounded
annually.  We may repay the loan, in whole or in part, at any time
without prepayment penalty or premium.  In addition, our obligations
toQuintilesunder the loanagreementaresecured by asecurityinterest in substantially all of our
assets, subject to limited exceptions set forth in therelated securityagreement.





Also in October 2006, in consideration
ofQuintiles’s agreement to restructure the loan, we
entered into a Warrant Agreement withQuintiles, pursuant to whichQuintileshas the right to purchase 1.5 million
shares of our common stock at an exercise priceof$3.5813 per share.  The
warrants have a seven-year term and are exercisable, in whole or in part, for
cash, cancellation of a portion of our indebtedness under theQuintilesloan agreement, or a combination of the
foregoing, in an amount equal to the aggregate purchase price for the shares
being purchased upon any
exercise.





As of December 31, 2009, the outstanding balance under the loan
was $10.5million ($8.5 million principal and
$2.0million accrued interest) and was
classified as acurrent
liabilityon the
Consolidated Balance Sheetas of such date.





For the years ended December 31,
2009, 2008and 2007, we incurred interest expense
associated with theQuintilesloan of $0.3million, $0.5million and $0.7million,
respectively.The decrease in interest expense in 2009
and 2008 is due to declines in the prime rate during 2008 ranging from 7.25% to
3.25%.During
2009, the prime rateremained at 3.25%.In addition, for the years
endedDecember 31, 2009,
2008 and 2007, we incurred interest expense associated with the amortization of
deferredfinancing costs in
connection with warrants issued toQuintilesin October 2006 of $0.5million, $0.5 million and
$0.5million,
respectively.





Equipment
Loans





Our equipment loan liabilities as of
December 31, 2009and 2008are as follows:





(in
    thousands)
                              
                              2009
                              
                              
                              2008GE Business Financial Services,
      Inc.Short-term
                              
                              $
                              538
                              
                              
                              $
                              2,385Long-term
                              
                              
                              65
                              
                              
                              
                              664Total
                              
                              
                              603
                              
                              
                              
                              3,049Pennsylvania Machinery and
      Equipment LoanShort-term
                              
                              
                              59
                              
                              
                              
                              57Long-term
                              
                              
                              363
                              
                              
                              
                              428Total
                              
                              
                              422
                              
                              
                              
                              485Total
      Short-term
                              
                              597
                              
                              
                              
                              2,442Total
    Long-term
                              
                              428
                              
                              
                              
                              1,092Total
                              
                              $
                              1,025
                              
                              
                              $
                              3,534





For the years ended December 31,
2009, 2008and 2007, we incurred interest expense
associated with ourequipment loansof $0.2million, $0.6 million and
$0.6million,
respectively.


F-15





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Equipment Financing Facility with GE
Business Financial Services Inc.





In May 2007, we entered into a Credit
and Security Agreement (Credit Agreement) with GE Business Financial Services
Inc. (formerly Merrill Lynch Business Financial Services Inc.) (GE), as Lender,
pursuant to which GE agreed to provide a $12.5 million facility (Facility) to
fund our capital programs.  The right to draw under this Facility
expired on November 30, 2008.Over the term of the Facility, we
received $7.2 million, $4.0 million of which wasapplied toprepayment of apriorfacility and $2.3 million of which
was associated with construction and equipment fortheanalytical and development
laboratorythat
webuilt in our
Warrington, Pennsylvaniaheadquarters in
2007.





Advancesunderthe Facilityto finance the acquisition of property
and equipment are amortized over a period of 36months and all other equipment and
related costs are amortized over a period of 24 months.  The advance
to prepay ourpriorfacility is amortized over a period of
27 months.  Interest on each advance accrues at a fixed rate per annum
equal toone-monthLIBOR plus 6.25%,
determined on the funding date of such advance.  Principal and
interest on all advances are payable in equal installments on the first business
day of each month.  We may prepay advances, in whole or in part, at
any time, subject to a prepayment penalty, which, depending on the period of
time elapsed from the closing of the Facility, will range from 4% to
1%.





Our obligations under the Facility are
secured by a security interest in (i) the financed property and equipment, and
(ii) all of our intellectual property (Supplemental Collateral), subject to
limited exceptions set forth in the Loan Agreement.  The Supplemental
Collateral will be released on the earlier to occur of (a) receipt by us of FDA
approval of our NDA for Surfaxinfor the prevention of RDS in premature
infants, or (b) the date on which we shall have maintained over a continuous
12-month period ending on or after March 31, 2008, measured at the end of each
calendar quarter, a minimum cash balance equal to our projected cash
requirements for the following 12-month period.  In addition, we, GE
andQuintilesentered into an Intercreditor Agreement
under which GE agreed to subordinate its security interest in the Supplemental
Collateral (which does not include financed property and equipment) to the
security interest in the same collateral that we previously granted toQuintilesasdiscussed above.





Pennsylvania Machinery and Equipment
Loan Fund (MELF)





We entered into a Loan Agreement and
Security Agreement with the Commonwealth of Pennsylvania, Department of
Community and Economic Development (Department), effective September 8, 2008,pursuant to which the Department made a
loan to us from the Machinery and Equipment Loan Fund in the amount of $500,000
(MELF Loan) to fund the purchase and installation of new machinery and equipment
and the upgrade of existing machinery and equipment at our analytical and
development laboratory in Warrington, Pennsylvania.  Principal and
interest on the MELF Loan is payable in equal monthly installments over a period
of seven years.  Interest on the principal amount accruesat a fixed rateof five percent (5.0%)per annum.  We may prepay the
MELF Loan at any time
without penalty.





In addition to customary terms and
conditions, the MELF Agreement provides that we must meet certain criteria
regarding retention and creation of new jobs within a three-year
period.  In the event that we fail to comply with this requirement,
the interest rate on the Promissory Note, except in limited circumstances, will
be adjusted to a fixed rate equal to two percentage points above the current
prime rate for the remainder of the term.





Note10–Stockholders’Equity





Registered
Public Offerings and Private Placements




InFebruary 2010, we completed apublicofferingof 27,500,000 shares of our common stockand warrants to purchase
13,750,000 shares ofour
commonstock, sold as units,with eachunit consisting of one share ofcommonstock and awarrant to purchase 0.50 of a share ofcommonstock, at a public offering price of
$0.60 perunit,resultingin gross and net proceeds to us of
$16.5million and $15.1million,
respectively.The warrants expire in February 2015 and
are exercisable, subject to an aggregate share ownership limitation,at a price per share of $0.85, for cashor, in the event that the related registration statement or an exemption
from registration is not available for the resale of the warrant shares, on a
cashless basis.  Thisofferingwas madepursuant tothe 2008 Universal Shelf (see,Universal Shelf Registration Statements
of thisNote).


F-16





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





InMay 2009, we completed a registered
direct offeringof
14,000,000 shares of our common stock and warrants to purchase 7,000,000 shares
of our common stock, sold as unitsto select institutional investors,with eachunit consisting of one share ofcommonstock and awarrant to purchase 0.50 of a share ofcommonstock, at anoffering price of $0.81perunit,resulting in gross and net proceeds to
us of $11.3 million and $10.5 million, respectively.


The warrants expire in May 2014 and are
exercisable, subject to an aggregate share ownership limitation,at a price per share of $1.15, for cashor, in the event that the related registration statement or an exemption
from registration is not available for the resale of the warrant shares, on a
cashless basis.  This
offering was made pursuant to our 2008UniversalShelf.





In December 2007, we completed a
registered direct offering of 10,000,000 shares of our common stock to select
institutional investors.  The shares were priced at $2.50 per share
resulting in gross and net proceeds to us of $25.0 million and $23.6 million,
respectively.Thisofferingwas madepursuant tothe 2005 Universal Shelf (see,Universal Shelf Registration Statements
of thisNote).





In April 2007, we completed a registered
direct offering of 14,050,000 shares of our common stock to select institutional
investors.  The shares were priced at $2.15 per share resulting in
gross and net proceeds to us of $30.2 million and $28.1 million,
respectively.  This offering was made pursuant to our 2005UniversalShelf.





Committed
Equity Financing Facilities (CEFFs)





We have
entered into four Committed Equity Financing Facilities (CEFFs) with Kingsbridge
Capital Limited (Kingsbridge), a private investment group, under which
Kingsbridge is committed to purchase, subject to certain conditions,
newly-issued shares of our common stock.  The CEFFs allow us, at our
discretion, to raise capital at the time and in amounts deemed suitable to us,
to support our business plans.  We are not obligated to utilize any of
the funds available under the CEFFs.  Each CEFF is available for a
period of 2 to 3 years from inception.  Should we choose to utilize
any of the CEFFs, our ability to access the funds available under the CEFFs is
subject to certain conditions, including stock price and volume
limitations.







As of December 31, 2009,we hadtwoCEFFsavailablefor future financings as follows: the
CEFF dated December 12, 2008 (December 2008 CEFF)andthe CEFF dated May 22, 2008 (May 2008
CEFF).  A third
CEFF entered in April 2006 expired on May 12, 2009 and is no longer
available.The
following table sets forth an overview of the “draw down” requirements and
availability under each CEFF:







(in
      millions, except
      per
                        share
      data and trading
      days)
                      
                      Minimum
      Price
                      
                      Minimum
                      
                      #
      of
      Trading
                        Days
                      
                      
                      Amount
      per
                        Contract
                      
                      
                      Potential
      Availability
                        at
                        December
      31,
      2009Expiration
                      
                      to
      Initiate
                        Draw
                        Down(1)
                      
                      VWAP
      for
                        Daily
                        Pricing(2)
                      
                      In
      Each
                        Draw
                        Down(2)
                      
                      
                      Shares
                      
                      
                      Maximum
                        Proceeds
                      
                      
                      Shares
                      
                      
                      Maximum
                        ProceedsMay
      2008
      CEFF
                      June
      18,
      2011
                      
                      $
                      1.15
                      
                      90%
      oftheclosingmarketpriceon
      the
                        day
      preceding the first day
      of
                        draw
      down
                      
                      
                      8
                      
                      
                      
                      19.3
                      
                      
                      $
                      60.0
                      
                      
                      
                      12.8
                      
                      
                      $
                      51.8Dec.
      2008
      CEFF
                      Feb.
      6,
      2011
                      
                      $
                      0.60
                      
                      
                      
                      6
                      
                      
                      
                      15.0
                      
                      
                      $
                      25.0
                      
                      
                      
                      7.1
                      
                      
                      $
                      17.7




(1)
            To initiate a draw down, the
      closing price of our common stock on the trading day immediately preceding
      the first trading day of the draw downperiodmust be at least equal to the
      minimum price set forth
above.


(2)
            If on any trading day, the daily
      volume-weighted average of our common stock (VWAP) is less than the
      minimum VWAP set forth above, no shares are purchased on that trading day
      and the aggregate amount that we originally designatedfor the overalldraw down is reduced for each such
      dayby1/8thin the case of theDecember2008 CEFF, and1/6thin the case of the May2008 CEFF, respectively.  Unless we and
      Kingsbridge agree otherwise, a minimum of three trading days must elapse
      between the expiration of any draw-down pricing period and the beginning
      of the next draw-down pricing
period.


F-17


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Each draw down is limited in amount as
follows:





·
            May 2008 CEFF – the lesser of 3.0
      percent of the closing price market value of the outstanding shares of our
      common stock at the time of the draw down or $10 million;
      and


·
            December 2008 CEFF – the lesser of
      1.5 percent of the closing price market value of the outstanding shares of
      our common stock at the time of the draw down or $3
      million.





The
purchase price of shares sold to Kingsbridge under the CEFFs is at a discount to
the VWAP (as defined in the applicable agreement) for each of the trading days
following our initiation of a “draw down” under the CEFF, as
follows:





Daily VWAP
                  
                  % of VWAP
                  
                  
                  Applicable DiscountMay
      2008 CEFFGreater
      than $7.25 per share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less
      than or equal to $7.25 but greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less
      than or equal to $3.85 but greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less
      than or equal to $1.75 but greater than or equal to $1.15 per
      share
                  
                  
                  88
                  %
                  
                  
                  12
                  %December
      2008 CEFFGreater than $7.25 per
      share
                  
                  
                  94
                  %
                  
                  
                  6
                  %Less than or equal to $7.25 but
      greater than $3.85 per share
                  
                  
                  92
                  %
                  
                  
                  8
                  %Less than or equal to $3.85 but
      greater than $1.75 per share
                  
                  
                  90
                  %
                  
                  
                  10
                  %Less than or equal to $1.75 but
      greater than or equal to $1.10 per share
                  
                  
                  88
                  %
                  
                  
                  12
                  %Less than or equal to
      $1.10 but greater
      than or equal to $.60
                  
                  
                  85
                  %
                  
                  
                  15
                  %





In addition, Kingsbridge may terminate
the CEFFs under certain circumstances, including if a material adverse event
relating to our business continues for 10 trading days after notice of the
material adverse event.





In
connection with the December 2008 CEFF, we issued a warrant to Kingsbridge on
December 22, 2008 to purchase up to 675,000 shares of our common stock at an
exercise price of $1.5132 per share.  The warrant expires in May 2014
and is exercisable, in whole or in part, for cash, except in limited
circumstances, with expected total proceeds to us, if exercised, of
approximately $1.0 million.  As of December 31, 2009, this warrant had
not been exercised.





In
connection with the May 2008 CEFF, we issued a warrant to Kingsbridge on May 22,
2008 to purchase up to 825,000 shares of our common stock at an exercise price
of $2.506 per share.  The warrant expires in November 2013 and is
exercisable, in whole or in part, for cash, except in limited circumstances,
with expected total proceeds to us, if exercised, of approximately $2.1
million.  As of December 31, 2009, this warrant had not been
exercised.





In
connection with the 2006 CEFF, we issued a Class C Investor Warrant to
Kingsbridge on April 17, 2006 to purchase up to 490,000 shares of our common
stock at an exercise price equal to $5.6186 per share.  The warrant
expires in October 2011 and is exercisable, in whole or in part, for cash,
except in limited circumstances, with expected total proceeds to us, if
exercised, of approximately $2.8 million.  As of December 31, 2009,
this Class C Investor Warrant had not been exercised.





In
connection with a CEFF that we entered in 2004, we issued a Class B Investor
Warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at
an exercise price equal to $12.0744 per share.  The warrant expired
unexercised in January 2010.


F-18





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





CEFF
Financings





The financings that wecompleted under theDecember2008 CEFF
are:





(inthousands, exceptper share data)


Completion
    Date
                      
                      Shares
    Issued
                      
                      
                      Gross
    Proceeds
                      
                      
                      Discounted
                        Average Price
                        Per ShareApril 8,
    2009
                      
                      
                      806
                      
                      
                      $
                      1,000
                      
                      
                      $
                      1.24May 7, 2009
                      
                      
                      1,273
                      
                      
                      
                      1,000
                      
                      
                      
                      0.79September 23,
      2009
                      
                      
                      1,793
                      
                      
                      
                      1,583
                      
                      
                      
                      0.88October 13,
      2009
                      
                      
                      1,909
                      
                      
                      
                      1,800
                      
                      
                      
                      0.94October 21,
      2009
                      
                      
                      2,101
                      
                      
                      
                      1,900
                      
                      
                      
                      0.90





The
financings that we completed under the May 2008 CEFF are:





(inthousands, exceptper share data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareJuly 11,
    2008
                    
                    
                    1,105
                    
                    
                    $
                    1,563
                    
                    
                    $
                    1.41July 31,
    2008
                    
                    
                    992
                    
                    
                    
                    1,500
                    
                    
                    
                    1.51October 17,
      2008
                    
                    
                    914
                    
                    
                    
                    1,313
                    
                    
                    
                    1.44November 20,
      2008
                    
                    
                    221
                    
                    
                    
                    250
                    
                    
                    
                    1.13January2, 2009
                    
                    
                    479
                    
                    
                    
                    500
                    
                    
                    
                    1.04January16, 2009
                    
                    
                    419
                    
                    
                    
                    438
                    
                    
                    
                    1.04February 18,
      2009
                    
                    
                    857
                    
                    
                    
                    1,000
                    
                    
                    
                    1.17March 31,
    2009
                    
                    
                    1,015
                    
                    
                    
                    1,094
                    
                    
                    
                    1.08October 13,
      2009
                    
                    
                    559
                    
                    
                    
                    606
                    
                    
                    
                    1.09





The financings that we completed under
thenow expired2006 CEFF
are:





(inthousands, exceptper share data)


CompletionDate
                    
                    SharesIssued
                    
                    
                    GrossProceeds
                    
                    
                    Discounted
                      AveragePrice
                      PerShareMay 29,
2006
                    
                    
                    1,079
                    
                    
                    $
                    2,188
                    
                    
                    $
                    2.03October 11,
      2006
                    
                    
                    1,205
                    
                    
                    
                    2,300
                    
                    
                    
                    1.91November 10,
      2006
                    
                    
                    1,372
                    
                    
                    
                    3,000
                    
                    
                    
                    2.19February 22,
      2007
                    
                    
                    943
                    
                    
                    
                    2,000
                    
                    
                    
                    2.12October 12,
      2007
                    
                    
                    1,909
                    
                    
                    
                    5,000
                    
                    
                    
                    2.62September 9,
      2008
                    
                    
                    676
                    
                    
                    
                    1,250
                    
                    
                    
                    1.85




F-19





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





401(k)
Employer Match





We have a voluntary 401(k) savings plan
covering eligible employees that allows for periodic discretionary matches as a
percentage of each participant’s contributions (up to the maximum
deduction allowed, excluding “catch up” amounts) in newly issued shares of
common stock.  For the years ended December 31, 2009, 2008and 2007, the match resulted in the issuance of346,904, 231,287,and 118,330 shares of common stock,
respectively.





Common
Shares Reserved for Future Issuance


Common shares reserved for potential
future issuance upon exercise of warrants




The chart below summarizes shares of our
common stock reserved for future issuance upon the exercise of
warrants.




(in thousands, except  price
per share data)





December
      31,
                
                
                Exercise
                
                Expiration2009
                
                
                2008
                
                
                Price
                
                DateInvestor
      Warrants – May 2009 Financing (1)
                
                
                7,000
                
                
                
                -
                
                
                $
                1.15
                
                5/13/2014Kingsbridge
      – December 2008 CEFF(2)
                
                
                675
                
                
                
                675
                
                
                $
                1.51
                
                6/12/2014Kingsbridge
      – May 2008 CEFF(2)
                
                
                825
                
                
                
                825
                
                
                $
                2.51
                
                11/22/2013Private
      Placement – 2006 (3)
                
                
                2,315
                
                
                
                2,315
                
                
                $
                3.18
                
                11/22/2011Quintiles
      - 2006 Loan Restructuring (4)
                
                
                1,500
                
                
                
                1,500
                
                
                $
                3.58
                
                10/26/2013Class
      C Investor Warrants - 2006 CEFF (2)
                
                
                490
                
                
                
                490
                
                
                $
                5.62
                
                10/17/2011Quintiles
      - 2004 Partnership Restructuring (5)
                
                
                850
                
                
                
                850
                
                
                $
                7.19
                
                11/3/2014Class
      B Investor Warrants - 2004 CEFF (2)
                
                
                375
                
                
                
                375
                
                
                $
                12.07
                
                1/6/2010Class
      A Investor Warrants – 2003
                
                
                809
                
                
                
                809
                
                
                $
                6.88
                
                9/19/2010Total
                
                
                14,839
                
                
                
                7,839





(1)
            Refer to the Registered Public
      Offerings and Private Placements section of this
    Note.


(2)
            Refer to the Registered Public
      Offerings and Private Placements section of this
    Note.


(3)
            InNov. 2006, in connection with a
      sale of 4.6 million shares of our common stock, weissued warrants to purchase common
      stock at an exercise price equal to $3.18 per share.  The
      warrants expire in Nov. 2011 and, subject to an aggregate share
      ownership limitation, are exercisable, in whole or in part, for cash,
      except in limited circumstances, with expected proceeds to us of $7.4
      million.  As of December 31, 2009, the warrants had not been
      exercised


(4)
            Refer to Note 9 –
      Debt


(5)
              Issued in connection with a
      restructuring of a 2003 arrangement with Quintiles Transnational Corp that
      resulted in cancellation of a 2001 commercialization agreement and
      extension of theQuintilesLoan.  Refer to Note 9
      – Debt.




Common shares reserved for potential
future issuance upon exercise of stock options





In June 2007, our stockholders approved
the adoption of the 2007 Long-Term Incentive Plan (the “2007
Plan”).  The 2007 Plan provides for the grant of long-term equity and
cash incentive compensation awards and replaced the Amended and Restated 1998
Stock Incentive Plan (the “1998 Plan”) whose ten-year term was to expire in
March 2008.  The 2007 Plan continues many of the features of the 1998
Plan, but is updated to reflect changes to Nasdaq rules regarding equity
compensation, other regulatory changes and market and corporate governance
developments.  Awards outstanding under the 1998 Plan will continue to
be governed by the terms of the 1998 Plan and the agreements under which they
were granted.


F-20


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Stock options outstanding and available
for future issuance as of December 31, 2009and 2008are as follows:





(in
    thousands)
                    
                    As of December
      31,2009
                    
                    
                    20082007 PlanOutstanding
                    
                    
                    6,688
                    
                    
                    
                    7,296Available for Future
      Grants
                    
                    
                    1,812
                    
                    
                    
                    1,204Total
                    
                    
                    8,500
                    
                    
                    
                    8,5001998 PlanOutstanding
                    
                    
                    9,298
                    
                    
                    
                    9,916Available for Future
      Grants
                    
                    
                    –
                    
                    
                    
                    –Total
                    
                    
                    9,298
                    
                    
                    
                    9,916Total
      Outstanding
                    
                    
                    15,986
                    
                    
                    
                    17,212Total Available for Future
      Grants
                    
                    
                    1,812
                    
                    
                    
                    1,204Total
                    
                    
                    17,798
                    
                    
                    
                    18,416





The 1998 Plan was suspended upon
approval of the 2007 Plan in June 2007; therefore, no shares were available for
future grants under the 1998 Plan.See,Note11– Stock Options and Stock-based
Employee Compensation.





Universal Shelf Registration
Statements





2008 Universal Shelf





In June
2008, we filed a universal shelf registration statement on Form S-3 (No.
333-151654) (2008 Universal Shelf) with the SEC for the proposed offering from
time to time of up to $150 million of our securities, including common stock,
preferred stock, varying forms of debt and warrant securities, or any
combination of the foregoing, on terms and conditions that will be determined at
that time.  As of December 31, 2009 and March 1, 2010, respectively,
up to $138.7 million and $122.2 million of our securities are potentially
available for issuance pursuant to the 2009 Universal Shelf.  See, Registered Public
Offering and Private Placements in this Note for offerings made pursuant to the
2008 Universal Shelf.




2005 Universal Shelf




In October 2005, we filed a universal
shelf registration statement onForm S-3 (File No. 333-128929)(2005 Universal Shelf)with the SEC for the proposed offering,
from time to time, of up to $100 million of our debt or equity securities.See,Registered Public Offering and Private
Placements in this Note for a discussion of offerings pursuant to the 2008
Universal Shelf.The October 2005UniversalShelf expired in December
2008.





Common shares
reserved for potential future issuance under CEFF
arrangements





As of December 31, 2009, the Company hadtwoCEFFs available for future
financings,as follows:




(in
    thousands)
                  
                  Potential future
      issuance
                    as ofDecember
31,Expiration
                  
                  2009
                  
                  
                  2008May 2008
    CEFF
                  June 18,
    2011
                  
                  
                  12,768
                  
                  
                  
                  15,618December2008 CEFF
                  February6, 2011
                  
                  
                  7,118
                  
                  
                  
                  15,000




F-21


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Common shares reserved for potential
future issuance under our 401(k) Plan





In
September 2009 and December 2008, our Board approved an increase of 160,000 and
350,000 shares, respectively, to the reserve for issuance under the 401(k)
Plan.  As of December 31, 2009 and 2008, we had 137,435 and 324,339
shares, respectively, reserved for potential future issuance under the 401(k)
Plan.





Note11–Stock Options and Stock-based Employee
Compensation





Long-Term Incentive
Plans





In June 2007, our stockholdersapprovedthe2007 Plan, which replaced the 1998 Plan, which by
its terms would have expired in March 2008.See,Note 10 –Common shares reserved for potential
future issuance upon exercise of stock options.The purposes ofthe 2007 Plan are to (i) encourage
eligible participants to acquire a proprietary interest in our company,
(ii)provide employees
incentives to contribute to our future success, thereby enhancing stockholder
value, and(iii)attract and retain exceptionally
qualified individuals upon whom, in large measure, our sustained progress,
growth and profitability depend.





Under the 2007 Plan, we may grant awards
for up to8,500,000 shares of our common
stock.  An
administrative committee (the Committee – currently the Compensation Committee
of the Board) or Committee delegates may determine the types, the number of
shares covered by, and the terms and conditions of, such
awards.  Eligible participants may include any of our employees,
directors, advisors or consultants.





The 2007 Plan continues many of the
features of the 1998 Plan, butisupdated to reflect changes to Nasdaq
rules regarding equity compensation, other regulatory changes and market and
corporate governance developments.Awards outstanding under the 1998 Plan
continue to be governed by the terms of that plan and the applicable award
agreements.





Award under the two plans may
include:





Stock Options and Stock Appreciation
Rights (SARs)





The Committee may award nonqualified
stock options, incentive stock options, or SARs with a termof not more thanten years and apurchase price not be less than 100% of
the fair market value on the date of grant.  The Committee will
establish the vesting schedule for stock options and the method of payment for
the exercise price, which may include cash, shares, or other
awards.  Although individual grants may vary, option awards generally
are exercisable upon vesting, vest based upon three years of continuous service
and have a 10-year term.In addition, the 2007 Plan provides for
limits on the number of options and SARs granted to any one participant and the
terms of any incentive stock option must comply with the provisions of Section
162(m) of the Internal Revenue Code.





Restricted Stock and Restricted Stock
Units





The Committee maygrantrestricted stockawards (RSAs)and restricted stock units and, among
other things, establish the applicable restrictions, including any limitation on
voting rights or the receipt of dividends, and will establish the manner and
timing under which restrictions may lapse.  If employment is
terminated during the applicable restriction period (other than as a result of
death or disability), shares of restricted stock and restricted stock units
still subject to restriction will be forfeited, except as determined otherwise
by the Committee.




F-22





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Performance Awards
and Other Stock-Based Awards





The Committee may grant performance
awards, which may be denominated in cash, shares, other securities or other
awards and payable to, or exercisable by, the participant upon the achievement
of performance goals during performance periods, as established by the
Committee.  The Committee may grant other stock-based awards that are
denominated or payable in shares, under the terms and conditions as the
Committee will determine.  The Committee may decide to include
dividends or dividend equivalents as part of a performance or other stock-based
award, and may accrue dividends, with or without interest, until the award is
paid.





Automatic Grant of Non-Employee Director
Options





Each non-employee directors is entitled
to automatic option grants on specified dates as follows: (i) options to
purchase 40,000 shares on the date of first election or appointment to the board
and (ii) options to purchase 30,000 shares on the date of each subsequent annual
stockholders meeting if such director continues to, and has served as a director
for at least six months.  Non-employee director options vest on the
first anniversary of the date of grant (subject to continued service through
such date) and will otherwise vest in full upon the termination of service as a
result of death or disability.  Non-employee director options have a
term of ten years (subject to earlier termination twelve months after any
termination of service).





No SARs or Performance Awards have been
granted under either plan.NoRSAshave been granted under the 2007
Plan.  Under the 1998 Plan, in 2007, 56,660RSAsweregrantedto certain employees for no cash
consideration.These RSAs initially were to veston the date that Surfaxin
for RDS first becomes widely commercially available; however, the Committee amended the
vesting provisions in 2009 to provide for vesting on the third anniversary of
the grant date.As of December 31, 2009, there were
27,500 unvested restricted stock awards outstanding, which vested on January 3,
2010.





Under the 2007 Plan, as of December 31,
2009, options to purchase6,687,719shares of common stock were outstanding
and1,812,281shares were available for potential
future grants.  As of December 31, 2008, options to purchase 7,295,667 shares
of common stock were outstanding and 1,204,333 shares were available for
potential future grants.Under the 1998 Plan, options to
purchase9,297,792and9,916,644 shares of common stock were
outstandingas ofDecember 31,
2009 and December 31,
2008,respectively.  No sharesareavailable for future grantsunder the 1998
Plan.




A summary of option activity under the
2007 Plan and 1998 Plan as of December 31, 2009and changes during the
periods ended December 31,
2007, 2008 and 2009, respectively,is presented below:




(in thousands, except for
weighted-average data)




Stock Options
                                      
                                      Price Per Share
                                      
                                      
                                      Shares
                                      
                                      
                                      Weighted-
                                        Average
                                        Exercise
                                        Price
                                      
                                      Weighted-
                                        Average
                                        Remaining
                                        Contractual
                                        Term(In Yrs)Outstanding at December 31,
      2006
                                      
                                      
                                      $0.19 – $10.60
                                      
                                      
                                      
                                      10,690
                                      
                                      
                                      $
                                      4.89Granted
                                      
                                      
                                      2.08 – 3.58
                                      
                                      
                                      
                                      3,907
                                      
                                      
                                      
                                      2.94Exercised
                                      
                                      
                                      0.19 – 2.46
                                      
                                      
                                      
                                      (61
                                      )
                                      
                                      
                                      1.72Forfeited or
      expired
                                      
                                      
                                      0.19 – 9.80
                                      
                                      
                                      
                                      (606
                                      )
                                      
                                      
                                      5.07Outstanding at December 31,
      2007
                                      
                                      
                                      $0.19 – $10.60
                                      
                                      
                                      
                                      13,930
                                      
                                      
                                      $
                                      4.35Granted
                                      
                                      
                                      1.21 – 2.90
                                      
                                      
                                      
                                      3,950
                                      
                                      
                                      
                                      1.78Exercised
                                      
                                      
                                      0.32 – 1.62
                                      
                                      
                                      
                                      (18
                                      )
                                      
                                      
                                      1.21Forfeited or
      expired
                                      
                                      
                                      0.19 – 10.60
                                      
                                      
                                      
                                      (650
                                      )
                                      
                                      
                                      5.17Outstanding at December 31,
      2008
                                      
                                      
                                      $0.81 – $10.43
                                      
                                      
                                      
                                      17,212
                                      
                                      
                                      $
                                      3.72Granted
                                      
                                      
                                      0.49 – 1.18
                                      
                                      
                                      
                                      297
                                      
                                      
                                      
                                      0.78Exercised
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —Forfeited or
      expired
                                      
                                      
                                      0.81–9.17
                                      
                                      
                                      
                                      (1,523
                                      )
                                      
                                      
                                      2.63Outstanding at December 31,
      2009
                                      
                                      
                                      $0.49 – $10.43
                                      
                                      
                                      
                                      15,986
                                      
                                      
                                      $
                                      3.76
                                      
                                      6.1Exercisable at December 31,
      2009
                                      
                                      
                                      $1.15 – $10.43
                                      
                                      
                                      
                                      13,608
                                      
                                      
                                      $
                                      4.09
                                      
                                      5.7




F-23


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY




Based
upon application of the Black-Scholes option-pricing formula described below,
the weighted-average grant-date fair value of options granted during the years
ended December 31, 2009, 2008 and 2007 was $0.56, $0.88 and $2.05,
respectively.  The total intrinsic value of options exercised during
the years ended December 31, 2009, 2008 and 2007 was $0, $13,000 and $57,000,
respectively.  The total intrinsic value of options outstanding,
vested and exercisable as of December 31, 2009 is $13,000, $0 and $0,
respectively.




A summary of the status of our nonvested
shares issuable upon exercise of outstanding options and changes during
2009is presented below:




(shares in
      thousands)
                          
                          Option
                            Shares
                          
                          
                          Weighted-
                            Average Grant-
                            Date Fair
    ValueNon-vested at December 31,
      2008
                          
                          
                          6,607
                          
                          
                          $
                          1.40Granted
                          
                          
                          297
                          
                          
                          
                          .56Vested
                          
                          
                          (3,636
                          )
                          
                          
                          1.55Forfeited
                          
                          
                          (891
                          )
                          
                          
                          1.33Non-vested at December 31,
      2009
                          
                          
                          2,377
                          
                          
                          $
                          1.11





The following table provides detail with
regard to options outstanding, vested and exercisable at December 31,
2009:




(sharesinthousands)
                          
                          Outstanding
                          
                          VestedandExercisablePricepershare
                          
                          Shares
                          
                          
                          Weighted-
                            Average
                            Price
                            perShare
                          
                          Weighted-
                            Average
                            Remaining
                            Contractual
                            Life
                          
                          Shares
                          
                          
                          Weighted-
                            Average
                            Price
                            perShare
                          
                          Weighted-
                            Average
                            Remaining
                            Contractual
                            Life$0.49 –
    $2.00
                          
                          
                          4,148
                          
                          
                          $
                          1.63
                          
                          7.86 Years
                          
                          
                          2,404
                          
                          
                          $
                          1.69
                          
                          7.23
  years$2.01 –
    $4.00
                          
                          
                          7,463
                          
                          
                          $
                          2.66
                          
                          6.41 Years
                          
                          
                          6,829
                          
                          
                          $
                          2.65
                          
                          6.44
  years$4.01 –
    $6.00
                          
                          
                          657
                          
                          
                          $
                          4.75
                          
                          0.88 Years
                          
                          
                          657
                          
                          
                          $
                          4.75
                          
                          0.88
  years$6.01 –
    $8.00
                          
                          
                          1,350
                          
                          
                          $
                          6.87
                          
                          5.26 Years
                          
                          
                          1,350
                          
                          
                          $
                          6.87
                          
                          5.26
  years$8.01 –
    $10.00
                          
                          
                          2,343
                          
                          
                          $
                          8.93
                          
                          4.24 Years
                          
                          
                          2,343
                          
                          
                          $
                          8.93
                          
                          4.24
  years$10.01 –
    $10.43
                          
                          
                          25
                          
                          
                          $
                          10.43
                          
                          4.22 Years
                          
                          
                          25
                          
                          
                          $
                          10.43
                          
                          4.22
  years15,986
                          
                          
                          
                          
                          
                          
                          
                          
                          13,608





Stock-Based
Compensation





As a result of adoptingAccounting Standards Codification (ASC)
Topic 718“Stock
Compensation,”on January 1, 2006, we recognized
compensation expense for the years ended December 31, 2009, 2008and 2007of $2.7million, $4.6million and $5.3million,
respectively.




F-24


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Stock-based compensation expenses was
classified as follows:




Years Ended December
      31,(in
    thousands)
                        
                        2009
                        
                        2008
                        
                        2007Research and
      development
                        
                        $
                        649
                        
                        
                        $
                        1,501
                        
                        
                        $
                        1,706General and
      administrative
                        
                        
                        2,035
                        
                        
                        
                        3,127
                        
                        
                        
                        3,613Total
                        
                        $
                        2,684
                        
                        
                        $
                        4,628
                        
                        
                        $
                        5,319





The fair value of each option award is
estimated on the date of grant using the Black-Scholes option-pricing formula
that uses assumptions noted in the following table.  Expected
volatilities are based uponthehistorical volatilityof our common stockand other factors.  We also
use historical data and other factors to estimate option exercises, employee
terminations and forfeiture rates within the valuation model.  The
risk-free interest rates are based upon the U.S. Treasury yield curve in effect
at the time of the grant.




Years Ended December
      31,2009
                    
                    
                    2008
                    
                    
                    2007Weighted average expected
      volatility
                    
                    
                    99
                    %
                    
                    
                    81
                    %
                    
                    
                    88
                    %Weighted average expected
term
                    
                    4.7 years
                    
                    
                    4.6 years
                    
                    
                    4.8 yearsWeighted average risk-free interest
      rate
                    
                    
                    1.7
                    %
                    
                    
                    2.1
                    %
                    
                    
                    4.8
                    %Expected
      dividends
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    –




The total fair value of the underlying
shares of the options vested during 2009, 2008, and 2007equals $5.6million, $4.7million and $4.9million, respectively.  As of
December 31, 2009, there was $2.2million of total unrecognized
compensation cost related to non-vested share-based compensation
arrangements granted under the Plan.  That cost is expected to be
recognizedover a
weighted-average vesting period of1.37years.





On August 13, 2009, Dr. Robert J.
Capetola, our formerPresident and Chief
Executive Officer, resigned
his position and with us and as a member of our Board.Under the terms of a Separation of
Employment Agreement and General Release dated August 13, 2009 between Dr.
Capetola and ourselves,all of Dr. Capetola’soutstandingRSAsand optionsimmediately vested and all such RSAs
and optionsshall remain
exercisable to the end of their stated terms.During 2009, the company recognized $0.3 million in
stock option modification costs related to these items.





Note12–Corporate Partnership, Licensing and
Research Funding Agreements





Laboratorios del Dr. Esteve,
S.A.





We have a strategic alliance with
Laboratorios del Dr. Esteve, S.A. (Esteve) for the development, marketing and
sales of a broad portfolio of potentialsurfactantproducts in Andorra, Greece, Italy,
Portugal, and Spain.  Esteve will pay us a transfer price on sales of
Surfaxin and otherKL4surfactantproducts.  We will be responsible for
the manufacture and supply of all of the covered products and Esteve will be
responsible for all sales and marketing in the territory.  Esteve is
obligated to make stipulated cash payments to us upon our achievement of certain
milestones, primarily upon receipt of marketing regulatory approvals for the
covered products.  In addition, Esteve has agreed to contribute to
Phase 3 clinical trials for the covered products by conducting and funding
development performed in the territory.As part of a restructuring
of this alliance in December 2004,we regained full commercialization
rights to ourKL4surfactant technologyin portions of the original territory
licensed to Esteve, including key European markets, Central America, and South
America (Former Esteve Territories) and agreed to pay to Esteve 10% of any cash
up-front and milestone fees (not to exceed $20 million in the aggregate) that we
may receive in connection with any strategic collaborations for the development
and commercialization of certain of ourKL4surfactantproducts, including Surfaxin and
Aerosurf  in the Former Esteve Territories.


F-25





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Licensing and Research Funding
Agreements





Philip Morris USA Inc. andPhilip Morris Products
S.A.





In March 2008, werestructured ourDecember 2005strategicalliance with Philip Morris USA Inc. (PMUSA),
d/b/a Chrysalis Technologies (Chrysalis), and assumed full
responsibilityfrom
Chrysalisfor the further
development of thecapillary aerosolization
technology, including
finalizing design development for the initial prototype aerosolization device
platform and disposable dose packets.  In connection with the
restructuring, werestated
our prior agreement as of March 28, 2008 andentered into an Amended and Restated
License Agreement with PMUSAwith respect tothe United States(U.S. License Agreement), and, as PMUSAhadassigned to Philip Morris Products S.A.
(PMPSA) all rights in and to thecapillary aerosolization
technologyoutside of the
United States (International Rights), effectiveonthe same date, we entered into a
License Agreement with PMPSA with respect to the International Rights
(International License Agreement) on substantially the same terms and conditions
as the U.S. License Agreement.  We currently hold exclusive licenses
to thecapillary
aerosolization technologyboth in and outside of the United States for use with pulmonary surfactants
(alone or in combination with any other pharmaceutical compound(s)) for all
respiratory diseases and conditions (the foregoing uses in each
territory,theExclusive Field).  In
addition, under the U.S. License Agreement, our license to use thecapillary aerosolization
technologyincludes other
(non-surfactant) drugs to treat a wide range of pediatric and adult respiratory
indications in hospitals and other health care institutions.





As part of therestructuring, Chrysalis completed a
technology transfer, provided development support to us through June 30, 2008,
and also paid us $4.5 million to support our future development
activities.  We are obligated to pay royalties at a rate equal to a
low single-digit percent of sales of products sold in the Exclusive Field in the
territories.  In connection with exclusive undertakings of PMUSA and
PMPSA not to exploit thecapillary aerosolization
technologyfor all licensed
uses, we are obligated to pay royalties on all product sales, including sales of
aerosol devices and related components that are not based on thecapillary aerosolization
technology; provided,
however, that no royalties are payable to the extent that we exercise our right
to terminate the license with respect to a specific indication.  We
also agreed in the future to pay minimum royalties, but are entitled to a
reduction of future royalties in an amount equal to the excess of any minimum
royalty paid over royalties actually earned in prior
periods.





Johnson & Johnson andOrthoPharmaceutical
Corporation





We,Johnson & Johnson and its
wholly-owned subsidiary, OrthoPharmaceutical Corporation,are parties to an agreement granting to
us an exclusive worldwide licensetotheproprietaryKL4surfactanttechnology, including Surfaxin, in
exchange for certain license fees, milestone payments aggregatingup to$2,500,000 and royalties.  To
date, we have paid $450,000of such amountfor milestonesthat have beenachieved.





Note13–Commercial Strategy and Cost Containment
Measures





Following receipt of theApril 2009Complete Response Letter for Surfaxin
for the prevention of RDS in premature infants, we reviewed all aspects of our
businesswith a view to
conserving our cash andimplemented a fundamental change in our business strategy.  We no
longerareplanning to establish our own specialty
pulmonary organization to commercialize our potential pediatric products in the
United States.Rather,
to secure capital and
advance our KL4surfactant pipeline programs, we are
now seeking strategic alliances in all markets, including the United States, to
support our research and development programs and, if approved, to commercialize
our products.





In addition, in April 2009, we
implemented cost containment measures and reduced our workforce from 115 to 91
employees, focusingprimarilyon our commercial and corporate
administrative groups.We continue to maintain our core
capabilities to support development of our KL4surfactant technology, including
quality, manufacturing and research and development resources.  We
incurred a charge of $0.6 million in the second quarter of 2009 associated with
staff reductions and the close-out of certain contractual arrangements, which is
included within the appropriate line items on the Statementsof Operations ($0.4 million in general
and administrative expenses and $0.2 million in research and development
expenses).  As ofDecember 31, 2009, payments totaling $0.6million had been made related to these
items and $29,000wasunpaid, as follows:


F-26





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





(in thousands)
                  
                  Severance
                    andBenefits
                    Related
                  
                  
                  Termination
                    of
                    Commercial
                    Programs
                  
                  
                  TotalQ2 2009
    Charge
                  
                  $
                  554
                  
                  
                  $
                  74
                  
                  
                  $
                  628Payments /
      Adjustments
                  
                  
                  (450
                  )
                  
                  
                  —
                  
                  
                  
                  (450
                  )Liability as of June 30,
      2009
                  
                  $
                  104
                  
                  
                  $
                  74
                  
                  
                  $
                  178Payments /
      Adjustments
                  
                  
                  (97
                  )
                  
                  
                  (4
                  )
                  
                  
                  (101
                  )Liability as of September 30,
      2009
                  
                  $
                  7
                  
                  
                  $
                  70
                  
                  
                  $
                  77Payments /
      Adjustments
                  
                  
                  (7
                  )
                  
                  
                  (41
                  )
                  
                  
                  (48
                  )Liability as of December 31,
      2009
                  
                  $
                  -
                  
                  
                  $
                  29
                  
                  
                  $
                  29





Note14–Commitments




Future payments due under contractual
obligations at December 31, 2009are as follows:





(in
      thousands)
                
                2010
                
                
                2011
                
                
                2012
                
                
                2013
                
                
                2014
                
                
                There-
                  after
                
                
                TotalLoan
      payable(1)
                
                $
                10,573
                
                
                $
                –
                
                
                $
                –
                
                
                $
                –
                
                
                $
                –
                
                
                $
                –
                
                
                $
                10,573Equipment
      loan obligations(1)
                
                
                722
                
                
                
                152
                
                
                
                85
                
                
                
                85
                
                
                
                85
                
                
                
                70
                
                
                
                1,199Operating
      lease obligations
                
                
                1,127
                
                
                
                1,146
                
                
                
                1,166
                
                
                
                320
                
                
                
                150
                
                
                
                –
                
                
                
                3,909CEO
      Severance obligations
                
                
                1,211
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                1,211Total
                
                $
                13,633
                
                
                $
                1,298
                
                
                $
                1,251
                
                
                $
                405
                
                
                $
                235
                
                
                $
                70
                
                
                $
                16,892





(1)See,Note 9: “Debt”




Our operating leases consist primarily
of facility leases for our operations in Pennsylvania and New
Jersey.




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





We lease
approximately 21,000 square feet of space for our manufacturing facility in
Totowa, New Jersey, at an annual rent of $150,000.  This space is
specifically designed for the manufacture and filling of sterile pharmaceuticals
in compliance with cGMP and is our only manufacturing facility. The lease
expires in December 2014, subject to the landlord’s right, upon two years’ prior
notice, to terminate the lease early.  This early termination right is
subject to certain conditions, including that the master tenant, a related party
of the landlord, must have ceased all activities at the premises, and, depending
upon the timing of the notice, if we satisfy certain financial conditions, the
landlord would be obligated to make early termination payments to
us. At the present time, we understand that the master tenant continues to
be active in the premises. The total aggregate payments over the term of
the lease are $1.4 million.  In connection with our manufacturing
operations in Totowa, New Jersey, we have 15 employees subject to a collective
bargaining arrangement which expires on December 3, 2010. For a
discussion of our manufacturing strategy, see, “Item 1 – Business
– Business Operations – Manufacturing and Distribution,” in our Annual
Report on Form 10-K.
  F-27


DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Our lease for 5,600 square feet of
office and analytical laboratory space in Doylestown, Pennsylvania was
terminated effective July 31, 2008 and all activities at this location have been
consolidated into our laboratory space in Warrington,
Pennsylvania.  Our lease for 16,800 square feet of office and
laboratory space at our facility in Mountain View, California, expired without
renewal or extension on June 30, 2008.  In December 2007, we
consolidated these activities into our laboratory space in Warrington,
Pennsylvania.





Rent expense under all of these leases
for the years ended December 31, 2009, 2008, and 2007 was $1.1 million, $1.2
million and $1.5 million,respectively.





In addition to the contractual
obligations above, we have certain milestone and royalty payment obligations to
Johnson & Johnson related to our product licenses.  To date,of the $2,500,000 aggregate
potential amount of such milestone payments,we have paid $450,000formilestonesthat have been achieved.





Former CEO
Commitment





Effective August 13, 2009, Dr. Robert J.
Capetola resigned his positions as our President and Chief Executive Officer and
as a member of our Board.  We entered into a separation agreement and
general release (Separation Agreement) with Dr. Capetola providing for (i) an
upfront severance payment of $250,000, and (ii) periodic payments in an amount
equal to his base salary (calculated at a rate of $490,000 per annum), in
accordance with our payroll practices and less required
withholdings.  The periodic payments will end the earlier of (x) May
3, 2010 or (y) the date, if ever, that a Corporate Transaction (as defined
below) occurs.  In addition, Dr. Capetola will be entitled to (A)
continuation of medical benefits and insurance coverage for a period of 24 or 27
months, depending upon circumstances, and (B) accelerated vesting of all
outstanding restricted shares and options, which shall remain exercisable to the
end of their stated terms.





The Separation Agreement provides
further that, upon the occurrence of a Corporate Transaction prior to May 4,
2010, Dr. Capetola will receive a payment of up to $1,580,000(Additional Severance)or, if any such Corporate Transaction
also constitutes a Change of Control (as such term is defined in the Separation
Agreement), a payment of up to $1,777,500; provided, however, that, in each
case, any such payment will be reduced by the sum of the amounts described in
clauses (i) and (ii) of this paragraph that theretofore have been
paid.  A “Corporate Transaction” is defined in the Separation
Agreement as (1) one or more corporate partnering or strategic alliance
transactions, Business Combinations or public or private financings that (A) are
completed during the Severance Period (as defined in the Separation Agreement)
and (B) result in cash proceeds (net of transaction costs) to the Company of at
least $20 million received during the Severance Period or within 90 calendar
days thereafter, or (2) an acquisition of the Company, by business combination
or other similar transaction, that occurs during the Severance Period and the
consideration paid to stockholders of the Company, in cash or securities, is at
least $20 million.  For this purpose, net proceeds will be calculated
without taking into account any amounts received by the Company as reimbursement
for costs of development and research activities to be performed in connection
with any such transaction.Seealso,Note 18 – Subsequent
Events.





Note15–Litigation





We are not aware of any pending or
threatened legal actions that would, if determined adversely to us, have a
material adverse effect on our business and operations.





We have from time to time been involved
in disputes and proceedings arising in the ordinary course of business,
including in connection with the conduct of our clinical trials.  In
addition, as a public
company, we are alsopotentially susceptible to
litigation, such as claims asserting violations of securities
laws.  Any such
claims, with or without merit, if not resolved, could be time-consuming and
result in costly litigation.There can be no assurance that an
adverse result in any future proceeding would not have a potentially material
adverse effecton our
business, results of operations and financial condition.


F-28





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





Note16–Income Taxes





Since our inception, we have never
recorded a provision or benefit forFederaland state income
taxes.





The reconciliation of the income tax
benefit computed at theFederalstatutory rates to our recorded tax
benefit for the years ended December 31, 2009, 2008and 2007isas follows:





(in
    thousands)
                  
                  December
31,2009
                  
                  
                  2008
                  
                  
                  2007Income tax benefit, statutory
      rates
                  
                  $
                  10,282
                  
                  
                  $
                  13,296
                  
                  
                  $
                  13,601State taxes on income, net ofFederalbenefit
                  
                  
                  423
                  
                  
                  
                  2,102
                  
                  
                  
                  2,363Research and development tax
      credit
                  
                  
                  756
                  
                  
                  
                  1,026
                  
                  
                  
                  960Employee
      Related
                  
                  
                  (1,471
                  )
                  
                  
                  (1,306
                  )
                  
                  
                  (1,118
                  )Other
                  
                  
                  (19
                  )
                  
                  
                  (32
                  )
                  
                  
                  (24
                  )Income tax
      benefit
                  
                  
                  9,971
                  
                  
                  
                  15,086
                  
                  
                  
                  15,782Valuation
      allowance
                  
                  
                  (9,971
                  )
                  
                  
                  (15,086
                  )
                  
                  
                  (15,782
                  )Income tax
      benefit
                  
                  $
                  –
                  
                  
                  $
                  –
                  
                  
                  $
                  –





The tax effects of temporary differences
that give rise to deferred tax assets and deferred tax liabilities, at
December 31, 2009and 2008, are as follows:




(in
    thousands)
                  
                  December
31,2009
                  
                  
                  2008Long-term deferred tax
      assets:Net operating loss
      carryforwards(Federaland state)
                  
                  $
                  126,291
                  
                  
                  $
                  115,401Research and development tax
      credits
                  
                  
                  7,893
                  
                  
                  
                  7,137Compensation expense on
      stock
                  
                  
                  4,730
                  
                  
                  
                  4,334Charitable contribution
      carryforward
                  
                  
                  6
                  
                  
                  
                  6Other
    accrued
                  
                  
                  1,635
                  
                  
                  
                  2,073Depreciation
                  
                  
                  2,341
                  
                  
                  
                  2,494Capitalized research and
      development
                  
                  
                  2,069
                  
                  
                  
                  2,411Total long-term deferred tax
      assets
                  
                  
                  144,965
                  
                  
                  
                  133,857Long-term deferred tax
      liabilities
                  
                  
                  –
                  
                  
                  
                  –Net deferred tax
      assets
                  
                  
                  144,632
                  
                  
                  
                  133,857Less:  valuation
      allowance
                  
                  
                  (144,965
                  )
                  
                  
                  (133,857
                  )Deferred tax assets, net of
      valuation allowance
                  
                  $
                  –
                  
                  
                  $
                  –




We are in a net deferred tax asset
position at December 31, 2009and 2008before the consideration of a valuation
allowance.  Due to the fact that we have never realized a profit,
management has fully reserved the net deferred tax asset since realization is
not assured.




F-29





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





At December 31, 2009 and 2008, we had
available carryforward net operating losses for Federal tax purposes of $315.5
million and $292.6 million, respectively, and a research and development tax
credit carryforward of $7.9 million and $7.1 million,
respectively.  The Federal net operating loss and research and
development tax credit carryforwards began to expire in 2008 and will continue
through 2028.  Approximately $11.9 million of the $315.5 net operating
loss carryforwards expire prior to 2013.




At
December 31, 2009, we
had available carryforward Federal and state net operating losses of $1.8
million and $16,000, respectively, related to stock-based
compensation.  Additionally, at December 31,2008 and 2007, we
had available carryforward losses of approximately $271.1 million and $250.2
million, respectively, for state tax purposes.  Of the $271.1 state
tax carryforward losses, $246.7 million is associated with the state of
Pennsylvania, with the remainder associated with New Jersey, California and
Florida.





Utilization ofnet operating loss (NOL)andresearch and development(R&D)credit carryforwards may be subject to
a substantial annual limitation under Section 382 of the Internal Revenue Code
of 1986 due to ownership change limitations that have occurred previously or
that could occur in the future.These ownership changes may limit the
amount of NOL and R&D credit carryforwards that can be utilized annually to
offset future taxable income and tax, respectively.  There also could
be additional ownership changes in the future which may result in additional
limitations in the utilization of the carryforward NOLs and
credits.





A full valuation
allowance has been provided against our research and development credits and, if
a future assessment requires an adjustment, an adjustment would be offset by an
adjustment to the valuation allowance.  Thus, there would be no impact
to the consolidated balance sheet or statement of operations if an adjustment
were required.





Federal and state net operating
losses,$1.8million and $16,000, respectively, relate to
stock-based compensation,
the tax effect of which will result in a credit to equity as opposed to income
tax expense,to the extent these losses are utilized
in the future.




On January 1, 2007, we adopted the
provisions ofAccounting
Standards Codification (ASC) Topic 740,“Accounting for
Income Taxes”.Topic 740creates a single model to address
uncertainty in tax positions and clarifies the accounting for income
taxesby prescribing the minimum recognition
threshold a tax position is required to meet before being recognized in the
financial statements.  The provisions ofTopic 740apply to all material tax positions in
all taxing jurisdictions for all open tax years.The adoption ofTopic 740did not have a material effect on the
Company’s financial condition or results of
operations for the year ended December 31, 2009.





Note17–Selected Quarterly Financial Data
(Unaudited)





The following table contains unaudited
statement of operations information for each quarter of 2009and 2008.  The operating results for
any quarter are not necessarily indicative of results for any future
period.


F-30





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





2009Quarters
      Ended:(in thousands, except per share
      data)
                  
                  Mar. 31
                  
                  
                  June 30
                  
                  
                  Sept. 30
                  
                  
                  Dec.31
                  
                  
                  Total YearRevenues
                  
                  $
                  –
                  
                  
                  $
                  –
                  
                  
                  $
                  –
                  
                  
                  $
                  –
                  
                  
                  $
                  –Expenses:Research and
      development
                  
                  
                  5,607
                  
                  
                  
                  5,052
                  
                  
                  
                  4,530
                  
                  
                  
                  3,888
                  
                  
                  
                  19,077General and
      administrative
                  
                  
                  3,096
                  
                  
                  
                  2,592
                  
                  
                  
                  2,417
                  
                  
                  
                  2,015
                  
                  
                  
                  10,120Total
    expenses
                  
                  
                  8,703
                  
                  
                  
                  7,644
                  
                  
                  
                  6,947
                  
                  
                  
                  5,903
                  
                  
                  
                  29,197Operating
    loss
                  
                  
                  (8,703
                  )
                  
                  
                  (7,644
                  )
                  
                  
                  (6,947
                  )
                  
                  
                  (5,903
                  )
                  
                  
                  (29,197
                  )Other expense,
      net
                  
                  
                  (297
                  )
                  
                  
                  (264
                  )
                  
                  
                  (244
                  )
                  
                  
                  (238
                  )
                  
                  
                  (1,043
                  )Net loss
                  
                  $
                  (9,000
                  )
                  
                  $
                  (7,908
                  )
                  
                  $
                  (7,191
                  )
                  
                  $
                  (6,141
                  )
                  
                  $
                  (30,240
                  )Net loss per common share
      -  basic and diluted
                  
                  $
                  (0.09
                  )
                  
                  $
                  (0.07
                  )
                  
                  $
                  (0.06
                  )
                  
                  $
                  (0.05
                  )
                  
                  $
                  (0.26
                  )Weighted average number of
      commonshares
      outstanding
                  
                  
                  102,093
                  
                  
                  
                  112,712
                  
                  
                  
                  119,993
                  
                  
                  
                  125,638
                  
                  
                  
                  115,200





2008Quarters
      Ended:(in thousands, except per share
      data)
                    
                    Mar. 31
                    
                    
                    June 30
                    
                    
                    Sept. 30
                    
                    
                    Dec.31
                    
                    
                    Total YearRevenues
                    
                    $
                    2,050
                    
                    
                    $
                    2,500
                    
                    
                    $
                    50
                    
                    
                    $
                    –
                    
                    
                    $
                    4,600Expenses:Research and
      development
                    
                    
                    7,232
                    
                    
                    
                    7,439
                    
                    
                    
                    6,724
                    
                    
                    
                    5,170
                    
                    
                    
                    26,566General and
      administrative
                    
                    
                    4,505
                    
                    
                    
                    5,076
                    
                    
                    
                    3,726
                    
                    
                    
                    3,121
                    
                    
                    
                    16,428Total
    expenses
                    
                    
                    11,737
                    
                    
                    
                    12,515
                    
                    
                    
                    10,450
                    
                    
                    
                    8,291
                    
                    
                    
                    42,994Operating
    loss
                    
                    
                    (9,687
                    )
                    
                    
                    (10,015
                    )
                    
                    
                    (10,400
                    )
                    
                    
                    (8,291
                    )
                    
                    
                    (38,394
                    )Other expense,
      net
                    
                    
                    (27
                    )
                    
                    
                    (200
                    )
                    
                    
                    (239
                    )
                    
                    
                    (246
                    )
                    
                    
                    (712
                    )Net loss
                    
                    $
                    (9,714
                    )
                    
                    $
                    (10,215
                    )
                    
                    $
                    (10,639
                    )
                    
                    $
                    (8,537
                    )
                    
                    $
                    (39,106
                    )Net loss per common share
      -  basic and diluted
                    
                    $
                    (0.10
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.11
                    )
                    
                    $
                    (0.08
                    )
                    
                    $
                    (0.40
                    )Weighted average number of
      commonshares
      outstanding
                    
                    
                    96,649
                    
                    
                    
                    96,691
                    
                    
                    
                    98,619
                    
                    
                    
                    100,474
                    
                    
                    
                    98,116





Note18–Subsequent Events





We
evaluated all events or transactions that occurred after December 31, 2009 up
through the date we issued these financial statements. During this period we did
not have any material recognized subsequent events, however, there were three
nonrecognized subsequent events described below:





InFebruary 2010, we completed apublicofferingof 27,500,000 shares of our common stockand warrants to purchase
13,750,000 shares ofour
commonstock, sold as units,with eachunit consisting of one share ofcommonstock and awarrant to purchase 0.50 of a share ofcommonstock, at a public offering price of
$0.60 perunit,resultingin gross and net proceeds to us of
$16.5million and $15.1million, respectively.See,Note 10 – Stockholders’ Equity –Registered Public Offerings
and Private Placements, for
a further discussion of this offering.





With respect to our Former CEO
Commitment (see,Note 14 – Commitments – Former CEO
Commitment), since August 13, 2009, we have raised approximately $5.89 million
in gross proceeds utilizing our CEFFs (see,Note 10 – Stockholders’ Equity –
Committed Equity Financing Facilities – CEFF Financings).  In
addition, on February 23, 2010, we completed a public offering that resulted in
net proceeds to us of approximately $15.1 million  (see,Note 10 – Stockholders’ Equity –Registered Public Offerings
and Private Placements).As the receipt from
financings of more than $20 million qualifies as a Corporate Transaction, our
obligation under the Separation Agreement to make payment to Dr. Capetola of the
Additional Severance has matured.  Therefore, in accordance with the
Separation Agreement, on March 5, 2010, we made a payment to Dr. Capetola in the
amount of approximately$1.06million (less withholding),
representing his Additional Severance payment, reduced by the payments
previously made to him under the Severance Agreement, which total approximately$0.52million.  Our obligation to
make periodic payments under the Separation Agreement has been satisfied and no
further payments are due at this time.


F-31





DISCOVERY LABORATORIES, INC. AND
SUBSIDIARY





OnFebruary 16, 2010, we announced that we
had receivedwritten
guidance from theFDAadvising us that, since an
acceptable animal model (preterm lamb) of RDS already exists,a PD clinical trial approach would not
beappropriate.We had previously expected,
based on prior guidance
received from the FDA, that a limited, pharmacodynamic-based (PD) clinical trial
in preterm infants would be required to address the sole remaining
CMCissue relating to the
BAT that must be addressed to obtainapproval ofSurfaxinfor the prevention of RDS in premature
infants.As a result, instead of
pursuing a limited clinical trial, we are nowfocusedoncompleting the optimization and
revalidation of the BAT and developing a comprehensive preclinical
planintended to meet the FDA’s
requirements.  If these studies are successful, we believe that we
could be in a position to file a Complete Response to the April2009 Complete Response Letter in the first
quarter of 2011, which could lead to approval ofSurfaxinfor the prevention of Respiratory
Distress Syndrome (RDS) in premature infantsin 2011.


F-32