**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K/A(Amendment No. 1)**

| **x**      | ** ** | **Annual Report pursuant to Section 13 or 15  (d) of the Securities Exchange Act of 1934**                                                                                                                                                                                  |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | **for the fiscal year ended December 31, 2005**                                                                                                                                                                                                                                  |
| ** ** | ** ** | **or**                                                                                                                                                                                                                                                                                |
| **o**      | ** ** | **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 0-28290

**AKSYS, LTD.**

(Exact name of registrant asspecified in its charter)

| **Delaware**                                                     |   | **36-3890205**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **Two Marriott Drive, Lincolnshire, IL**                         |   | **60069**                             |
| (Address of  Principal executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code: **(847) 229-2020**

Former name, formeraddress and former fiscal year, if changed since the last report: **Not applicable**

**Securitiesregistered pursuant to Section 12(b) of the Act: Not applicable**

**Securitiesregistered pursuant to Section 12(g) of the Act:**
| Common Stock, par value $.01  per share, and related preferred stock purchase rights |
|--------------------------------------------------------------------------------------|
| (Title of Class)                                                                     |

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  Yes o   No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.Yes o   No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes  x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein and willnot be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|--------------------------------|-------------------------------|------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act).  Yes  o   No x

Theaggregate market value of the voting stock held by non-affiliates of the registrantwas approximately $15,635,000 as of June 30, 2005, based on the closingsale price of $1.99 as reported by the Nasdaq National Market. This calculationof market value has been made for the purpose of this report only and shouldnot be considered as an admission or conclusion by the registrant that anyperson is or is not in fact an affiliate of the registrant.

As of March 20, 2006,the registrant had 32,177,574 shares of Common Stock issued and outstanding.

 

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**EXPLANATORY NOTE**

This Amendment No. 1 on Form 10-K/A toour Annual Report on Form 10-K for the fiscal year ended December 31,2005, which was filed with the Securities and Exchange Commission on April 14,2006 (the “Original Filing”), is being filed to provide the informationrequired by Part III of this Form 10-K/A and to correct certainnon-substantive typographical errors in Items 1A, 7 and 8 of Parts Iand II of the Original Filing, including notes 1, 2, 7, 11, 16 and 20 tothe Company’s consolidated financial statements.

As a result of these amendments, an additional Consentof KPMG LLP dated April 24, 2006 relating to the audit report on our consolidatedfinancial statements dated April 13, 2006 is being filed.

Except for the matters described above, the updatedcertifications pursuant to Section 302 and Section 906 of theSarbanes-Oxley Act of 2002 filed as Exhibits 31.1 and 32.1 hereto, andupdated exhibit index, this Form 10-K/A continues to speak as of thedate of the original filing and does not modify, amend or update in any way anyother item or disclosure in the original filing. This Form 10-K/Asets forth the Original Filing in its entirety and, no attempt has been made inthis Form 10-K/A to modify or update the disclosures in the OriginalFiling except as described above. In particular, this Form 10-K/Acontinues to describe conditions as of the date of the Original Filing, and thedisclosures contained herein have not been updated to reflect events, resultsor developments that occurred after the Original Filing, or to modify or updatethose disclosures affected by subsequent events. Among other things,forward-looking statements made in the Original Filing have not been revised toreflect events, results or developments that occurred or facts that becameknown to the Company after the date of the Original Filing, and suchforward-looking statements should be read in conjunction with the Company’sfilings with the SEC subsequent to the filing of the Original Filing.

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**AKSYS, LTD.INDEX TO ANNUAL REPORT ON FORM 10-K**

|                   | ** **         | ** **                                                                                      | ** ** | **Page** | ** ** |
|-------------------|--------------------|-------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |     | ** **                                                                                      |       | 1        |       |
| Item 1.           |               | Business                                                                                        | ** ** |     | 1          |   |
| Item  1A.         |               | Risk  Factors                                                                                   | ** ** |     | 22         |   |
| Item 2.           |               | Properties                                                                                      | ** ** |     | 36         |   |
| Item  3.          |               | Legal  Proceedings                                                                              | ** ** |     | 37         |   |
| Item 4.           |               | Submission of Matters to a Vote of Security Holders                                             | ** ** |     | 37         |   |
| **PART II**  |     | ** **                                                                                      |       | 38       |       |
| Item 5.           |               | Market for the Registrant’s Common Stock and Related  Stockholder Matters                  | ** ** |     | 38         |   |
| Item 6.           |               | Selected Financial Data                                                                         | ** ** |     | 39         |   |
| Item 7.           |               | Management’s Discussion and Analysis of Financial  Condition and Results of Operations     | ** ** |     | 41         |   |
| Item 7A.          |               | Quantitative and Qualitative Disclosures About Market  Risk                                     | ** ** |     | 59         |   |
| Item 8.           |               | Financial Statements and Supplementary Data                                                     | ** ** |     | 60         |   |
| Item 9.           |               | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure           | ** ** |     | 89         |   |
| Item 9A.          |               | Controls and Procedures                                                                         | ** ** |     | 89         |   |
| Item  9B.         |               | Other  Information                                                                              | ** ** |     | 89         |   |
| **PART III** |     | ** **                                                                                      |       | 90       |       |
| Item 10.          |               | Directors and Executive Officers of the Registrant                                              | ** ** |     | 90         |   |
| Item 11.          |               | Executive Compensation                                                                          | ** ** |     | 94         |   |
| Item 12.          |               | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters | ** ** |     | 99         |   |
| Item 13.          |               | Certain Relationships and Related Transactions                                                  | ** ** |     | 100        |   |
| Item 14.          |               | Principal Accountant Fees and Services                                                          | ** ** |     | 100        |   |
| **PART IV**  |     | ** **                                                                                      |       | 102      |       |
| Item 15.          |               | Exhibits, Financial Statement Schedules                                                         | ** ** |     | 102        |   |
| **SIGNATURES**    | ** **         |                                                                                            | 103        |     |
| **EXHIBIT INDEX** | ** **         |                                                                                            | 104        |     |

 

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**PART I**

**Item 1.**                        Business

**Note onForward-Looking Information**

Certain statements in this Annual Report on Form 10-Kand in future filings made by us with the Securities and Exchange Commissionand in our written and oral statements made by or with the approval of anofficer of ours constitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934, and we intend that such forward-looking statements be subject tothe safe harbors created thereby. The words “believes”, “expects”, estimates”,anticipates”, “will be” and similar words or expressions identifyforward-looking statements made by us or on our behalf. These forward-lookingstatements reflect our views as of the date they were made with respect tofuture events and financial performance, but are subject to many uncertaintiesand factors that may cause our actual results to be materially different fromany future results expressed or implied by such forward-looking statements. Webelieve factors that could cause such a difference include, but are not limitedto, the following: (i) our ability to obtain additional capital onacceptable terms and in a sufficient amount to run our business; (ii) uncertaintiesregarding our ability to maintain compliance with the Nasdaq Capital Market’scontinued listing requirements; (iii) uncertainty about the acceptance ofthe PHD System by both potential users and purchasers, including withoutlimitation, patients, clinics and other health care providers; (iv) risksrelated to uncertain unit pricing and product cost, which may not be at levelsthat permit us to be profitable; (v) risks related to quality controlissues and consistency of service applicable to the PHD System; (vi) market,regulatory reimbursement and competitive conditions; (vii) risks relatedto the failure to meet additional development and manufacturing milestones forthe current or next-generation PHD System on a timely basis, including, withoutlimitation, manufacturing and servicing cost reduction efforts; (viii) risksinherent in relying on third parties to manufacture the current PHD System ordevelop the next-generation PHD System; (ix) changes in QSR requirements; (x) risksand uncertainties relating to the DEKA agreement; (xi) risks and uncertaintiesrelating to the Delphi Medical Systems Corporation (“Delphi”) bankruptcy; and(xii) risks related to our relationship with the Durus Life Sciences MasterFund Ltd. (“the Durus fund”) and its affiliates.

The forward-lookingstatements made in this report speak only as of the date that they are made. Wedo not undertake to publicly update or revise our forward-looking statementseven if experience or future changes make it clear that any projected resultsor events expressed or implied therein will not be realized.

**Background**

Aksys, Ltd. was founded in 1991 to providehemodialysis products and services for patients suffering from end-stage renaldisease (“ESRD”), commonly known as chronic kidney failure. We have developedan automated personal hemodialysis system, known as the Aksys PersonalHemodialysis (PHDTM) System (the “PHD System”), which is designed to enablepatients to perform frequent hemodialysis at alternate sites (such as their ownhomes) and to thereby improve clinical outcomes, reduce total ESRD treatmentcosts and enhance the quality of life of patients. The terms “Aksys,” the “Company,”“we,” “us” and “our” as used in this report refer to Aksys, Ltd., a Delawarecorporation, and, unless we state otherwise or the context otherwise requires,its subsidiaries.

On March 27, 2002, we announced receipt of Foodand Drug Administration (“FDA”) clearance to market the PHD System in theUnited States. The FDA clearance had no restrictions and included authorizationto use the product in the home. 510(k) clearance by the FDA was requiredprior to the commercialization of the PHD System in the United States. On October 7,2002, we announced the receipt of EC Certification for CE Mark approvalpursuant to the Medical Device Directive of the European Economic Area. Thecertification approved the PHD System for home use. Such approval was requiredprior to the commercialization of the PHD System in the European Economic Area.

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On March 27, 2002, we announced receipt of FDA clearanceto market the PHD System in the United States. The FDA clearance had norestrictions and included authorization to use the product in the home. The FDArequired 510(k) clearance prior to the commercialization of the PHD Systemin the United States.

During the quarter ended September 30, 2002, wecommenced commercial activities and were no longer considered to be in thedevelopment stage.

On October 7, 2002, we announced receipt of ECCertification for CE Mark approval pursuant to the Medical Device Directive ofthe European Economic Area. The certification approved the PHD System for homeuse. Such approval was required prior to the commercialization of the PHDSystem in the European Economic Area.

On March 31, 2006 weexecuted definitive agreements that provide us with additional capital tosupport our ongoing operations and restructure our current relationship withthe Durus fund. See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Liquidity and Capital Resources—RecentFinancing Activities”.

**The Marketplace**

Our target market is the ESRD treatment market. Ahealthy human kidney continuously removes waste products and excess water fromthe blood. ESRD is a slow, progressive loss of kidney function caused by inheriteddisorders, prolonged medical conditions such as diabetes and hypertension, orthe long-term use of certain medications. ESRD is irreversible and lethal ifuntreated. Life can be sustained only through transplantation or dialysis. Transplantationis severely limited due to the shortage of suitable donors, the incidence oforgan transplant rejection and the age and health of many ESRD patients. Thevast majority (over 90%) of patients, therefore, must rely on dialysis for theremainder of their lives.

We estimate that over $27.3 billion was spent inthe U.S. during 2003 for the treatment of patients suffering from ESRD, ofwhich more than $7 billion was directly related to dialysis treatment. Basedupon information published by United States Renal Data System (“USRDS”), theapproximate number of ESRD patients in the United States requiring dialysistreatments has grown from 66,000 at the end of 1982 to an estimated 325,000 atthe end of 2003. The current estimated annual growth rate of ESRD patients in theU.S. is approximately 5%. In addition, it is estimated that there wereapproximately 565,000 dialysis patients in Europe and Japan at the end of 2004.We believe that the sustained growth in the ESRD population, especially in theUnited States, has been caused by (i) the aging of the population (themedian age of newly diagnosed ESRD patients in the United States is 65), (ii) theincreased incidence of diabetes and hypertension, (iii) the longer averagelife expectancy of patients with diabetes and hypertension (two patient groupsat high risk for ESRD), (iv) the relatively higher growth in the generalpopulation of certain ethnic subsets that have a higher incidence of ESRD, (v) competingrisk (i.e., with the decline in vascular diseases of the heart, there is a risein vascular diseases of the kidney), and (vi) a possible increase in theuse of medications that damage the kidneys.

Given the expense ofkidney dialysis treatments and the lack of effective alternative therapies, in1972 Congress enacted legislation providing for Medicare funding for alleligible patients with ESRD regardless of age or financial circumstances. Underthis program, after the first 30 months of treatment, Medicare is responsiblefor payment of 80% of the rate set by the Centers for Medicare and MedicaidServices (“CMS”) for reimbursement of outpatient dialysis. Although thisprogram made dialysis available to virtually all patients in need of treatment,the cost of funding the program grew rapidly, quickly exceeding original expectations.In an effort to hold down these costs, Congress, in 1983, capped the Medicarereimbursement rate for outpatient dialysis at approximately $21,000 per patientper year, and has approved only modest increases since then. The costs ofoperating dialysis centers, however, such as capital, labor 

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andfacility overhead, have continued to rise. These circumstances have forceddialysis providers to seek ways to reduce dialysis treatment costs.

**Reimbursement**

Demand for our productsand services is influenced by governmental and other third-party reimbursementprograms because providers of ESRD treatment are reimbursed by Medicare,Medicaid and private insurers.

***Medicare Reimbursement***

Medicare generally provides health insurance coveragefor persons who are age 65 or older and for persons who are completely disabled.Medicare also provides coverage for other eligible patients, regardless of age,who have been medically determined to have ESRD. For patients eligible forMedicare based solely on ESRD (generally patients under age 65), Medicareeligibility begins three months after the month in which the patient beginsdialysis treatments. During this three-month waiting period either Medicaid,private insurance or the patient is responsible for payment for dialysisservices. This waiting period is waived for individuals who participate in aself-care dialysis training program, or are hospitalized for a kidneytransplant and the surgery occurs within a specified time period.

For ESRD patients under age 65 who have any employergroup health insurance coverage (regardless of the size of the employer or theindividual’s employment status), Medicare coverage is generally secondary tothe employer coverage during a 30-month coordination period that followsthe establishment of Medicare eligibility or entitlement based on ESRD. Duringthe coordination period, an employer group health plan is responsible forpaying primary benefits at the rate specified in the plan, which may be anegotiated rate or the healthcare provider’s usual and customary rate. As thesecondary payer during this coordination period, Medicare will make payments upto the applicable composite rate for dialysis services to supplement anyprimary payments by the employer group health plan if the plan covers theservices but pays only a portion of the charge for the services.

Medicare generally is the primary payer for ESRDpatients after the 30-month coordination period. Under current rules,Medicare is also the primary payer for ESRD patients during the 30-monthcoordination period if, before becoming eligible for Medicare on the basis ofESRD, the patient was already age 65 or over (or eligible for Medicare based ondisability) unless covered by an employer group health plan (other than a “small”employer plan) because of current employment. This rule eliminates formany dual-eligible beneficiaries the 30-month coordination period duringwhich the employer plan would serve as primary payer and reimburses health careproviders at a rate that we believe may be higher than the Medicare compositerate. The rules regarding entitlement to primary Medicare coverage whenthe patient is eligible for Medicare on the basis of both age (or disability)and ESRD have been the subject of frequent legislative and regulatory changesin recent years and there can be no assurance that such rules will not beunfavorably changed in the future.

When Medicare is the primary payer, it reimburses 80%of the composite rate set by the Medicare prospective reimbursement system foreach dialysis treatment. The beneficiary is responsible for the remaining 20%,as well as any unmet Medicare deductible amount, although an approved Medicaresupplement insurance policy, other private health insurance or Medicaid may payon the beneficiary’s behalf. Reimbursement rates are subject to periodicadjustment based on certain factors, including budget and other legislation andcosts incurred in rendering the services if tied to certain criteria. From 1983through December 1990, numerous Congressional actions resulted in netreductions of the average composite reimbursement rate from a fixed fee of $138per treatment in 1983 to approximately $125 per treatment in December 1990.Effective January 1, 1991, Congress increased the ESRD composite 

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reimbursement rate,resulting in an average rate of $126 per treatment. The Balanced BudgetRefinement Act of 1999 raised the composite rate by 1.2% in 2000 and anadditional 2.8% in 2001.

Section 623 of the Medicare Prescription Drug,Improvement, and Modernization Act of 2003 (MMA) revised ESRD composite paymentrates effective for services furnished after January 1, 2005. The statutemandates that the current composite rates be increased by 1.6% for dialysistreatments furnished after January 1, 2005. The statute further mandatesthat the composite payment rates, as increased by the 1.6%, must also include adrug add-on adjustment in the amount of 8.7% for the difference between thepayment amounts for separate billable drugs and biologicals and theiracquisition costs, as determined by Inspector General Reports. Effective January 1,2006, the base composite payment rates were increased to $130.40 forindependent ESRD facilities and $134.53 for hospital-based ESRD facilities. Thedrug add-on adjustment for 2006 is 14.5 percent. Since the drug add-onadjustment is determined as a percentage of the composite rate, it wasnecessary to adjust the drug add-on percentage to account for the 1.6 percentincrease in the composite payment rate in order to ensure that the total dollarsallocated from the drug add-on adjustment remains constant. Using the updatedcomposite payment rates, the updated drug add-on adjustment is 12.9 percent. Theinflation adjustment of 1.4 percent is unchanged. Therefore, the total drugadd-on adjustment for 2006 is 14.5 percent instead of the 14.7 percent asindicated in CR416. Effective April 1, 2005, each ESRD facility’s rate hasbeen case-mix adjusted. Section 623(d) of the MMA requires a basiccase-mix adjusted composite rate for ESRD facility services. The case-mixadjusted system shall be for a limited number of patient characteristics. Thesecharacteristics were age, body surface area and body mass index of theindividual ESRD patients. Section 623(d) also requires an adjustmentof .9116% which was implemented on April 1, 2005 to ensure theoverall costs of programs are budget neutral.

Reimbursement for home dialysis can be made in twoways. A beneficiary may choose to receive home dialysis equipment, supplies andsupport services directly from a certified licensed facility or they may chooseto make arrangements with a single supplier for equipment and supplies. If thebeneficiary chooses to use a facility, the facility receives the composite ratefor each treatment the patient performs at home. If the beneficiary chooses tomake independent arrangements, the supplier bills Medicare on an assignmentbasis and payment is made at a capped rate of no more than $1,481, except forcontinuous cycling peritoneal dialysis (“CCPD”). There is a monthly payment capof $1,975 for CCPD.

The Medicare ESRD composite reimbursement rate hasbeen the subject of a number of reports and studies. Actions to change suchrate usually occur in the context of federal budget negotiations.

We cannot predict what, ifany, future changes may occur in the Medicare composite reimbursement rate orin any other reimbursement program. Any reductions in the Medicare compositereimbursement rate or in any other reimbursement program could have a materialadverse effect on our prospects, revenues and earnings. In addition, there havebeen various legislative proposals for the reform of numerous aspects ofMedicare—the occurrence and effect of which are uncertain. See “PotentialHealth Care Legislation.”

***Medicaid Reimbursement***

Medicaid programs arestate-administered programs partially funded by the federal government. Theseprograms are intended to provide coverage for patients whose income and assetsfall below state defined levels and who are otherwise uninsured. The programsalso serve as supplemental insurance programs for the Medicare co-insuranceportion and provide certain coverage (*e.g.*, oralmedications) that is not covered by Medicare. State regulations generallyfollow Medicare reimbursement levels and coverage without any co-insuranceamounts. Certain states, however, require beneficiaries to pay a monthly shareof the cost based upon levels of income or assets.

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***Private Reimbursement***

Some ESRD patients have private insurance that coversdialysis services. As discussed above, health care providers receivereimbursement for ESRD treatments from the patient or private insurance duringa “waiting period” of up to three months before the patient becomes eligiblefor Medicare. In addition, if the private payer is an employer group healthplan, it is generally required to continue to make primary payments fordialysis services during the 30-month period following eligibility orentitlement to Medicare. In general, employer group health plans may not reducecoverage or otherwise discriminate against ESRD patients by taking into accountthe patient’s eligibility or entitlement to Medicare benefits.

We believe that beforeMedicare primary coverage is established, private payers may reimburse dialysisexpenses at rates higher than the per-treatment composite rate set by Medicare.When Medicare becomes a patient’s primary payer, private insurance often coversthe per-treatment 20% coinsurance that Medicare does not pay.

***Potential Health Care Legislation***

Because the Medicareprogram represents a substantial portion of the federal budget, Congress takesaction in almost every legislative session to modify the Medicare program forthe purpose of reducing the amounts otherwise payable by the program to healthcare providers in order to achieve deficit reduction targets or meet otherpolitical goals. Legislation and/or regulations may be enacted in the futurethat may significantly modify the Medicare or Medicaid ESRD programs orsubstantially affect reimbursement for dialysis services.

**Prevailing TreatmentMethods**

Hemodialysis andperitoneal dialysis are the two prevailing methods of dialysis.

***Hemodialysis***

USRDS states that nearly 300,000 prevalent patientsreceived hemodialysis in 2003. Less than 1% of these patients performedtreatment in their homes, and all others received treatment at outpatientfacilities. Outpatient hemodialysis requires that a patient travel to adialysis clinic three times per week for dialysis sessions lasting three tofour hours. In each session, the patient’s blood is cleansed by circulationthrough an artificial kidney controlled by a dialysis machine.

Home hemodialysis wascommon practice prior to Medicare funding, with approximately 40% of the 11,000United States dialysis patients on home hemodialysis in 1973. Although theinitial motivation for performing home treatment for many patients reflectedthe lack of availability of dialysis clinics and the desire to reduce the costof hospital-based dialysis, clinicians report that many of these patients foundsignificant advantages in quality of life when treating themselves at home. AsMedicare funding became available, however, the vast majority of patients beganreceiving treatment in outpatient facilities, and hemodialysis machines becamemore complex and sophisticated as they evolved for use in clinics. The dialysismachines currently used in these centers are predominantly operated by trainedpersonnel and require significant manual preparation and cleaning in connectionwith each treatment session.

***Peritoneal Dialysis***

USRDS estimates that as ofDecember 31, 2003, approximately 8% (26,000) of the ESRD dialysis patientsin the United States were receiving peritoneal dialysis, with over 99%performing such treatment in their homes. There are two principal forms of peritonealdialysis, and all forms use the patient’s peritoneum, a large membrane rich inblood vessels that surrounds many of the body’s internal organs, as a filter toeliminate toxins and excess fluids from the patient’s blood. Dialysate, ablood-cleansing electrolyte 

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solution,is infused through a catheter into the patient’s peritoneal cavity. Once thisfluid absorbs the toxins and excess water that are filtered from the bloodthrough the peritoneum, it is drained from the peritoneal cavity through a catheter.In the most common form of peritoneal dialysis, Continuous AmbulatoryPeritoneal Dialysis (“CAPD”), the process of exchanging dialysate into and outof the patient’s peritoneal cavity occurs four times daily, seven days per week.The other form, Continuous Cycling Peritoneal Dialysis (“CCPD”), uses aninstrument to automatically perform exchanges of solution through theperitoneal cavity overnight, while the patient sleeps. Both forms of treatmentrequire strict aseptic technique.

***Limitations of Prevailing Treatment Methods***

*Hemodialysis.**  *Patients receiving outpatient hemodialysis oftenexperience a number of chronic and acute health problems. The chronic problemsinclude hypertension, anemia (low red blood cell count), malnutrition, fluidand electrolyte imbalance, calcium deficiency, insomnia, sexual impotency,decreased mental acuity and lower energy levels. The acute problems includeheadaches, nausea, hypotension and asthenia (a general lack of strength andvitality), which are associated with three weekly dialysis sessions. Inaddition, a general feeling of ill health tends to increase between dialysistreatments as a result of toxins, sodium and water building up in the patient’sblood. These side effects have a significant impact on (i) clinical outcomes,with the leading cause of death among ESRD patients being cardiovasculardisease, which many clinicians believe is caused in large part by oscillationsin toxins, sodium and body fluid levels and by chronic inflammation, which isstimulated in part by the conventional hemodialysis process, (ii) totalpatient costs, resulting from the frequent need to hospitalize ESRD patients aswell as the need to treat anemia and hypertension with medication and (iii) patientquality of life, with patients having to not only suffer through these chronicand acute health problems and related “hangover” frequently following eachtreatment, but also to essentially devote three days per week to the treatmentregimen.

We believe that these health problems are caused inpart by inadequate doses and frequency of dialysis. The amount of toxinsremoved from the blood during dialysis is widely accepted to be determined by aformula indicating that hemodialysis is most efficient in the earlier stages oftherapy. Thus, simply increasing the duration of a treatment session is not themost efficient way to improve the dose of hemodialysis. Rather, the efficiencyof hemodialysis and the delivered dose can be improved with more frequentdialysis sessions of shorter duration. More frequent sessions also decrease thesevere oscillations in toxin and hydration levels associated with theprevailing three times per week dialysis regimen and should result in fewerside effects.

The clinical outcomes of conventional dialysis havecontributed to the significant patient treatment cost. According to the USRDS,total annual treatment costs per dialysis patient have risen from $39,800 in 1991to $63,000 in 2003. The cost of hospitalization on a fee for service basisrepresents the most significant component of this increase. While reimbursementfor outpatient hemodialysis treatment (the “composite rate”) has been cappedsince 1983 with only modest increases, reimbursement for the associated cost ofcare due to chronic and acute health problems and other complications continuesto be reimbursed on a fee for service basis. Under this reimbursement scheme,providers have an incentive to reduce the cost of outpatient dialysis ratherthan the total cost of treating dialysis patients.

*Peritoneal Dialysis.**  *Approximately 22% (or 5,720) of the peritonealpatients in the United States switch to outpatient in-center hemodialysisannually. We believe that most of these patients switched from peritonealdialysis to outpatient hemodialysis because of the following limitationspresented by CAPD, the most common form of peritoneal dialysis: (i) due tothe limited efficiency of using the peritoneal membrane as a filter for toxinremoval, patients must have a relatively low body weight or have some residualkidney function to achieve adequate levels of dialysis (once residual kidneyfunction is lost, which is eventually the case in most patients, CAPD is nolonger a viable treatment for a majority of the population); (ii) CAPDdemands considerable responsibility and time to perform the required four 

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exchanges of solution each day, which often causespatient “burnout” and non-compliance with the prescribed regimen;(iii) peritoneal dialysis demands that patients follow strict aseptictechniques when changing dialysate bags because the failure to do so oftenleads to peritonitis, an infection of the peritoneum; and (iv) thesupplies used in peritoneal dialysis require considerable storage space giventhe quantity of dialysate (up to 30 large boxes per month) used in thistreatment.

We believe that most newperitoneal dialysis patients choose CCPD, in part, in an attempt to improveclinical outcomes. Although CCPD addresses some of the limitations imposed byCAPD, it continues to present a risk of infection of the peritoneum and in manycases requires some residual kidney function to achieve adequate levels ofdialysis. Moreover, because CCPD must often be supplemented with peritonealdialysis performed by the patients during the day using the CAPD method,patient “burnout” also occurs.

**Home Hemodialysisas an Alternative**

We believe that increasing the frequency ofhemodialysis treatments while decreasing the length of each treatment sessioncan significantly improve clinical outcomes and patient quality of life whilereducing the total cost of managing ESRD patients. We completed a clinicaltrial of the PHD System in November 2000, whereby a total of 23 patientsconverted from three times per week dialysis at home to a treatment regimen ofmore frequent dialysis on the PHD System. Patients showed better clinicaloutcomes and improved quality of life on more frequent dialysis. Since then,more than 63,300 dialysistreatments have been performed by patients on the PHD System, includingtreatments at home and at clinics during the patient’s training period.

Several other studies over the past 35 years indicate that increasing thenumber of dialysis treatments per week leads to dramatic improvements inpatients. Several study centers report that most of the ESRD patients whoperformed hemodialysis on a daily basis reported that daily hemodialysis gavethem a more positive attitude toward treatment and a higher quality of life. Neitherwe nor the PHD System was involved in the treatments received by patients inthese other studies and we did not fund these studies. Moreover, patientselection for these studies was not randomized; we gathered the data on aretrospective basis from providers that we knew were treating patients with adaily hemodialysis regimen. Consequently there can be no assurance that thepatient populations in these studies are representative of the general ESRDpatient population. As a result, these studies should not be deemed to haveestablished the impact of daily hemodialysis on clinical outcomes.

Despite the potential benefits of frequent hemodialysis,several barriers have prevented it from becoming a widely-used treatmentregimen. The most significant is the economic implication of administering morefrequent hemodialysis to patients from the traditional three times per weekdialysis. Under the current capped Medicare reimbursement level, dialysisproviders cannot afford the additional costs that would be incurred inproviding more frequent treatments in outpatient facilities. Requiring morefrequent visits to a dialysis treatment facility would also place additionalburdens on a patient’s lifestyle.

There is also a perception that vascular accesscomplications arising from inserting the needles into the patient’s bloodaccess site may increase with daily treatment sessions. These complications arecommon in the clinical setting already and account for a significant portion ofthe cost of treating patients. We believe that vascular access complications donot increase with more frequent hemodialysis sessions in a home or self-caresetting and such complications may in fact decrease. That belief is based onour own clinical experience as well as several clinical investigations thathave been published in peer-reviewed medical journals. Most of this data hasbeen collected on patients whose blood access site is a native arterio-venousfistula or a central venous catheter. There is less data available on thecomplication rate when performing high-frequency hemodialysis on patients usingartificial blood vessel grafts, and there is no assurance that such grafts orcatheters will withstand daily treatment. There are a number of approaches tovascular access that may enhance more frequent treatments, including (i) theuse of “single 

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needle” vascular accessdevices which reduce the number of punctures by half, (ii) the use ofcentral venous catheters which eliminate the need to use needles at all, (iii) novelgraft materials, (iv) new, totally implanted central venous catheters withtitanium ports and (v) the practice of inserting needles in the same site eachday, which has been demonstrated to have several benefits according topublications by Dr. Zbylut J. Twardowski, a leading dialysisresearcher. We have a license agreement with Dr. Twardowski. See “—IntellectualProperty—*Twardowski License*.”

We believe that mostbarriers to a more frequent hemodialysis regimen can be overcome by making itavailable and conducive for convenient and easy use in the patient’s homes.

**Product Development**

**The Aksys PHDSystem**

By addressing the manydrawbacks of conventional hemodialysis systems, which have prevented thewidespread use of daily home hemodialysis, we believe our products and servicescan be instrumental in improving clinical outcomes, decreasing the totaltreatment costs and improving quality of life for dialysis patients. Thefollowing chart describes how the PHD System addresses the drawbacks presentedwhen ESRD patients and helpers use conventional systems for home hemodialysis:

| **Drawback**         | ** ** | ** **                                                                                                                                               | ** ** | **Conventional Home Systems**                                                                                               | ** ** | **PHD System** |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------|
| Complexity           |       | Complicated  equipment designed for operation only by trained personnel.                                                                                 |       | Designed for ease  of operation at home, including computerized, user-friendly interface.                                   |
| Time and Effort      |       | Difficult and time consuming to setup, operate,  clean and maintain.                                                                                     |       | Fully automated, significantly reducing operator  time, effort and involvement.                                             |
| Cost of Consumables  |       | Requires frequent replacement of  blood circuit.                                                                                                         |       | Integrated automatic disinfection system designed to  enable safe and effective reuse of blood circuit reduces consumables. |
| Storage Requirements |       | Large volume of consumables and dialysate consumed  each month.                                                                                          |       | Substantially fewer and smaller items consumed with  each treatment.                                                        |
| Dirty Dialysate      |       | According to the national AAMI standards, dialysate  may contain significant quantities of bacteria and endotoxin.                                       |       | Injectable quality dialysate is produced in which  endotoxin cannot be measured even with extremely sensitive tests.        |
| Water purification   |       | Water purification is accomplished by a separate  free-standing device, which must be maintained and disinfected independently  of the dialysis machine. |       | Water purification membrane is integrated into the  dialysis instrument and disinfected simultaneously with it.             |

 

We believe that the PHD System offers patientssimplification and control. The technology of the PHD System integrates foursystems into one: water purification, delivery of dialysis, dialyzerreprocessing and online manufacturing of infusion-quality solution.  The PHD System is a fully automated personaldialysis instrument designed to enable operators to perform hemodialysis in aself-care setting, such as the patient’s home, on a frequent or daily basis. ThePHD System is designed to reduce the patient’s time and effort involved inperforming each hemodialysis treatment with minimal assistance. Through a touchsensitive display screen with instructions available on a graphic videodisplay, the PHD System is designed to be less intimidating and easier to usethan current hemodialysis systems.

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The PHD System is designed to evaluate the performanceof the artificial kidney in removing toxins from the patient’s blood prior toeach treatment to ensure that the prescribed dose of hemodialysis is achievedduring the treatment. The PHD System also automatically evaluates the watertreatment filters and indicates whether a replacement is required and verifiesthat all critical safety systems, sensors and alarms are operating correctly.

To begin a treatment session on the PHD System, theoperator connects the blood tubing to the vascular access device. Auser-friendly, touch-sensitive monitor prompts the patient through thetreatment and displays procedure and patient-specific information for review. ThePHD System is designed to monitor during the treatment a variety of vitalstatistics, including the patient’s blood flow rate, the amount of waterremoved from the patient, the length of the treatment session and other keyparameters. Data during a hemodialysis treatment is displayed for viewing bythe patient.

At the end of a treatmentsession, the operator reconnects the blood tubing set to the system andreplaces the two small bottles of electrolytes, which are used to produce thedialysate for the patient’s next treatment. The PHD System then automaticallyflushes and disinfects all fluid pathways, performs a self-diagnostic test todetermine whether the disinfection was adequate and readies itself for the nexttreatment session without further patient involvement.

**Services Supportingthe PHD System**

To fully service hemodialysis patients, we have developeda service network to provide support for patients and dialysis providers in allaspects relating to the use and maintenance of the PHD System. Our servicenetwork provides the following: (i) delivery and installation of the PHDSystem, (ii) technical service through a 24 hour call center and throughfield representatives who maintain and repair all components of the PHD System,(iii) delivery of consumables used in dialysis such as the artificialkidney and arterial and venous blood tubing (which are replaced periodically),water purification components and dialysate concentrate and (iv) customerservice representatives who interface with the dialysis provider to address thestatus of, and any necessary changes in, the patient’s treatment as ordered bythe patient’s physician.

**On December 6, 2005, weannounced a plan to realign our service network by designating geographicoperating districts (which we refer to as “PODS” or “PHD Operating Districts”)which have shown the highest adoption rates for the PHD System. The planincludes several operational changes designed to significantly reduce our cashburn rate and provide a more focused resource allocation. We are focusing oursales and servicing efforts on these target markets. While our decision to realignour operating model through the designation of various PHD Operating Districtsmay strengthen our relationships with patients and clinics within designatedareas, it may adversely affect our relationships outside of those areas.**

The PHD System is intended to reduce total treatmentcosts for ESRD patients, including hospitalization costs. There is no reliableway at this time, however, to quantify the potential savings in total treatmentcosts. We have priced the PHD System at a level to fit within currentreimbursement guidelines. An economic case study was performed on a Midwesterndialysis clinic where approximately 12 patients were being dialyzed athome on the PHD System. This study was conducted by the clinic’s ownaccountants and concluded that with 25 patients dialyzing on the PHD, theclinic could achieve $92,000 more in total profit compared to if those patientswere dialyzed in the clinic on a three times per week regimen. The study waslimited however, and therefore there can be no assurance that similar resultswould be realized by other clinics.

Although we believe thatthe PHD System provides a solution to many of the problems presented byconventional dialysis modalities, there are a number of risks that must beovercome in order for the PHD System to succeed, including, among others,achieving market acceptance and the uncertainty of obtaining 

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regulatoryclearance or approval in jurisdictions other than the United States and theEuropean Economic Area.

**2006 Activities**

During 2006, we expect touse approximately $16 to $18 million in our operations, including service andsupport of the PHD Systems being used by patients today. Resources will also bedirected toward using the PHD System’s platform technology to develop our nextgeneration product. On March 31, 2006, we executed definitive agreementsthat provide us with additional capital to support our ongoing operations andrestructure our current relationship with the Durus fund. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources—Recent Financing Activities”.

**Sales and Marketing**

In October 1997, the National Kidney Foundationreleased the results of the first comprehensive effort to standardize practicesat U.S. dialysis centers (the Dialysis Outcomes Quality Initiative, or “DOQI”guidelines). The recommendations called for doses of dialysis at or abovecertain amounts. Because the PHD System delivers doses that meet DOQIguidelines, this recommendation supports our belief that patients who receive ahigher dose as a result of daily dialysis will benefit through improvedclinical outcomes. We believe that the PHD System offers the potential forbetter clinical outcomes, lower total treatment costs and improved quality oflife for dialysis patients. The relatively poor patient outcomes resulting fromcurrent dialysis treatment methods and the increasing total cost of treatingESRD patients have created significant demand for improved dialysis systems. Throughthe PHD System, we intend to capitalize on this demand by pursuing thefollowing strategies.

*TargetSpecific Market Segments.*   We currently marketour products and services directly to providers of dialysis services; theseproviders are both independent businesses and national chains. We are stagingthe product availability in core markets in order to develop efficiencies inour sales and service network The target markets have a high density ofpotential patients, have demonstrated an interest in providing homehemodialysis as an option for the patient population and have a number ofclinics that have received or applied for certification to provide this serviceline to their patients.

*Providea Broad Range of Dialysis Products and Services.**  *We have developed a portfolio of services surroundingthe PHD System. These services include the delivery, installation andmaintenance of the equipment as well as training, technical support, nurseadministration support and delivery of consumable supplies. The PHD may bepurchased or leased, and the services and additional products are provided fora single monthly fee or as individually priced components.

*MeasuringQuality of Patient Care.**  *ThePHD System monitors many components of patient treatments. These patienttreatment metrics allow the health care provider to record and document qualityof care. There are well-established CMS guidelines for treating ESRD patientsand we anticipate future reimbursement structures will require documentation ofquality measurements.

*Clinicaland Patient Education.**  *Manyof today’s healthcare practitioners are unfamiliar with the requirements forestablishing a home hemodialysis program and the process of managing patientsin a home environment. We focus a portion of the marketing effort on directlyeducating health care professionals about the benefits of more frequentdialysis and the benefits of treating patients at home. In addition, we educatethe patient population about this treatment modality as an option to beconsidered in conjunction with their physician.

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*SalesFocus.**  *Webelieve that there is worldwide demand for a cost effective, more clinicallyeffective approach to dialysis. In addition to the United States, we also havea sales office in the United Kingdom, and have established marketing andregulatory resources in Japan.

We operate with a relatively small direct sales forceto market our products and services, primarily to healthcare providers such ashospitals, dialysis clinics, managed care organizations and nephrologyphysician groups. We distribute and provide technical support for the PHDSystem through a combination of in-house resources and contracted thirdparties.

Our largest customers,DaVita, the Dialysis Centers of Lincoln and Northwest Kidney Center accountedfor 16%, 11% and 8%, respectively, of our revenues (by dollar volume) forfiscal year 2005.

**Manufacturing andSuppliers**

We do not currently manufacture any component of thePHD System or related consumables. With respect to the PHD System, we havecontracted with Delphi, a contract manufacturer of medical devices, to assembleand produce the dialysis machine. Delphi specializes in the custommanufacturing of medical instrumentation and is certified to ISO 13485 formanufacture of such products. ISO 13485 is an internationally recognized qualitysystems standard for the medical device industry. Delphi is also FDA registeredand quality system regulations (“QSR”) compliant. Our contract with Delphiautomatically renews on an annual basis each February unless a six-monthadvance notice is provided by either party to terminate the contract or a partyexercises its right to terminate the contract for breach or under certain othercircumstances.

Delphi is our sole supplier of the PHD System, andconducts its manufacturing operations for our product at a single location. Wemay identify and use additional or alternate manufacturers in differentlocations in the future to avoid having to rely on a single source and location.There can be no assurances that we will be able to use additional or alternatemanufacturers on acceptable terms or at all. The manufacturing of our productsis subject to quality regulations and other requirements prescribed byregulatory agencies. There can be no assurance that Delphi or any othermanufacturer of our products will continue to comply with applicable regulatoryrequirements or that Delphi or any other manufacturer will be able to supply uswith products in sufficient quantity or at all.

On October 8, 2005, Delphi and its parentcorporation filed a voluntary petition for business reorganization underChapter 11 of the U.S. Bankruptcy Code.  The ultimate effect of the bankruptcy on ourrelationship with Delphi is unclear. We have a Uniform Commercial Codefinancing statement on file with the Colorado Secretary of State with respectto certain component inventory located at Delphi’s warehouses.  In addition, as of December 31, 2005, wehad a cash deposit with Delphi of $1,432,000 as security for certain of ourpurchase obligations. We have recorded a reserve to reflect the uncertaintyassociated with the bankruptcy filing; however, we are pursuing the full valueof the deposit. We have had ongoing discussions with Delphi regarding ouraccounts payable balance, our deposit and certain parts inventory located atDelphi’s warehouses. In the first quarter of 2006, we received correspondencefrom Delphi advising us of their decision to stop further shipments of PHDSystems and parts until these items have been resolved. We plan to continue ourdiscussions with Delphi and believe that we have a sufficient inventory ofparts and machines on hand to enable us to continue operations pending theresolution of this matter.

Certain key accessories ofthe PHD System, such as the dialyzer, are available from other manufacturers. Otheraccessories and supplies, such as the blood tubing set and the dialysatechemicals supplied to users of the PHD System are custom made and packaged toour specifications by FDA-registered and QSR-compliant companies. There can beno assurances that any of these accessories and supplies will continue to beavailable on terms acceptable to us or at all.

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**Research andDevelopment**

As of December 31, 2005, we employed a researchand development staff of 22 full time employees, most of whom are engineers andtechnicians. In addition, we used contractors on an as needed basis to assistin the development process.  The researchand development staff is composed of specialists in the fields of mechanicalengineering, electrical engineering, software engineering, biomedical andsystems engineering, chemistry and microbiology. For the years ended December 31,2005, 2004 and 2003, we incurred total research and development expenditures ofapproximately $8,069,000, $6,684,000, and $5,474,000, respectively.  Our 22 research and development employees at December 31,2005 represented a significant reduction from the approximately 41 research anddevelopment employees at December 31, 2004. The decline in the number ofemployees resulted both from reductions in force and voluntary attrition ofemployees who were not replaced.

On November 1, 2005,we entered into a Research, Development and License Agreement (the “DEKAAgreement”) with DEKA Products Limited Partnership and DEKA Research andDevelopment Corp. (“DEKA”). The purpose of the DEKA Agreement is to develop anext generation product consisting of hemodialysis equipment and relatedsolution preparation processes. We view the DEKA Agreement as an integralcomponent of our ongoing research and development efforts. See “IntellectualProperty below”.

**Competition**

We compete in the kidney dialysis market withsuppliers of hemodialysis and peritoneal dialysis devices, supplies andservices. We do not compete with providers of dialysis services such as thenational dialysis providers or managed care companies. Rather, we are marketingour products and services to these providers and working with them to make homehemodialysis a viable alternative to currently available treatment methods.

Our primary competitors in supplying dialysis equipment,disposables, and services are Fresenius Medical Care AG Baxter International, Inc.,and Gambro AB. These competitors have more financial, scientific, and technicalresources than do we, as well as more experience with respect to manufacturing,product development, and marketing in the dialysis market. We also compete withNxStage Medical, Inc.  One keyfactor for success in the market for more frequent home dialysis relates to theability of a supplier to offer a system that cost-effectively provides a broadrange of patients with dialysis therapy meeting or exceeding DOQI guidelines. Today,our competitors meet these standards to varying degrees. We believe thatclinical data shows that the PHD System provides an amount of dialysis thatsignificantly exceeds these guidelines.

In order to competeeffectively, we will need, among other things, to continue to reinforce theclinical and cost effectiveness of daily home hemodialysis made possible by thePHD System. We believe that the PHD System is the only system today thatcombines the following five elements key to both the clinical well-being of thepatients and the financial health of providers offering more frequent therapy:

·       Webelieve the PHD System, with its built-in reuse capability, is the only systemthat permits more frequent dialysis treatments at essentially a fixed cost toproviders.

·       ThePHD System can be programmed to run up to eight hours per treatment, providingincreasing quantities of dialysis at that same fixed cost.

·       Webelieve the PHD System provides the purest and most biocompatible dialysateavailable today. This is one of the reasons, in our opinion, that patients havereported feeling so good following treatment on this system.

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·       Webelieve the PHD System, with its highly intuitive and interactive graphic userinterface, coupled with a reuse capability that eliminates the need fordisposable set-up and tear-down with each treatment, is state-of-the-art interms of patient friendliness, simplicity, and ease of use.

·       Andfinally, in addition to the standard complement of alarms found on all machinesapproved by the FDA for home use, the PHD System uniquely offers a “one-touch”infusion button that a patient can use whenever he or she senses a hypotensiveepisode coming on. All other machines require a patient to perform a procedurerequiring reasonable dexterity and focus in response to the onset of ahypotensive episode. We believe this simple “one touch” feature, along with thepurity of its dialysis, makes the PHD System the “safest among the safe” forhome use.

Our ability to successfully market our products andservices could be adversely affected by pharmacological and technologicaladvances in preventing the progression of ESRD in high-risk patients (such asthose with diabetes and hypertension), technological developments by others inthe area of dialysis, the development of new medications designed to reduce theincidence of kidney transplant rejection and progress in using kidneysharvested from genetically-engineered animals as a source of transplants. Therecan be no assurance that competitive pressure or pharmacological ortechnological advancements will not have a material adverse effect on ourbusiness.

We believe thatcompetition in the market for kidney dialysis equipment, supplies and servicesis based primarily on clinical outcomes, price, product performance,cost-effectiveness, reliability and technological innovation and thatcompetition in the home hemodialysis market will be based on these factors aswell as on products being relatively easy to use, transport and maintain. Certainkidney dialysis equipment manufacturers and service providers currently own andoperate, or may in the future acquire, dialysis treatment facilities and otherproviders. As a result, our ability to sell our products and services to theseproviders may be adversely affected.

**GovernmentRegulation**

**Food and DrugAdministration**

The PHD System is regulated as a medical device by theFDA under the Federal Food, Drug and Cosmetic Act (the “FDC Act”).  Pursuant to the FDC Act, the FDA regulates themanufacture and distribution of medical devices in the United States. Noncompliancewith applicable requirements can result in, among other things, fines,injunctions and civil penalties; recall or seizure of products; total orpartial suspension of production; denial or withdrawal of pre-market clearanceor approval of devices; recommendations by the FDA that we not be allowed toenter into government contracts; and criminal prosecution. The FDA also hasauthority to require repair, replacement or refund of the cost of any deviceillegally manufactured or distributed by us.

In the United States, medical devices are classifiedinto one of three classes (Class I, II or III) on the basis of thecontrols deemed necessary by the FDA to reasonably ensure their safety andeffectiveness. Class I devices are subject to general controls (*e.g.*, labeling and adherence to some of the QSRs).Class II devices are subject to general and special controls (*e.g.*, performance standards, post-market surveillance andpatient registries). Class III devices are those which must receivepre-market approval by the FDA to ensure their safety and effectiveness (*e.g.*, life-sustaining, life-supporting and implantabledevices or new devices which have been found not to be substantially equivalentto legally marketed devices).

The PHD System is classified as a Class IIdevice. On March 30, 1999, we filed an Investigational Device Exemption (“IDE”)with the FDA, a prerequisite for conducting a clinical evaluation of the PHDSystem. We received full IDE approval in July 1999, and in September 1999began the clinical trial of the PHD System. Twenty-five patients participatedin the trial at three centers. The protocol for the study called for patientsto dialyze at home on existing hemodialysis equipment for 10 weeks, followed byone 

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month in the center on thePHD System and two months at home on the PHD System. The clinical trial wascompleted in November 2000, with 23 patients receiving dialysis on the PHDSystem. Over 63,300 dialysistreatments have now been performed by patients on the PHD System, including inthe home and at clinics during the patient’s training period.

On March 27, 2002, we announced receipt of FDAclearance to market the PHD System in the United States. The FDA clearance hadno restrictions and included authorization to use the product in the home. Wehad been working toward satisfying the regulatory requirements of the FDA sincesubmitting a 510(k) pre-market notification for clearance to market thePHD System in January 2001. The FDA required 510(k) clearance priorto the commercialization of the PHD System in the United States.

The FDC Act requires that medical devices bemanufactured in accordance with the FDA’s current QSRs. These regulationsrequire, among other things, that (i) the manufacturing process beregulated and controlled by the use of written procedures and (ii) theability to produce devices that meet the manufacturer’s specifications bevalidated by extensive and detailed testing of every aspect of the process. Theyalso require investigation of any deficiencies in the manufacturing process orin the products produced and detailed record keeping. Manufacturing facilitiesare therefore subject to FDA inspection on a periodic basis to monitorcompliance with QSRs. If violations of the applicable regulations are notedduring FDA inspections of the manufacturing facilities of our contractmanufacturers, there may be a material adverse effect on the continuedmarketing of our products.

Even though the FDA hascleared the PHD System, the FDA will periodically inspect the manufacturingfacilities and processes for compliance with QSRs. In addition, in the eventthat additional manufacturing sites are added or manufacturing processes arechanged, such new facilities and processes may be subject to FDA inspection forcompliance with QSRs.

**Foreign GovernmentRegulation**

On October 7, 2002, we announced receipt of ECCertification for CE Mark approval pursuant to the Medical Device Directive ofthe European Economic Area. The certification approved the PHD System for homeuse. Such approval was required prior to the commercialization of the PHDSystem in the European Economic Area.

Requirements pertaining tothe PHD System vary widely from country to country. We believe the extent andcomplexity of regulations of medical devices such as the PHD System isincreasing worldwide. We anticipate that this trend will continue and that thecost and time required to obtain approval to market in any given country willincrease, with no assurance that such approval will be obtained.

**Fraud and AbuseLaws**

*American Health Insurance Portability andAccountability Act of 1996**(“HIPAA”) and Privacy Rules*

HIPAA and the rules promulgatedthereunder require certain entities, referred to as covered entities, to complywith established standards, including standards regarding the privacy andsecurity of protected health information. HIPAA further requires that coveredentities enter into agreements meeting certain regulatory requirements withtheir business associates, as such term is defined by HIPAA, which, among otherthings, obligate the business associates to safeguard the covered entity’sprotected health information against improper use and disclosure. While notdirectly regulated by HIPAA, a business associate may face significantcontractual liability pursuant to such an agreement if the business associatebreaches the agreement or causes the covered entity to fail to comply with HIPAA.In the course of our business operations, we have entered into several businessassociate agreements with certain of our customers that are covered entities.Pursuant to the terms of these business associate agreements, we have agreed,among other things, not to use or further disclose the covered entity’sprotected health information except as 

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permittedor required by the agreements or as required by law, to use reasonablesafeguards to prevent prohibited disclosure of such protected healthinformation and to report to the covered entity any unauthorized uses ordisclosures of such protected health information. Accordingly, we incurcompliance related costs in meeting HIPAA-related obligations under businessassociate agreements to which we are a party. Moreover, if we fail to meet ourcontractual obligations under such agreements, we may incur significantliability. In addition, HIPAA’s criminal provisions could potentially beapplied to a non-covered entity that aided and abetted the violation of, or conspiredto violate HIPAA, although we are unable at this time to determine conclusivelywhether our actions could be subject to prosecution in the event of animpermissible disclosure of health information to us. Also, many state lawsregulate the use and disclosure of health information, and are not necessarilypreempted by HIPAA, in particular those laws that afford greater protection tothe individual than does HIPAA. Finally, in the event we change our businessmodel and become a HIPAA covered entity, we would be directly subject to HIPAA,its rules and its civil and criminal penalties.

*Anti-Kickback Laws*

The federal healthcare program Anti-Kickback Statuteprohibits persons from knowingly and willfully soliciting, offering, receivingor providing remuneration, directly or indirectly, in exchange for or to induceeither the referral of an individual for, or the furnishing, arranging for orrecommending a good or service for which payment may be made in whole or partunder a federal healthcare program such as Medicare or Medicaid. The definitionof remuneration has been broadly interpreted to include anything of value,including for example gifts, discounts, the furnishing of supplies orequipment, credit arrangements, payments of cash and waivers of payments.Several courts have interpreted the statute’s intent requirement to mean thatif any one purpose of an arrangement involving remuneration is to inducereferrals or otherwise generate business involving goods or services reimbursedin whole or in part under federal healthcare programs, the statute has beenviolated. The law contains a few statutory exceptions, including payments tobona fide employees, certain discounts and certain payments to group purchasingorganizations. Violations can result in significant penalties, imprisonment andexclusion from Medicare, Medicaid and other federal healthcare programs.Exclusion of a manufacturer would preclude any federal healthcare program frompaying for its products. In addition, some enforcement officials have arguedthat kickback arrangements can provide the basis for an action under theFederal Civil False Claims Act, which is discussed in more detail below.

Government officials havefocused recent enforcement efforts on, among other things, the sales and marketingactivities of healthcare companies, and recently have brought cases againstindividuals or entities with personnel who allegedly offered unlawfulinducements to potential or existing customers in an attempt to procure theirbusiness. Settlements of these cases by healthcare companies have involvedsignificant fines and/or penalties and in some instances criminal pleas. Inaddition to the Anti-Kickback Statute, many states have their own kickbacklaws. Often, these laws closely follow the language of the federal law,although they do not always have the same exceptions or safe harbors. In somestates, these anti-kickback laws apply with respect to all payers, includingcommercial health insurance companies.

*False ClaimsStatutes*

Federal false claims laws prohibit any person fromknowingly presenting, or causing to be presented, a false claim for payment tothe federal government or knowingly making, or causing to be made, a falsestatement to get a false claim paid. Manufacturers can be held liable underfalse claims laws, even if they do not submit claims to the government, if theyare found to have caused submission of false claims. The Federal Civil FalseClaims Act also includes whistle blower provisions that allow private citizensto bring suit against an entity or individual on behalf of the United Statesand to recover a portion of any monetary recovery. Many of the recent highlypublicized settlements in the healthcare industry related to sales and 

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marketing practices have been cases brought under theFalse Claims Act. The majority of states also have statutes or regulationssimilar to the federal false claims laws, which apply to items and servicesreimbursed under Medicaid and other state programs, or, in several states,apply regardless of the payer. Sanctions under these federal and state laws mayinclude civil monetary penalties, exclusion of a manufacturer’s products fromreimbursement under government programs, criminal fines, and imprisonment.

**IntellectualProperty**

As of March 20,2006, we either owned or had rights in relevant fields to 47 U.S. patents and 26 foreign patents (excluding patentswhich may be made available under the DEKA Agreement described below) fortechnologies that are important to developing a safe, convenient,self-contained hemodialysis system. We haveone additional patentapplication pending in the United States, and have additional patentapplications pending in several other countries that have significanthemodialysis markets. We expect to file additional patent applicationswith respect to the PHD System as new technology is developed.

*DEKAResearch, Development and License Agreement.*   On November 1,2005, we entered into a Research, Development and License Agreement with DEKAProducts Limited Partnership and DEKA Research and Development Corp. Thepurpose of the DEKA Agreement is to develop a next generation productconsisting of certain hemodialysis equipment and related solution preparationprocesses. DEKA is compensated for its development work on a cost plus basis,which is generally determined based upon DEKA’s costs incurred and hours spenton the project. We made a payment to DEKA of approximately $950,000 forservices performed through December 31, 2005. We are required to makeadditional payments to DEKA of approximately $200,000 per month, subject toperiodic reconciliation to DEKA’s actual costs incurred and hours spentpursuant to the project. We have the right to terminate this development workat any time with 90 days notice. In addition, we will pay DEKA royalties basedupon a percentage of net sales of products developed under the project. Finally,we have agreed to issue to DEKA warrants to purchase 350,000 shares of ourcommon stock having an exercise price of $1.62 per share which vest upon theachievement of certain milestones for the project. DEKA will own theintellectual property created or developed in connection with the project,except that we shall own title to any and all intellectual property created anddeveloped solely by us independent of any assistance from DEKA as a result ofour own development efforts. DEKA has granted us an exclusive worldwide licenseto use certain patents related to hemodialysis within a specified field of useand a nonexclusive worldwide license to use certain patents related to solutionpreparation processes within a specified field of use. DEKA has also granted usa nonexclusive license to use certain technical information related tohemodialysis and solution preparation processes within a specified field of use.In most instances, termination of the DEKA Agreement would result in ourlicense under the DEKA Agreement terminating.

*TwardowskiLicense.*   On April 1, 1993, we entered intoa License Agreement (the “Twardowski License”) with Dr. Zbylut Twardowskigranting to us a worldwide exclusive license to the patent filed on August 21,1991 entitled “Artificial Kidney for Frequent (Daily) Hemodialysis” expiring August 21,2011, and several subsequent patents (the “Twardowski Patents”). The TwardowskiPatents relate to an artificial kidney intended to provide frequent (daily)home hemodialysis. The Twardowski License continues for as long as theTwardowski Patents remain in effect. The Twardowski License provides forroyalty payments to Dr. Twardowski based on the revenue we receive fromthe sale or lease of the licensed product, with certain minimum semiannualroyalty payments. If we fail to make any such minimum royalty payment, Dr. Twardowskihas the option to convert the Twardowski License to a non-exclusive license. Therecan be no assurance that the Twardowski Patent will provide us significantexclusivity or benefit in our markets. Furthermore, competitors may developalternative technology that achieves the same advantages as the TwardowskiPatents.

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*BoagLicense.**  *On April 1,1993, we also entered into a License Agreement (the “Boag License”) withCynthia P. Walters for the use of a patent entitled “Dialyzer Reuse System”issued on September 22, 1987, which expired April 29, 2005 (the “BoagPatent”). We do not believe the expiration of this license will have a materialadverse effect on our ongoing operations.

*AllerganLicense.**  *On March 11,1996, we entered into a License Agreement (the “Allergan License”) withAllergan, Inc. for the use of a U.S. patent entitled “Pressure TransducerMagnetically-Coupled Interface Complementing Minimal Diaphragm Movement DuringOperation” issued February 28, 1995, which expires on December 16,2013, and its foreign counterparts (the “Allergan Patent”).  We have exclusive worldwide rights to thepatented technology, limited to the field of use of kidney dialysis machinesand methods. The Allergan License continues for as long as the Allergan Patentremains in effect and provides for royalty payments to Allergan based onmanufacturing of the PHD System, which incorporates the patented technology.  Royalty payments are to be made quarterly,with minimum annual royalty payments beginning in 1998. If we fail to pay thefull minimum annual royalties, the License Agreement will terminate. If we payat least half of the minimum annual royalties but do not pay such royalties infull, the License Agreement shall be converted to a non-exclusive license.  We pay the minimum annual royalties and, assuch, the license remains exclusive. There can be no assurance that theAllergan Patent will provide us significant exclusivity or benefits in ourmarkets.  Furthermore, competitors maydevelop alternative technology that achieves the same advantages as theAllergan Patent.

There can be no assurance that any of our pendingpatent applications will be approved by the patent offices in the variousjurisdictions in which they were filed. In addition, there can be no assurancethat we will develop additional proprietary products or processes that arepatentable or that any patents that may be issued to or be licensed by us willprovide us with competitive advantages. There can be no assurance that ourpatent applications or patents that may be issued to us or be licensed by uswill not be challenged by any third parties or that the patents of others willnot prevent the commercialization of products incorporating our technologies. Furthermore,there can be no assurance that others will not or have not independentlydeveloped similar products or duplicated any of our products covered by thepatents that may be issued to or be licensed by us. Any of the foregoingresults could have a material adverse effect on our business, operating resultsand financial condition.

Our commercial success depends, in part, on our abilityto avoid infringing patents issued to others. The field of dialysis includes asignificant number of patents that have been issued to third parties. We mayreceive from third parties, including potential or actual competitors, noticesclaiming that we are infringing third party patents or other proprietary rights.If it is determined that we are infringing any third-party patent, we could berequired to pay substantial damages, alter our products or processes, obtainlicenses or cease certain activities. In addition, if patents are issued toothers which contain claims that compete or conflict with our licensed patentsor patent applications, and such competing or conflicting claims are ultimatelydetermined to be valid, we may be required to pay damages, to obtain licensesto these patents, to develop or obtain alternative technology or to cease usingsuch technology. If we are required to obtain any licenses, there can be noassurance that we will be able to do so on commercially favorable terms, if atall. Our failure to obtain a license to any technology that we may require tocommercialize our products could have a material adverse impact on ourbusiness, operating results and financial condition.

In addition to patentlicenses and applications for patents, we possess trade secrets, copyrights,proprietary know-how and unpatented technological advances. We seek to protectthese assets, in part, by confidentiality agreements with our businesspartners, consultants and vendors and non-competition agreements with ourofficers and employees. There can be no assurance that these agreements willnot be breached, that we will have adequate remedies for any breach or that ourtrade secrets and proprietary know-how will not otherwise become known or beindependently developed by others.

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**Employees**

As of December 31, 2005, we had 87 full-timeemployees, 22 of whom were employed in research and development capacities, 23of whom were employed in the technical and clinical services area, 13 of whomwere employed in sales and marketing efforts, 14 of whom were employed in thegeneral and administrative area, 11 of whom were employed in manufacturing,operations and regulatory groups, and 4 of whom were employed in the UnitedKingdom subsidiary**.**  Our 87 employees at December 31, 2005represented a significant reduction from the approximately 119 employees at December 31,2004. The decline in the number of employees resulted both from reductions inforce and voluntary attrition of employees who were not replaced. While webelieve that our relations with our employees remain good, our recent costreduction initiatives could potentially affect our relationship with employees.Our continued performance depends on our ability to attract and retainqualified professional, scientific, and technical staff.

**Executive Officers**

The information under thisItem is furnished pursuant to Instruction 3 to Item 401(b) of Regulation S-K.Executive Officers of the Company are elected by and serve at the discretion ofthe Board of Directors.

**William C. Dow, 59**

Mr. Dow was appointedPresident and Chief Executive Officer and a director of the Company in September 1999and served in these positions through March 31, 2006. From August 1997until joining the Company in September 1999, he served as President andChief Executive Officer of PLC Systems Inc., a manufacturer of lasers used incardiac surgery. From 1993 to 1997, he served as President and Chief ExecutiveOfficer of Deknatel Snowden Pencer Worldwide, Inc., a $100 million medicaldevice manufacturer that became a manufacturing and marketing subsidiary ofGenzyme Corporation in 1996. Mr. Dow has over 25 years of experience inthe medical device and service industry having held various positions in sales,marketing, distribution and general management with Griffith Micro Science,Kendall, Terumo and American Hospital Supply. Mr. Dow is a graduate of theUnited States Naval Academy with a Bachelor of Science in Engineering andserved as both a pilot and a Supply Corps officer in the U.S. Navy.

**Laurence P. Birch,46**

Mr. Birch wasappointed to the Company’s Board of Directors and elected as interim Presidentand Chief Executive Officer on March 31, 2006. Mr. Birch joined theCompany in February 2005 as Senior Vice President and assumed the dutiesof Chief Financial Officer effective March 17, 2005. From 2003 until hejoined the Company, Mr. Birch served as Managing Director for StrategoPartners, a corporate cost management company. From 2002 to 2003, he served asChief Financial Officer of Seurat, Inc. From 2001 to 2002, he served asChief Financial Officer of Fieldglass, Inc. From 2000 to 2001, he servedas Senior Vice President and Chief Financial Officer of Technology Solutions, Inc.In 2000 he served as Chief Financial Officer of Brigade, Inc. From 1999 to2000, he served as Chief Financial Officer of Gateway Homecare, Inc.Mr. Birch has over fifteen years experience in the healthcare sector whichincludes his fourteen years with Baxter International, Inc. and AmericanHospital Supply in various financial positions. Mr. Birch received hisBachelor of Science degree in finance from the University of Illinois, hisMasters of Business Administration degree from the Kellogg Graduate School ofManagement at Northwestern University, and is a Certified Public Accountant.

**Lawrence D. Damron,59**

Mr. Damron wasappointed Senior Vice President and Chief Financial Officer in May 2002,and became a member of the board of directors in August 2004. Effective March 17,2005 Mr. Damron 

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resignedhis position as Chief Financial Officer and on April 29, 2005 he resignedfrom his position as Senior Vice President. Mr Damron continues to serve as amember of the board of directors and provide consulting services to us under anagreement that expires April 30, 2006. Mr. Damron has over 25 yearsof experience in the healthcare sector. From June 1999 to December 2000,he served as the Chief Financial Officer for Everest Healthcare ServicesCorporation, a provider of dialysis and other blood treatment services. From July 1997until June 1999, he was Senior Vice President, Finance and Treasurer atEvanston Northwestern Healthcare. Mr. Damron was with Baxter International, Inc.since 1985 in a number of key management positions including CorporateTreasurer from 1992 until 1997. From 1980 until 1985, he was with AmericanHospital Supply in a variety of financial positions. Mr. Damron receivedhis Bachelor of Arts degree in economics from the University of Cincinnati andhis Masters of Arts degree in international relations from the University ofSouthern California. He received his Masters of Business Administration fromHarvard University, and is a Certified Public Accountant. Mr. Damronserved as a Lieutenant in the U.S. Navy. He serves on the board of directors ofTrinity Health.

**Jerry D. Fisher, 58**

Mr. Fisher wasappointed Senior Vice President and Chief Technical Officer in October 2004.Mr. Fisher  has over 30 years ofexperience in the healthcare sector. Prior to joining the Company, he served invarious roles with Baxter International, Inc. from 1970 to 2003. Mr. Fisherwas Vice President of Technology Resources for Baxter from 2000 to 2003. He wasVice President, Quality Affairs of Baxter Hyland Immuo division from 1998 to2000. Mr. Fisher was a board member and founder of The Consortium forPlasma Science, LLC; a member of the New York Academy of Sciences; the AmericanAssociation for the Advancement of Science; the American Chemical Society, andholds seven patents. He earned his Masters of Science degree in AnalyticalChemistry in 1975 from Indiana University. In 1981 he earned his MBA from LakeForest School of Management. 

**Richard P.Goldhaber, 62**

Mr. Goldhaber wasappointed Senior Vice President Special Projects in October 2004. From2000 until 2004 Mr. Goldhaber served as Chief Technical Officer of theCompany. Prior to joining the Company, from 1993 to 2000, he was Vice Presidentof Research and Development at Minntech Corporation, a company that develops,manufactures and distributes dialysis related products. Prior to Minntech, from1965 to 1993, he held positions of increasing responsibility in productdevelopment with Baxter International, Inc., including 20 years developingdialysis products. Mr. Goldhaber received his Bachelor of Science inMechanical Engineering from Purdue University, and his Masters of Science inPhysiology from Illinois Institute of Technology.

**Rodney S. Kenley,56**

Mr. Kenley wasappointed Senior Vice President of Advanced Product Development in February 2004.Mr. Kenley founded Aksys in 1991 and served in varying capacities,including CEO, COO, and VP, Business Development, until he left in 1999. Duringhis five years away from the Company, Mr. Kenley founded OrthAssist, acompany which provides management services for orthopedic physician offices.Mr. Kenley rejoined the Company in February 2004. He has 30 years ofexperience in healthcare, most of which have been spent in the RenalReplacement Therapy arena. Prior to founding Aksys, he held several positionsat Baxter Healthcare from 1977 through 1990, including International MarketingManager, Business Unit Manager for Peritoneal and Hemodialysis products,Manager of New Business Development, Director of Worldwide Product Planning,Director of Advanced Product Development, and VP of Electronic Drug Infusion.Mr. Kenley received his Bachelor of Arts degree in Biology and Chemistryfrom Wabash College, a Masters of Science degree in Molecular Biology fromNorthwestern University, 

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and aMasters of Management from the Kellogg Graduate School of Management atNorthwestern University.

**Lawrence A. Rohrer,55**

Mr. Rohrer wasappointed Senior Vice President, Global Sales and General Manager,International in May 2003. Mr. Rohrer has over 25 years of experiencein the healthcare sector. From 1996 until joining the Company in May 2003,he served as Vice President of Marketing and Business Development for thenon-hospital medical/surgical distribution business at Cardinal Health Inc., aprovider of products and services supporting the healthcare industry. From 1995to 1996 he was Vice President, Business Development in the Nephrology Divisionof Caremark, International, a pharmaceutical services company. From 1978through 1994, Mr. Rohrer served in various positions of increasingresponsibility in engineering, marketing, and sales management with the RenalDivision of Baxter International, Inc. Mr. Rohrer received hisBachelor of Science degree in aeronautical engineering from the University ofNotre Dame, his Masters of Science degree in Mechanical Engineering fromNorthwestern University, and his Masters of Business Administration degree fromNorthern Illinois University. Mr. Rohrer served as a Captain in the U.S.Air Force. 

**Nancy S. Schmelkin,47**

Ms. Schmelkin wasappointed Senior Vice President, Global Marketing and Customer Care in 2003. Ms. Schmelkinjoined Aksys in October 2002 as the Vice President of Marketing. Ms. Schmelkinhas over 20 years of experience in the healthcare sector. Prior to joining theCompany she was the Director of Marketing for Motorola Life Sciences, adivision of Motorola focusing on technology in the field of genomics from 2000to 2002. Prior to 2002 Ms. Schmelkin worked with Sabratek Healthcare, CNAInsurance and served 12 years in various positions of increasing responsibilitywith Baxter International, Inc. Ms. Schmelkin received her Bachelorof Arts from Grinnell College and her Masters of Business Administration inMarketing and Finance from the Kellogg Graduate Schol of Management atNorthwestern University. 

**Thomas F. Scully,59**

Mr. Scully wasappointed Senior Vice President of Manufacturing and Global Logistics in January 2002.Mr. Scully joined the Company in January 1996, and served as VicePresident of Operations through December 2001. Mr. Scully has over 30years of experience in the healthcare sector. From 1971 to 1995, Mr. Scullyworked at Baxter International, Inc. in various operational roles,including Vice President, Sales and Operations of the Renal Division. In thatrole, Mr. Scully was involved principally in the design, development andmanagement of the Renal Division’s home care operations network. Mr. Scullyreceived his Bachelor of Arts degree from the University of Notre Dame and hisMaster’s of Management degree from Northwestern University. Mr. Scully servedas a Captain in the U.S. Army.

**Product LiabilityExposure**

Our business exposes us topotential product liability risks relating to the production, marketing andsale of dialysis products. There can be no assurance that we will be able toavoid significant product liability exposure. Upon commencement of the firsthuman use of the PHD System in January 2000, we initiated productliability insurance coverage, with a limit of $10 million. There can be noassurance that such insurance coverage is sufficient, or that additionalcoverage will be available on acceptable terms or at all or that any insurancepolicy, if obtained, will provide adequate protection against potential claims.Furthermore, our agreements with contract manufacturers require us to obtainproduct liability insurance, and the failure to obtain adequate insurancecoverage could materially and adversely affect our ability to produce the PHDSystem. A successful claim brought against us in excess of any insurancecoverage 

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maintainedby us could have a material adverse effect on our business, operating resultsand financial condition. In addition, we have agreed to indemnify certain ofour contract manufacturers against certain liabilities resulting from the saleof the PHD System.

**Foreign Operations**

In April 1996, we established Aksys Japan, K.K. (“AJKK”),our indirect, wholly owned Japanese subsidiary.  AJKK had no employees as of December 31,2005.  We have engaged the services of abusiness consultant to act on behalf of AJKK in pursuing business opportunitiesin Japan. We do not anticipate any activity in Japan through 2006. All effortsand decisions are directed from our headquarters in Lincolnshire, Illinois.

In 1999, we entered into a co-development and licenseagreement with Teijin Limited of Osaka, Japan. Under the agreement,Teijin has the right to develop, manufacture, seek regulatory approval, andupon such approval, to market, rent and sell the PHD System in Japan. Teijinwill pay royalties to us in the amount of 10% of all revenues received inconnection with their sales and rentals of PHD Systems in Japan. Under theagreement, we have an option to sell the PHD System in Japan, but our exerciseof this option would cause the royalty rate to drop to 5%. To date there havenot been any PHD System sales in Japan.  Teijin is a leading Japanese manufacturer ofsynthetic fibers, chemicals and plastics, with annual sales of approximately$7.5 billion, of which over $800 million is derived from pharmaceuticals andhome health care.

In August 1998, weestablished Aksys Healthcare, Ltd. (“AHL”), our indirect, wholly ownedsubsidiary in the United Kingdom. AHL is a sales office which employed fourindividuals at December 31, 2005. In 2005, AHL recorded revenue of$292,000.

**AvailableInformation**

We file annual, quarterly and current reports, proxystatements and other information with the Securities and Exchange Commission (“SEC”).You may read and copy any document we file at the SEC’s public reference roomat 100 F Street, NE, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330for information on the public reference room. The SEC maintains a web site(www.sec.gov) that contains annual, quarterly and current reports, proxystatements and other information that issuers (including us) fileelectronically with the SEC.

We make available free of charge, through a directlink from our web site (www.aksys.com) to the SEC’s web site, our annualreports on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, Forms 3, 4 and 5 filed on behalf of directorsand executive officers, and any amendments to those reports filed or furnishedpursuant to the Securities Exchange Act of 1934 as soon as reasonablypracticable after such documents are electronically filed with, or furnishedto, the SEC.

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**Item 1A.**                Risk Factors.

**RISK FACTORS**

*Investing in our common stock involves a high degreeof risk. You should carefully consider the risks and uncertainties describedbelow before investing. If any of the following risks actually occur, ourbusiness, financial condition, or results of operations would likely suffer. Inthat case, the market price of the common stock could fall, and you may loseall or part of the money you paid to buy such common stock. Also considercarefully the statements under the heading “Note on Forward-Looking Information”below. You should be prepared to accept the occurrence of any and all of therisks associated with purchasing our commons stock, including a loss of all ofyour investment.*

**Risks Related toOur Business**

***As aresult of our transaction with the Durus fund and the Durus fund’s currentownership position in our common and preferred stock, persons other than theDurus fund who own our common stock will own a minority of our common stock andwill not be able to exercise voting control over most matters put to a vote ofstockholders.***

**On March 31,2006 we executed definitive agreements for a financing transaction with theDurus fund**. These documents included an amendment toour existing settlement agreement with the Durus fund and Artal Long BiotechPortfolio LLC (the “Artal fund”) to release the Durus fund and the Artal fundfrom standstill and other restrictive covenants, including elimination of therequirement for the Durus fund to reduce its ownership in our common stock to15% by May 2006 and the requirement that, on matters requiring the vote ofthe Company’s stockholders, the Durus fund and the Artal fund vote their sharesof the Company’s common stock in proportion to the votes cast by all otherholders of the Company’s common stock. By releasing the Durus fund from theserestrictions, the Durus fund is no longer prohibited from acquiring oursecurities or making any solicitation of proxies to vote our shares. Inaddition, we took actions to amend our shareholder rights agreement so that itwill not be applicable to the Durus fund or the transactions with the Durusfund and to eliminate our shareholder rights outstanding under our rightsagreement.

Stockholders other than the Durus fund own a minorityof our outstanding shares of common stock. After giving effect to the financingtransaction, the Durus fund’s ownership position and representation on theboard of directors will entitle the Durus fund to exercise control over mostmatters put to a vote of our board of directors and our stockholders. The Durusfund will be in a position to control the election of our directors, determineour corporate and management policies and to determine, without the consent ofour other stockholders, the outcome of any corporate transaction or othermatter submitted to our stockholders for approval, including exercising itsvoting control to prevent a sale or merger transaction in which stockholderscould receive a premium for their shares. In addition, the Durus fund also hassufficient voting power to amend our organizational documents.

The Durus fund’s interests may not coincide with theinterests of other holders of our common stock. The Durus fund is in thebusiness of making investments in companies and may, from time to time, acquireand hold interests in businesses that compete directly or indirectly with us. TheDurus fund may pursue, for its own account, acquisition opportunities that maybe complementary to our business, and as a result, those acquisitionopportunities may not be available to us. Such concentration of ownership couldalso have the effect of delaying, deterring or preventing a change in controlof the Company that might otherwise be beneficial to minority stockholders andmay also discourage acquisition bids for the Company and limit the amountcertain investors may be willing to pay for shares of our common stock.

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***Werequire additional capital to operate our business which, if not available tous, may prevent our ability to continue operations and which, if raised, willdilute stockholder ownership interest in us or otherwise reduce the value ofour common stock.***

Our capital requirements have been and will continueto be significant. To date, we have raised approximately $152 million fromequity offerings and have received approximately $53.7 million in payments andfinancings from the Durus fund, approximately $48.7 million as part of theoriginal settlement in 2004 and $5.0 million on March 31, 2006 in the formof a short term loan. Our capital requirements will depend on many factors,including without limitation:

·       thecost of servicing and supporting PHD Systems in use;

·       manufacturingand associated costs;

·       costs associated withmarketing, distribution, patient training and technical and patient supportnetworks;

·       continuedprogress in research and development; and

·       thecosts involved with protecting our proprietary rights.

During 2006, we expect to use approximately $16 to $18million in our operations, including service and support of the PHD Systemsbeing used by patients today. Resources will also be directed toward using thePHD System’s platform technology to develop our next generation product. Webelieve our cash and liquid investments (including the receivable for thesettlement of the sale of long-term investment securities) at December 31,2005, combined with expected proceeds from the Durus fund financing, are onlysufficient to finance our operations into 2007. In 2006, we will seek to raisethe additional capital required to fund commercial activities in 2007.  See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Liquidity and Capital Resources—RecentFinancing Activities”.

We received a letter dated as of March 31, 2006,in which the Durus fund stated its intention, and confirmed its ability, toprovide financing necessary to fund our operations at least through January 1,2007. However, this letter does not represent a legally binding commitment ofthe Durus fund to provide the Company with any financing, and the letterfurther provides that there are no third party beneficiaries to the letter.

Any additional capitalthat we are able to raise through additional issuances of our equity securitiesmay result in substantial dilution to our then existing stockholders, and anydebt financing we may be able to obtain could result in the imposition ofsignificant financial and operational restrictions on us. Should the financingwe require to sustain our working capital needs be unavailable or prohibitivelyexpensive when we require it, our business, operating results, financialcondition and prospects could be materially and adversely effected.

***Customers,suppliers and other third parties may not do business with us, may terminatebusiness relationships with us or may not extend business relationships.***

Due to our capital constraints, vendors and otherthird parties may decide not to conduct business with us, or may conductbusiness with us only on a cash basis and on other terms that are lessfavorable than those customarily extended by them. In that event, our costs mayincrease. In addition, our capital constraints may make it difficult for us tomarket the PHD System and related services to current and prospective customers.If we are unable to maintain relationships with existing clinics and/or developrelationships with new clinics, our future revenues will likely decrease.

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***We currently rely on a few key customers for asignificant portion of our sales***

We currently derive, and expect to continue to derive,a substantial percentage of our net sales from fewer than ten customers. A lossof one or more of those customers could cause a significant decrease in our netrevenue. Our largest customers, DaVita, the Dialysis Centers of Lincoln andNorthwest Kidney Center accounted for 16%, 11% and 8%, respectively, of ourrevenues (by dollar volume) for fiscal year 2005. For fiscal year 2004, ourlargest customers, Northwest Kidney Center, the Dialysis Centers of Lincoln andBerkshire Medical Center accounted for 24%, 10% and 9%, respectively, of ourtotal revenue. The amount of revenue we derive from a specific customer islikely to vary from period to period, and a major customer in one period maynot produce significant additional revenue in a subsequent period. Weanticipate that our operating results will continue to depend on sales to asmall number of key customers in the foreseeable future. Loss of a significantamount of business from any of our large customers could have a materialadverse effect on our results of operations and financial condition if suchbusiness were not substantially replaced by additional business from existingor new customers. Additionally, our results of operations and financialcondition could be materially adversely affected if any of our large customersexperience financial difficulties that cause them to delay, or fail to make,payments for goods sold or leased to them.

***If our current manufacturing agreement with Delphi isterminated and we are required to establish new manufacturing or parts sourcingrelationships, we may experience increased costs, disruptions in themanufacture and shipment of PHD Systems and a loss of revenue.***

The PHD System ismanufactured by Delphi. On October 8, 2005, Delphi and its parentcorporation filed a voluntary petition for business reorganization underChapter 11 of the U.S. Bankruptcy Code.  The ultimate effect of the bankruptcy on ourrelationship with Delphi is unclear. We have a Uniform Commercial Code financingstatement on file with the Colorado Secretary of State with respect to certaincomponent inventory located at Delphi’s warehouses. In addition, as of December 31,2005, we had a cash deposit in the amount of $1,432,000 with Delphi as securityfor certain of our purchase obligations. We have recorded a reserve to reflectthe uncertainty associated with the bankruptcy filing; however, we are pursuingthe full value of the deposit. We have had ongoing discussions with Delphiregarding our accounts payable balance, our deposit and certain parts inventorylocated at Dephi’s warehouses. In thefirst quarter of 2006, we received****correspondencefrom Delphi advising us of their decision to stop further shipments of PHDSystems and parts until these items have been resolved. We plan to continue ourdiscussions with Delphi and believe that we have a sufficient inventory ofparts and machines on hand to enable us to continue operations pendingresolution of this matter. If Delphi rejects our manufacturing agreement inconnection with its bankruptcy proceeding or we are unable to settle openissues with Delphi on a timely basis, we would be forced to establish newmanufacturing and/or direct parts sourcing relationships which could expose usto a number of risks and uncertainties. These risks and uncertainties couldinclude whether the new manufacturer(s) and parts suppliers will agree todo business with us on satisfactory terms as well as whether such manufactures(s) andparts suppliers will perform to our expectations and produce the PHD System andsupply parts in a timely, cost-efficient manner on a consistent basis and inaccordance with all regulatory requirements including QSRs. Any of these riskscould make it difficult for us to produce the PHD System on satisfactorycommercial terms, if at all.

***We have a history of operating losses and asignificant accumulated deficit, and we may not achieve or maintainprofitability in the future.***

We have not beenprofitable since our inception in January 1991. As of December 31,2005, we had an accumulated deficit of approximately $190.8 million. Weexpect to continue to incur additional losses for the foreseeable future as aresult of a high level of operating expenses, significant up-frontexpenditures, production and marketing activities and very limited revenue fromour core business. We may never realize 

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significantrevenues from our core business or be profitable. Factors that will influencethe timing and amount of our profitability include:

·       thesuccess of the product development efforts under the DEKA Agreement;

·       ourability to obtain sufficient financing to operate our business;

·       marketacceptance of the PHD System;

·       oursuccess in commercializing the PHD System;

·       ourability to effectively and efficiently manufacture, market and distribute thePHD System; and

·       ourability to sell or lease the PHD System and related services at a price thatcovers our per unit costs, which result may be difficult to achieve, in partbecause of the significant restrictions on the reimbursement of dialysistreatment by the Medicare program, as discussed below, and the high cost ofmanufacturing the PHD System.

We face significantchallenges in shifting from the development stage to the commercializationstage for the PHD System. Our prospects must be considered in light of therisks, expenses and difficulties frequently encountered in such a transition,and there can be no assurance that we will have any significant revenues orthat we will ever achieve profitable operations.

***Our cost to produce the PHD System and deliver relatedservices and supplies currently exceeds the market price of the PHD System andrelated services and supplies.***

The pricing of the PHD System and related services andsupplies is constrained by limitations on governmental and third partyreimbursement programs. Although we are working to reduce the cost of servicingthe machine and we are attempting to reduce manufacturing costs by identifyingalternative materials and suppliers, there can be no assurance that theseefforts will enable us to achieve profitable operations.

In addition, the cost of services and supplies for thePHD System currently exceeds the market price as a result of the need to have alocal presence of field service and clinical service personnel in eachgeographical area that PHD Systems are sold. Furthermore, the PHD System iscomprised of new, complex, highly automated technologies, which operate in arigorous process. While we continue to realize improvements in the PHD System’sreliability as a result of the acquisition and development of new parts andsubsystems, there can be no assurance that we will be successful in reachingindustry norms for reliability. If we are unable to improve the reliability ofthe PHD System, our operating costs will be adversely impacted and we may neverachieve profitability as a result.

If a PHD System isunavailable for treatments for more than a few days, the patient assigned tothe machine must go back to his dialysis clinic for in-center treatment untilhis PHD System is repaired. Although we have experienced infrequent incidentsof patients on the PHD System needing to go back in center for treatments todate, we cannot assure you, based on our limited experience that such incidentswill not occur more frequently in the future.

***Our business will fail if we cannot successfullycommercialize the PHD System; because we have only recently begun thiscommercialization process, our success cannot be predicted and is uncertain. Oursuccess is dependent on many variables entirely outside of our control.***

Acceptance of the PHD System in the marketplace byboth potential users and purchasers (two separate groups with at timesconflicting interests) is uncertain, and failure to achieve sufficient marketacceptance will significantly limit our ability to generate revenue and becomeprofitable. The success of the PHD System is dependent on many variables,including its safety, price, reliability, effectiveness and 

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cost-effectivenessas an alternative dialysis modality. The failure to conclusively demonstrateeach of these factors could significantly hinder market acceptance of our PHDSystem, and the failure of our PHD System to achieve sustained commercialviability or market acceptance would have a material adverse effect on us andyour investment in us. Moreover, successful commercialization will depend upon,among other things, market acceptance of the efficacy of daily hemodialysis. Thiswill require substantial marketing efforts and the expenditure of significantfunds by us to inform nephrologists, dialysis clinics, other healthcareproviders and dialysis patients of the benefits of daily hemodialysis, and thusthe benefits of the PHD System.

In marketing thePHD System, we may encounter significant clinical and market resistance to:

·       usingthe PHD System;

·       home hemodialysis, which iscurrently employed by only a small percentage of patients suffering from end-stagerenal disease; and

·       dailyhemodialysis, which to our knowledge has never been a widely implemented dialysisalternative.

There can be no assurance that our efforts will besuccessful or that the PHD System will ever achieve market acceptance. Inaddition, the PHD System is a personal system, designed for use by a singlepatient, and requires several hours after a dialysis treatment to prepareitself for the next treatment session. As such, it is very unlikely to be usedin the prevailing method of outpatient hemodialysis, which generally involvestreating patients three times per week for treatment sessions lasting betweenthree and four hours. In this prevailing method of hemodialysis, patientsreceiving treatment on a given day are treated in shifts, with patients onsucceeding shifts using dialysis machines employed during prior shifts.

A number of other factorswill affect the future success and sales of our product. These factors include:

·       theamount of government and private reimbursement for dialysis treatment;

·       whether the system will besafe or effective or whether it will be cost-effective relative to otherdialysis treatment alternatives;

·       whetherdaily hemodialysis will be shown to be more clinically effective thanalternative dialysis modalities;

·       whetherpatients will be reluctant to administer and monitor the PHD System withlimited or no supervision; and

·       whether there areunexpected side effects, complications or other safety issues associated withdaily hemodialysis (or the PHD System) that may adversely affect the market forour products and services.

***We are entirely dependent on the PHD System, our soleproduct.***

Since our inception, wehave devoted substantially all of our efforts to the development of the PHDSystem. We expect to be entirely dependent for the foreseeable future on salesof, and services relating to, the PHD System for revenues. Our dependence on asingle product creates significant risk for our company and stockholders.

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***Ourstrategy to develop a new generation of our product under the DEKA Agreementinvolves a number of risks and uncertainties.***

Our strategy for development of a new generation ofour product depends upon the success of the DEKA Agreement. The ultimatesuccess of the development efforts under the DEKA Agreement is subject to anumber of cost, timing and other risks and uncertainties, many of which areoutside of our control. We cannot be certain that the DEKA Agreement will besuccessful or that any product will ultimately be developed under thisagreement.

***Uncertainty and amount of third-partyreimbursement could affect our profitability.***

Although most privateinsurance policies cover a substantial portion of the cost of dialysistreatment in the United States, most patients receiving dialysis treatment inthe United States are insured by Medicare or Medicaid. Medicare and Medicaidprovide reimbursement for dialysis treatment at set composite rates, which havenot increased significantly since 1983. There can be no assurance that thecurrent limitations or requirements on Medicare and Medicaid reimbursement fordialysis will not have a materially adverse effect on the market for the PHDSystem, that health administration authorities outside of the United Stateswill provide reimbursement at acceptable levels or at all or that current orfuture reimbursement rates will be sufficient to enable us to maintain pricesat levels sufficient to become profitable.

***Competitors and technological advances could cause usto lose current and future business opportunities and materially harm ourresults of operations and ability to grow.***

The dialysis industry is characterized by competitionfor financing, executive talent, intellectual property, and, ultimately,product sales. Our primary competitors in supplying dialysis equipment,disposables, and services are Fresenius Medical Care AG, Baxter International, Inc.,and Gambro AB. These competitors have more financial, scientific, and technicalresources than do we, as well as more experience with respect to manufacturing,product development, and marketing in the dialysis market. We also compete withNxStage Medical, Inc.  If ourcompetitors succeed in developing products that are more effective and/or lesscostly than the PHD System for performing more frequent home hemodialysis, bothour sales and our prospects for achieving profitability may be adverselyimpacted. We also expect that the number of our competitors will increase, andthere can be no assurance that we will be able to compete successfully againstany competitor.

Our ability to successfully market our products andservices could be adversely impacted by pharmacological and technologicaladvances in preventing the progression of ESRD in patients (such as those withdiabetes and hypertension), technological developments by others, developmentof new medications designed to reduce the incidence of kidney transplant rejectionand progress in using kidneys harvested from genetically-engineeredanimals as a source of transplants.

Furthermore, although homehemodialysis treatment options are available, adoption has been limited. Themost widely adopted form of dialysis therapy used in a setting other than adialysis clinic is peritoneal dialysis. Because the adoption of homehemodialysis has been limited to date, the number of patients who desire to,and are capable of, administering their own hemodialysis treatment is unknownand there is limited data upon which to make estimates. Our long-term growthwill depend on the number of patients who adopt home-based hemodialysis and howquickly they adopt it. We cannot be certain that this market will develop, howquickly it will develop or how large it will be.

***Our future sales could be adversely affected due toour limited marketing experience.***

We currently market our products and servicesprimarily through our own sales force. There can be no assurance that we willbe able to staff an adequate marketing staff or sales force or that the cost ofsuch 

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will not be prohibitive, or that our direct sales andmarketing efforts will be successful. The choice of dialysis therapy involvesthe successful marketing to dialysis clinic operators and nurses, nephrologistsand patients, each of which may have different factors that they consider inmaking their decision. Ineffective marketing to any one of these decisionmakers may adversely affect acceptance of the PHD System. We may havedifficulty in gaining acceptance of the PHD System for a number of factors including:

·       thefailure by us to demonstrate to patients, operators of dialysis clinics,nephrologists, dialysis nurses and others that our product is equivalent orsuperior to existing therapy options, or that the cost or risk associated withuse of our product is not greater than available alternatives;

·       competitionfrom products sold by companies with longer operating histories and greaterfinancial resources, more recognizable brand names and better establisheddistribution networks and relationships with dialysis clinics;

·       theownership and operation of some dialysis providers by companies that alsomanufacture and sell competitive dialysis products;

·       theintroduction of competing products or treatments that may be more effective,safer, easier to use or less expensive than ours;

·       thenumber of patients willing and able to perform therapy independently, outsideof a traditional dialysis clinic, may be smaller than we estimate; and

·       the continued availabilityof satisfactory reimbursement from healthcare payers, including Medicare.

***We are subject to extensive government regulation,which can be costly, time consuming and subject us to unanticipatedinterruptions or delays in our commercial operations.***

The PHD System, our sole product, is subject to stringentgovernment regulation in the United States and other countries. In the UnitedStates, the PHD System is regulated as a medical device by the FDA. In March 2002,we announced receipt of clearance from the FDA to market the PHD System in theUnited States. The FDA clearance had no restrictions and included authorizationto use the product in the home; however, FDA clearance under 510(k) issubject to continual review and later discovery of previously unknown problemsmay result in restrictions on product marketing or withdrawal of the productfrom the market.

In the European Economic Area, the PHD System isregulated as a medical device under the Medical Device Directive. In October 2002,we announced receipt of EC Certification for CE Mark approval pursuant to theMedical Device Directive. The certification approved the PHD System for homeuse. Such approval was required prior to the commercialization of the PHDSystem in the European Economic Area.

Additional government regulations may be establishedor imposed in the United States or the European Economic Area, or theinterpretation or enforcement of such regulations may change, which couldmaterially impact the regulatory clearances we have received for the PHD Systemand its continued commercialization.

In addition, various statutes and regulations alsogovern the testing, labeling, storage, record keeping, distribution, sale,marketing, advertising and promotion of our products, which present significantcompliance burdens for our company. Failure to comply with applicablerequirements can result in fines, recalls or seizures of products, total orpartial suspension of production, withdrawal of existing product approvals orclearances, refusal to approve or clear new applications or notices and criminalprosecution.

The manufacture of the PHD System must also comply orensure compliance with current QSR regulations promulgated by the FDA. We maybe required to expend time, resources and effort in product 

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manufacturing and qualitycontrol to ensure compliance even though our PHD System is manufacturedcurrently by an independent contractor. If violations of the applicableregulations are noted during FDA inspections of manufacturing facilities, itmay have a material adverse effect on the continued marketing of our products.

You should also be awarethat proper regulatory approvals have not been completed in any jurisdictionsother than the United States and the European Economic Area. There can be noassurance or guarantee that any of these approvals will be obtained in a timelymanner or at all.

***We rely on independent contract manufacturers for themanufacture of our PHD System. Our inability to manufacture the PHD System, andour dependence on independent contractors, may delay or impair our ability togenerate revenues, or adversely affect our profitability.***

To be successful, our PHD System must be manufacturedin commercial quantities and at acceptable cost. Production of this product,especially in commercial quantities, will create technical as well as financialchallenges for us. We may encounter unexpected delays or costs in the scale-upof manufacturing operations. Further, manufacturing or quality control problemsmay arise (and among other things increase our costs) as we increase productionof the PHD System or as additional manufacturing capacity is required in thefuture.

We currently rely on single contract manufacturers tomanufacture each of the major components of the PHD System. Such contractorsare not employed or otherwise controlled by us and are generally free toconduct their business at their own discretion. Although certain of ourcontract manufacturers have entered into contracts with us to manufacturecomponents of the PHD System, such contracts can be terminated at any timeunder certain circumstances by us or by the contractors, and can be breached atany time. Further, work stoppages and the slowing of production at asingle independent contractor would have a material adverse effect on ourresults of operations.

There are also other risks inherent in using a singlesource of supply. We have not made alternative arrangements for the manufactureof the major components of the PHD System and we may not be able to implementacceptable alternative arrangements on a timely basis, or at all. It is likelythat a significant interruption in supply would result if we utilize or wererequired to utilize a different manufacturing contractor for any of the majorcomponents of PHD Systems. The loss of the services of any of our contractmanufacturers would have a materially adverse effect on our results ofoperations. See “Risk Factors—*If our currentmanufacturing agreement with Delphi is terminated and we are required toestablish new manufacturing relationships, we may experience increased costs,disruptions in the manufacture and shipment of PHD Systems and a loss ofrevenue.*” In addition, we or our manufacturers may not be able toobtain, on a timely basis, components or other supplies necessary tomanufacture or use the PHD System.

***We may not be able to protect our intellectualproperty rights and, as a result, we could lose competitive advantages thatcould adversely affect our operating results.***

Our success depends, in part, on our ability and theability of our licensors to obtain, assert and defend patent rights, protecttrade secrets and operate without infringing the proprietary rights of others. Wecurrently own or have rights in relevant fields to 47 U.S. patents and 26foreign patents. There can be no assurance, however, that:

·       we will be able to obtainadditional licenses to patents of others or that we will be able to developadditional patentable technology of our own;

·       any patents issued to uswill provide us with competitive advantages or that the patents or proprietaryrights of others will not have an adverse effect on our ability to do business;

·       otherswill not independently develop similar products;

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·       otherswill not design around or infringe such patents or proprietary rights owned byor licensed to us; and

·       anypatent obtained or licensed by us will be held to be valid and enforceable ifchallenged by another party.

We are aware that numerous patents have been issuedrelating to methods of dialysis. Although we endeavor to protect our patentrights from infringement, it is possible that by virtue of the numerous patentsthat have been, or potentially will be, issued relating to hemodialysismethods, we may not be aware, or become aware, of patents issued to ourcompetitors or others that conflict with our own or those of our licensors. Suchconflicts could result in a rejection of important patent applications or theinvalidation of important patents, which could have a material adverse effecton our competitive position. In the event of such conflicts, or in the event webelieve that competitive products infringe patents to which we hold rights, wemay pursue patent infringement litigation or interference proceedings against,or may be required to defend against such litigation or proceedings involving,holders of such conflicting patents or competing products. Such litigation orproceedings may have a material adverse effect on our competitive position, andwe may not be successful in any such litigation or proceeding. Litigation andother proceedings relating to patent matters, whether initiated by us or athird party, can be expensive and time consuming, regardless of whether theoutcome is favorable to us, and can result in the diversion of substantialfinancial, managerial and other resources. An adverse outcome could subject usto significant liabilities to third parties or require us to cease any relateddevelopment or commercialization activities. In addition, if patents thatcontain dominating or conflicting claims have been or are subsequently issuedto others and such claims are ultimately determined to be valid, we may berequired to obtain licenses under patents or other proprietary rights of others.The licenses required under any such patents or proprietary rights may not bemade available on terms acceptable to us, if at all. If we do not obtain suchlicenses, we could encounter delays or could find that the development,manufacture or sale of products requiring such licenses is foreclosed which mayadversely affect our results of operations.

We rely on proprietary know-how and confidentialinformation and employ various methods, such as entering into confidentialityand noncompete agreements with our current employees and with certain thirdparties to whom we have divulged proprietary information, to protect theprocesses, concepts, ideas and documentation associated with our technologies. Suchmethods may not afford significant protection to us, and we may not be able toprotect adequately our trade secrets or our competitors or other companies mayacquire information that we consider proprietary.

***Product liabilityclaims may reduce demand for the PHD System or result in damages that exceedour insurance coverage.***

Ourbusiness exposes us to potential product liability risks that are inherent inthe production, marketing and sale of dialysis products. We currently maintainproduct liability insurance with a coverage limit of $10 million. Our insurance policy may not provide adequateprotection against potential claims. Furthermore, our agreements with contractmanufacturers require us to maintain product liability insurance, and thefailure to obtain such insurance could materially and adversely affect ourability to produce our PHD System. A successful claim brought against us inexcess of any insurance coverage obtained by us could have a material adverseeffect upon our business, financial condition and results of operations. Inaddition, we have agreed to indemnify certain of our contract manufacturersagainst certain liabilities resulting from the use of our PHD System.

***Our recent costreduction initiatives may make it difficult for us to retain and hire criticalpersonnel.***

We are dependent upon theservices of our senior executives and key scientific personnel. We do notmaintain key-man life insurance on our senior executives. In addition, wedo not have employment agreements, other than certain severance,confidentiality and non-competition agreements, with any of our 

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personnel.Our business would likely be interrupted if we lost the services of our seniorexecutives or key employees, which could have a material adverse effect onoperations. Also, our continued commercialization will depend upon, among otherthings, the successful recruiting and retention of highly skilled managerialand marketing personnel with experience in business activities such as those wecontemplate. Competition for the type of highly skilled individuals sought byus is intense, and we may not be able to retain existing employees or find,attract and retain other skilled personnel on acceptable terms. Our recent costreduction initiatives may make it difficult to retain critical personnel orreplace personnel who leave. In addition, due to the declines in the price ofour common stock, the exercise price of outstanding employee stock optionssubstantially exceeds the trading price of our common stock. These factors mayaffect our ability to retain critical employees, which could seriously harm ourability to generate revenue, manage day-to-day operations, and deliver ourproducts and services.

***If we cannot develop adequate distribution, customerservice and technical support networks, we may not be able to market anddistribute our PHD System effectively.***

Our strategy involvescontracting with dialysis providers to have us supply to dialysis patients thePHD System, dialysate and other consumables, patient training, customer serviceand maintenance and other technical service. To provide these services, we mustdevelop networks of employees or independent contractors in each of the areasin which we intend to operate. There can be no assurance that we will be ableto organize these networks on a cost-effective basis. The failure to establishthese networks on a cost-effective basis would have a material adverse effecton our results of operations.

***We maynot realize any of the anticipated benefits from our more focused resourceallocation.***

On December 6, 2005,we announced a plan to realign our service network by designating geographicoperating districts which have shown the highest adoption rates of the PHDSystem. The plan includes several operational changes designed to significantlyreduce our cash burn rate and provide a more focused resource allocation. Weare focusing our sales and servicing efforts on these target markets. While ourdecision to realign our operating model through the designation of PHDOperating Districts may strengthen our relationships with patients and clinicsin designated areas, it may adversely affect our relationships outside of thoseareas. We cannot assure you that as a result of this reallocation our losseswill decrease or we will achieve any particular patient count or revenue level.Our patient count and revenue level may decline in the near term due toattrition in areas outside of our PHD Operating Districts.

**Risks Related toOur Common Stock**

***Ourcommon stock has been delisted from the Nasdaq National Market and could bedelisted from the Nasdaq Capital Market.***

On November 14, 2005, we received a letter fromthe Nasdaq noting that we had failed to comply with the minimum $10 million ofstockholders’ equity required by Marketplace Rule 4450(a), MaintenanceStandard 1 and the alternative listing requirements of Marketplace Rule 4450(b),Maintenance Standard 2 relating to market value of listed securities (and relatedassets and revenue tests) and market value of publicly held shares. On December 16,2005, we were notified by the Nasdaq that for the last 30 consecutive businessdays the bid price of our common stock has closed below the minimum $1.00 pershare required by Marketplace Rule 4450(a)(5). On December 27, 2005,we received a letter from the Nasdaq denying our request for continued listingon the Nasdaq National Market. In response to this letter, on December 30,2005, we requested a hearing before the Nasdaq Listing Qualifications Panel toreview the Nasdaq staff’s determination. We subsequently received notificationfrom the Nasdaq Listing Qualifications Panel that our common stock would bedelisted from the Nasdaq National Market and would begin trading on the NasdaqCapital Market on February 14, 2006.

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**The Nasdaq Capital Market has its own standards forcontinued listing, including Marketplace Rule 4310(c)(2)(B), whichrequires us to have a minimum of $2,500,000 in stockholders’ equity or$35,000,000 market value of listed securities or $500,000 of net income fromcontinuing operations for the most recently completed fiscal year or two of thethree most recently completed fiscal years. In addition, continued listing onthe Nasdaq Capital Market requires satisfying the $1.00 minimum closing bidprice imposed by Marketplace Rule 4450(a)(5).**There can be no assurance that we willsustain compliance with these standards. In particular, we do not currentlyhave a minimum of $2,500,000 in stockholder’s equity and we did not have$500,000 of net income from continuing operations for the most recentlycompleted fiscal year or two of the three most recently completed fiscal years,but the current market value of our listed securities does exceed $35,000,000.In the event we cannot sustain compliance with the Nasdaq Capital Market’slisting standards, our common stock will be delisted from the Nasdaq Capital Market and we may be unable to list our commonstock on another stock exchange or quotation service. Such a delisting may makeit difficult or impossible for stockholders to sell their shares, for us toissue additional securities and for us to obtain additional financing in thefuture. A delisting may also result in a more limited amount of news andanalyst coverage for our Company and could have a material adverse effect onthe market price of our common stock.

***If our common stock becomes a “penny stock” you mayfind it difficult to resell shares.***

Generally, a “penny stock” is a common stock that isnot listed on a securities exchange and trades for less than $5.00 a share. Pricesoften are not available to buyers and sellers and the market may be verylimited. Penny stocks in start-up companies are among the riskiest equityinvestments. Broker-dealers who sell penny stocks must provide purchasers ofthese stocks with a standardized risk-disclosure document prepared by theSecurities and Exchange Commission. The document provides information aboutpenny stocks and the nature and level of risks involved in investing in thepenny stock market. A broker must also give a purchaser, orally or in writing,bid and offer quotations and information regarding broker and salespersoncompensation, make a written determination that the penny stock is a suitable investmentfor the purchaser, and obtain the purchaser’s written agreement to the purchase.Many brokers choose not to participate in penny stock transactions. If our common stock is delisted from theNasdaq Capital Market****and we areunable to satisfy certain other financial tests we will be classified as a “pennystock” as that term is defined under Rule 3a51-1 of the SecuritiesExchange Act of 1934. Because of the penny stock rules, there is less tradingactivity in penny stock, and consequently you may have difficulty selling yourshares.

***Our common stock is thinly traded, so you may beunable to sell at or near ask price or at all if you need to liquidate yourshares.***

Our common shares havehistorically been sporadically or “thinly-traded” on the Nasdaq Capital Marketand the Nasdaq National Market (priorto our delisting from the Nasdaq National Market), meaning that thenumber of persons interested in purchasing our common shares at or near askprices at any given time may be relatively small or non-existent. As of December 31, 2005, our averagetrading volume per day for the past three months was approximately 57,932 shares a day with a high of 425,322 shares traded and a low of1,775 shares traded. This situation is attributable to a number of factors, includingthe fact that we are a small company which is relatively unknown to stockanalysts, stock brokers, institutional investors and others in the investmentcommunity that generate or influence sales volume, and that even if we came tothe attention of such persons, they tend to be risk-averse and would bereluctant to follow an unproven company such as ours or purchase or recommendthe purchase of our shares until such time as we became more seasoned andviable. As a consequence, there may be periods of several days or more whentrading activity in our shares is low, as compared to a seasoned issuer whichhas a large and steady volume of trading activity that will generally supportcontinuous sales without an adverse effect on 

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shareprice. We cannot give you any assurance that a broader or more active publictrading market for our common shares will develop or be sustained, or thatcurrent trading levels will be sustained.

***The market price of our common stock may be subject tosignificant volatility.***

The price of our common stock may fluctuate widelydepending upon many factors, including our perceived prospects and those of thedialysis market in general. Since our initial public offering in May 1996,our common stock price has traded between $0.52 and $23.50 per share and we have generally experiencedrelatively low trading volume in relation to the aggregate number of sharesoutstanding.

Factors that mayhave a significant impact on the market price or liquidity of our common stockinclude:

·       reportsby official or unofficial health or medical authorities, the general media orthe FDA regarding the potential benefits or detriments of our PHD System or ofsimilar products distributed by other companies, or of daily or home dialysis;

·       announcementsof technological innovations or new products by us or our competitors;

·       eventsor announcements relating to our relationships with others, including our thirdparty manufacturers;

·       developmentsor disputes concerning patents or proprietary rights;

·       regulatorydevelopments in both the United States and foreign countries;

·       economicand other factors, as well as period-to-period fluctuations in ourfinancial results; and

·       salesof our common stock by the Durus fund.

External factors may also adversely affect the marketprice for the common stock. The common stock currently trades on the NasdaqCapital Market. The price and liquidity of the common stock may besignificantly affected by the overall trading activity and market factors onthe Nasdaq Capital Market or the market, if any, on which we are then trading.

Future sales of substantial amounts of our commonstock in the public market could adversely affect the market price of thecommon stock, and also could impair our ability to raise additional capital throughthe sale of our equity securities.

***The resale by the Durus fund of a substantial numberof shares of our common stock could adversely impact the market price of ourcommon stock.***

Based on information contained in a Schedule 13D filedby the Durus fund with the Securities and Exchange Commission on March 13,2006, we believe the Durus fund owns 21,498,118 shares of our common stock,representing approximately 66%of our outstanding shares. We have filed a registration statement coveringthese shares and 498,100 shares held by the Artal fund. This registrationstatement was declared effective by the Securities and Exchange Commission on May 17,2004, and enables the Durus fund and the Artal fund to resell their shares tothe public at their discretion. Although we believe that the Durus fund and theArtal fund will effectuate the sale of their shares in an orderly manner andwill seek to obtain the best prices available in connection with any sales, thetiming, volume and manner of any sales is within their discretion.

The Durus fund and theArtal fund’s sale of their shares may have a negative effect on the marketprice of our common stock due to, among other factors, the selling pressuresuch sales may cause. Moreover, the perception in the market that a significantportion of our outstanding shares may soon be sold may also have a negativeeffect on the market price of our common stock. These events may cause otherholders of our common stock to sell their shares, or it may encourage shortsales, all of which could 

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contributeto a decline in the market price of our stock. In addition, these factors mayhave a material adverse effect on our ability to raise capital through theissuance of our equity securities.

***We do not intend to pay cash dividends on our commonstock in the foreseeable future.***

We have never declared orpaid any cash dividends on our common stock. For the foreseeable future, weintend to retain any earnings to finance the development of our business, andwe do not anticipate paying any cash dividends on our common stock. Payment ofany future dividends on our common stock will depend upon our earnings andcapital requirements, the terms of any indebtedness we incur and other factorsour board of directors considers appropriate.

***We will likely need to issue additional shares of ourcommon stock and/or preferred stock in the future, which would dilute yourvoting and ownership percentage.***

Certain events overwhich you have no control could result in the issuance of additional shares ofour common stock, which would dilute your voting and ownership interest in ourCompany. As of March 20, 2006,there were 32,177,574 shares ofour common stock issued and outstanding and there were 717,677 shares of common stock reserved for issuance under ourequity incentive and stock purchase plans. As of March 20, 2006, there were outstanding options, warrants andother rights to acquire up to approximately 3,338,602 shares of common stock. We may also issue additionalshares of common stock or preferred stock:

·       toraise additional funds for working capital, research and development,commercialization, production and marketing activities;

·       uponthe exercise or conversion of outstanding options and warrants; and

·       inlieu of payment of cash dividends.

Furthermore, upon closingof our securities purchase agreement with the Durus fund dated March 31,2006 (the “Securities Purchase Agreement”), the Durus fund will acquire newlyissued shares of our Series B Preferred Stock, convertible into 5 millionshares of our common stock at a conversion price of $1.00 per share andWarrants to purchase 5 million shares of our common stock at an exercise priceof $1.10 per share. In addition, following the closing of the SecuritiesPurchase Agreement, the Durus fund will have the option to invest, by itself orwith other investors designated by the Durus fund, up to an additional $15million in cash for additional shares of Series B Preferred Stock andWarrants having essentially the same terms as the Series B Preferred Stockand Warrants acquired by the Durus fund at the closing. If the Durus fund (byitself or with other investors) invests the maximum additional $15 million incash for such additional shares of Series B Preferred Stock and Warrants,such additional shares of Series B Preferred Stock will be convertibleinto 15 million shares of common stock at a conversion price of $1.00 per Shareand the additional Warrants will be exercisable to purchase 15 million sharesof common stock at an exercise price of $1.10 per share. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources—Recent Financing Activities.” See also “Risks Related toOur Business—As a result of our transaction with the Durus fund and the Durusfund’s current ownership position in our common and preferred stock, personsother than the Durus fund who own our common stock will own a minority of ourcommon stock and will not be able to exercise voting control over most mattersput to a vote of stockholders.”

***Our charter documents and Section 203 of the DGCLcould make it more difficult for a third party to acquire us.***

OurRestated Certificate of Incorporation (“Charter”) and Amended and RestatedBylaws (“Bylaws”) contain certain provisions that are intended to enhance thelikelihood of continuity and stability in the composition of our board ofdirectors and which may have the effect of delaying, deferring or preventing a 

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future takeover or change in control of the Companyunless the takeover or change of control is approved by our board of directors.Such provisions may also render the removal of the current board of directorsand of management more difficult. These provisions provide for, among otherthings:

·       aclassified board of directors;

·       “fairprice” provision, which requires that our stockholders receive equivalentconsideration at both stages of a two-step acquisition (such as a tenderoffer followed by a merger);

·       aprohibition on stockholder action through written consents;

·       arequirement that special meetings of stockholders be called only by our boardof directors or our chief executive officer;

·       advancenotice requirements for stockholder proposals and nominations;

·       limitationson the ability of stockholders to amend, alter or repeal our Charter or ourBylaws; and

·       theauthority of our board of directors to issue, without stockholder approval,preferred stock with such terms as the board of directors may determine.

We aresubject to the “business combination” statute of the General Corporation Law ofthe State of Delaware (the “DGCL”). In general, Section 203 of the DGCLprohibits a publicly-held Delaware corporation from engaging in a “businesscombination” with an “interested stockholder,” for a period of three yearsafter the date of the transaction in which a person became an “interestedstockholder,” unless:

·       priorto such date the board of directors of the corporation approved either the “businesscombination” or the transaction which resulted in the stockholder becoming an “interestedstockholder,”

·       uponconsummation of the transaction which resulted in the stockholder becoming an “interestedstockholder,” the “interested stockholder” owns at least 85% of the votingstock of the corporation outstanding at the time the transaction commenced,excluding for purposes of determining the number of shares outstanding thoseshares owned (1) by persons who are directors and also officers and (2) employeestock plans in which employee participants do not have the right to determineconfidentially whether shares held subject to the plan will be tendered in atender or exchange offer, or

·       onor subsequent to such date the “business combination” is approved by the boardof directors and authorized at an annual or special meeting of stockholders bythe affirmative vote of at least 662¤3%of the outstanding voting stock, which is not owned by the “interestedstockholder.”

A “business combination”includes mergers, stock or asset sales and other transactions resulting in afinancial benefit to the “interested stockholders.” An “interested stockholder”is a person who, together with affiliates and associates, owns (or within threeyears, did own) 15% or more of the voting stock of the subject corporation. AlthoughSection 203 permits us to elect not to be governed by its provisions, wehave not made this election. As a result of the application of Section 203,potential acquirers of our company may be discouraged from attempting to effectan acquisition transaction with us, thereby possibly depriving holders of oursecurities of certain opportunities to sell or otherwise dispose of suchsecurities at above-market prices pursuant to such transactions.

The foregoing summaries donot purport to be complete and are subject to, and are qualified in theirentirety by reference to, our Charter and Bylaws, our Rights Agreement and theDGCL. Copies of our Charter and Bylaws are filed as exhibits to this report anddeemed to be incorporated herein in their entirety.

***If we sell commonstock to Fusion Capital under our common stock purchase agreement with them youwill likely experience significant dilution and the resale of shares of commonstock acquired by Fusion Capital could cause the price of our common stock todecline.***

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The sale of sharespursuant to our common stock purchase agreement with Fusion Capital or anyother future equity financing transaction will have a dilutive impact on ourstockholders. As a result, our net income or loss per share could decrease infuture periods, and the market price of our common stock could decline. Inaddition, the lower our stock price is, the more shares of common stock we willhave to issue under the common stock purchase agreement with Fusion Capital inorder to draw down the full amount available to us on any trading day. If ourstock price were lower, then our existing stockholders would experience greaterdilution. We cannot predict the actual number of shares of common stock thatwill be issued pursuant to the agreement with Fusion Capital or any otherfuture equity financing transaction, in part, because the purchase price of theshares will fluctuate based on prevailing market conditions and we do not knowthe exact amount of funds we will need. The purchase price for the common stockto be sold to Fusion Capital pursuant to the common stock purchase agreementwill fluctuate based on the price of our common stock. Fusion Capital may sellnone, some or all of the shares of common stock purchased from us at any time. Dependingupon market liquidity at the time, a sale of shares by Fusion Capital at anygiven time could cause the trading price of our common stock to decline. Thesale of a substantial number of shares of our common stock by Fusion Capital,or anticipation of such sales, could make it more difficult for us to sellequity or equity-related securities in the future at a time and at a price thatwe might otherwise wish to effect sales. See also “Risks Related to Our CommonStock—We will likely need to issue additional shares of our common stock and/orpreferred stock in the future, which would dilute your voting and ownershippercentage.”

**Item2.**                     Properties.

We lease approximately41,500 square feet of office space in Lincolnshire, Illinois to conduct ourresearch, development, marketing and administrative functions. This lease wasinitiated September 1, 1996, with an expiration date of August 31,2006. In November 2004, we amended the lease with an extension in the termof the lease to December 31, 2011. In December 2005, we abandonedapproximately 10,000 square feet of the office space which we lease inLincolnshire, Illinois in conjunction with the reduction of our work force. On December 29,2005, we entered into an agreement with a third party to market this vacantoffice space. In addition, we lease approximately 1,305 square feet of space inStone, United Kingdom to store component parts and perform maintenance andrepairs on the PHD System.

We believe that ourpresent facilities are adequate for our operations. At present, allmanufacturing has been contracted out to third party subcontractors.

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**Item 3.**                        LegalProceedings.

In July 2004, analleged short-seller of Aksys stock filed a lawsuit against the Durus fund andus in the Federal District for the State of Connecticut (*Collier v. Aksys, Ltd. et al., District ofConnecticut, Civil Action No. 3:04-CV-01232*). Thelawsuit is a purported class action filed on behalf of all short-sellers ofAksys stock during the period of January 1, 2003 through July 24,2003.  Aksys was voluntarily dismissed asa party from this case and was not named as a defendant in the plaintiff’ssubsequent amended complaint. In late 2005, the United States District Court inConnecticut dismissed Collier’s claims as to all parties. Collier has filed anappeal with the United States Court of Appeals for the Second Circuit. Aksys isnot a party to those proceedings.

**Item 4.**                        Submissionof Matters to a Vote of Security-Holders.

There were no matterssubmitted for a vote of our stockholders during the quarter ended December 31,2005.

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**PART II**

**Item 5.**                        Marketfor the Registrant’s Common Stock and Related Stockholder Matters

The Company’s common stockwas listed on the Nasdaq National Market****underthe symbol “AKSY” until February 14, 2006, when the Company’s stock begantrading on the Nasdaq Capital Market under the same symbol. The following tablelists the quarterly high and low closing prices of the common stock for theperiod from January 1, 2004 through December 31, 2005.

| **Fiscal  Year** | ** ** | ** ** | ** ** | **Fiscal  Quarter** | ** ** | **High Price** | ** ** | **Low Price** | ** ** |
|------------------|------------|------------|------------|---------------------|------------|---------------------|------------|--------------------|------------|
| 2005             |       |       | 1st        |                |       |                | $          | 5.45               |       |   |   | $ | 3.17 |   |   |
|             |       |       | 2nd        |                |       |                | 3.38       |               |       |   | 1.99 |   |   |
|             |       |       | 3rd        |                |       |                | 2.54       |               |       |   | 1.92 |   |   |
|             |       |       | 4th        |                |       |                | 2.20       |               |       |   | 0.58 |   |   |
| 2004             |       |       | 1st        |                |       |                | $          | 10.97              |       |   |   | $ | 6.12 |   |   |
|             |       |       | 2nd        |                |       |                | 6.99       |               |       |   | 4.40 |   |   |
|             |       |       | 3rd        |                |       |                | 6.23       |               |       |   | 4.56 |   |   |
|             |       |       | 4th        |                |       |                | 6.93       |               |       |   | 4.69 |   |   |

 

There were 208stockholders of record of our common stock as of March 20, 2006. In addition,we estimate that there were approximately 5,500 holders of our common stock at March 20,2006, who held shares in “street name.” We have not paid cash dividends to date, and management anticipates thatall future earnings will be retained for development of our business.

**Equity CompensationPlan Information**

The following table setsforth information about the Company’s common stock that may be issued under allof the Company’s existing equity compensation plans as of December 31,2005, including the 1993 Stock Option Plan, the 1996 Stock Awards Plan and the2001 Employee Stock Purchase Plan.

| ** **                                                  | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                             | ** ** | **(c)**                                                                                                        | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants or rights** | ** ** | **Weighted-average**

**exercise price of  outstanding options,  warrants or rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))** | ** ** |
| Equity compensation  plans approved by security holders     |       |       | 3,188,602  |                                                                                                                                                |       |                                                                                                           | $          | 6.38 |   |   |   | 751,797 |   |   |
| Equity compensation  plans not approved by security holders |       |       | 150,000    |                                                                                                                                                |       |                                                                                                           | 4.65       |   |   |   | —- |   |   |
| **Total**                                                   |       |       | 3,338,602  |                                                                                                                                                |       |                                                                                                           | $          | 6.30 |   |   |   | 751,797 |   |   |
|                                                             |            |            |            |                                                                                                                                                     |            |                                                                                                                |            |  |  |  |  |  |  |  |  |  |

                                                                                        

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**Item6.****                        SelectedFinancial Data.**

The selected consolidatedstatement of operations data for the years ended  December 31, 2005, 2004 and 2003 andconsolidated balance sheet data as of December 31, 2005 and 2004 set forthbelow have been derived from our audited consolidated financial statementsincluded as Item 8 to this Annual Report on Form 10-K. The selectedconsolidated statement of operations data as of December 31, 2002 and 2001and consolidated balance sheet data as of December 31, 2003, 2002 and 2001set forth below have been derived from our audited consolidated financialstatements that have not been included in this Annual Report on Form 10-K.Our historical financial data is not necessarily indicative of future resultsand should be read in conjunction with the consolidated financial statementsand notes thereto and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included elsewhere in this Annual Reporton Form 10-K.

| ** **                                     | ** ** | **Year ended December 31,** | ** **  |
|------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                     | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** | **2002(1)** | ** ** | **2001** | ** ** |
| **Consolidated Statement of Operations Data:** | ** ** | ** **                                 | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                       |       |                                       |        |   |   |   |   |   |   |   |   |
| Product sales                                  |       | $                                          | 516,666     |   | $ | 1,071,738 |   | $ | 1,075,696 |   | $ | 275,000 |   | $ | — |   |
| Product rentals                                |       | 705,809                                    |        | 385,966 |   | 117,010 |   | 1,680 |   | — |   |
| Service and  supplies                          |       | 1,446,514                                  |        | 958,355 |   | 298,757 |   | 21,986 |   | — |   |
| Total revenue                                  |       | 2,668,989                                  |        | 2,416,059 |   | 1,491,463 |   | 298,666 |   | — |   |
| Cost of sales:                                 |       |                                       |        |   |   |   |   |   |   |   |   |
| Product sales                                  |       | 5,715,535                                  |        | 4,313,855 |   | 4,239,091 |   | 1,995,320 |   | — |   |
| Product rentals                                |       | 2,529,478                                  |        | 481,326 |   | 110,000 |   | 1,334 |   | — |   |
| Service and  supplies                          |       | 6,680,065                                  |        | 5,867,759 |   | 3,343,102 |   | 774,274 |   | — |   |
| Total cost of  sales                           |       | 14,925,078                                 |        | 10,662,940 |   | 7,692,193 |   | 2,770,928 |   | — |   |
| Operating expenses:                            |       |                                       |        |   |   |   |   |   |   |   |   |
| Research and development                       |       | 8,068,829                                  |        | 6,684,465 |   | 5,474,220 |   | 5,522,772 |   | 10,882,796 |   |
| Sales and marketing                            |       | 4,532,240                                  |        | 4,791,684 |   | 4,188,939 |   | 2,305,110 |   | 1,753,499 |   |
| General and  administrative                    |       | 8,047,843                                  |        | 7,388,863 |   | 6,676,665 |   | 5,699,356 |   | 5,121,223 |   |
| Restructuring charges                          |       | 161,453                                    |        | — |   | — |   | — |   | — |   |
| Total operating  expenses                      |       | 20,810,365                                 |        | 18,865,012 |   | 16,339,824 |   | 13,527,238 |   | 17,757,518 |   |
| Operating loss                                 |       | (33,066,454                                | )           | (27,111,893 | ) | (22,540,554 | ) | (15,999,500 | ) | (17,757,518 | ) |
| Other income and  expense, net                 |       | (1,113,676                                 | )           | (466,084 | ) | 258,076 |   | 294,956 |   | 515,892 |   |
| Income tax expense                             |       | (17,800                                    | )           | (105,512 | ) | — |   | — |   | — |   |
| Net loss                                       |       | $                                          | (34,197,930 | ) | $ | (27,683,489 | ) | $ | (22,282,478 | ) | $ | (15,704,544 | ) | $ | (17,241,626 | ) |
| Net loss per share(2)                          |       | $                                          | (1.14       | ) | $ | (0.93 | ) | $ | (0.79 | ) | $ | (0.65 | ) | $ | (0.94 | ) |
| Weighted average  shares outstanding(2)        |       | 29,932,705                                 |        | 29,825,659 |   | 28,218,819 |   | 24,301,029 |   | 18,418,410 |   |

 

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| ** **                                         | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Consolidated Balance Sheet Data:**               | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash  equivalents and short-term investments |       | $                                     | 534,954    |   | $ | 31,116,769 |   | $ | 20,175,097 |   | $ | 11,509,757 |   | $ | 11,249,935 |   |
| Working capital                                    |       | 6,031,352                             |       | 32,611,166 |   | 20,392,362 |   | 11,872,340 |   | 10,548,397 |   |
| Total assets                                       |       | 19,155,947                            |       | 52,945,441 |   | 29,638,151 |   | 16,509,492 |   | 14,454,503 |   |
| Long-term  liabilities(3)                          |       | 15,337,848                            |       | 13,754,784 |   | 177,253 |   | 147,644 |   | 159,061 |   |
| Accumulated  deficit                               |       | (190,810,419                          | )          | (156,612,489 | ) | (128,929,000 | ) | (106,646,522 | ) | (90,941,978 | ) |
| Total  stockholders’ equity (deficit)         |       | (3,304,723                            | )          | 31,007,431 |   | 23,128,062 |   | 13,647,629 |   | 12,603,629 |   |
|                                                    |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)           The Company commenced commercial activities during thequarter ended September 30, 2002 and was no longer considered to be in thedevelopment stage as of that date.

(2)           Computed on the basis described in Note 1 of Notes toConsolidated Financial Statements.

(3)           Consists primarily of long term notes payable.

**You should read the followingdiscussion together with the consolidated financials statements and relatednotes appearing elsewhere in this annual report. This discussion containsforward-looking statements that involve risks and uncertainties. Actual resultsmay differ materially from those included in such forward-looking statements. See“Notes on Forward-Looking Information”.**

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

**Overview**

We were founded in January 1991to providehemodialysis products and services for patients suffering from ESRD. We havedeveloped an automated personal hemodialysis system, known as the Aksys PHDTMPersonal Hemodialysis System, which is designed to enable patients to performfrequent hemodialysis at alternate sites (such as their own homes) and tothereby improve clinical outcomes, reduce total ESRD treatment costs andenhance the quality of life of patients. During the quarter ended September 30,2002, we commenced commercial activities and were no longer considered to be inthe development stage. We have not been profitable since we commencedoperations and we expect to incur additional losses for the foreseeable future.

On March 27, 2002, we announced receipt of FDAclearance to market the PHD System in the United States. The FDA clearance hadno restrictions and included authorization to use the product in the home. TheFDA required 510(k) clearance prior to the commercialization of the PHDSystem in the United States.

On October 7, 2002, we announced receipt of ECCertification for CE Mark approval pursuant to the Medical Device Directive ofthe European Economic Area. The certification approved the PHD System for homeuse. Such approval was required prior to the commercialization of the PHDSystem in the European Economic Area.

During 2004 and 2005, we were pursuing a number ofinitiatives designed to help attract new patients, reduce manufacturing costs,improve machine performance and reduce service costs. During this period, weincreased the size of our sales team and started several programs to attractclinics and patients. Significant resources were also being devoted toimproving machine performance, with the goal of reducing the frequency ofservice calls and reducing service costs.

On December 6, 2005, we announced a plan torealign our service network by designating geographic operating districts whichhave shown the highest adoption rates for the PHD System. The plan includesseveral operational changes designed to significantly reduce our cash burn rateand provide a more focused resource allocation. We are focusing our sales andservicing efforts on these target markets. While our decision to realign ouroperating model through the designation of various PHD Operating Districts maystrengthen our relationships with patients and clinics within designated areas,it may adversely affect our relationships outside of those areas.

Our ability to add new clinics and patients isaffected by several factors, such as the number of new patients a particularclinic can service, the status of that clinic’s home certification and thelength of time required to train nurses and patients. These factors influencethe pace at which we can add additional clinics and patients.

In addition to patient outcome, clinics considerreimbursement options when deciding whether or not to implement a home program.Effective January 1, 2005, the Medicare composite rate for a dialysistreatment increased 1.6%. The actual amount varies by geography. The compositepayment rates now also include a drug add-on adjustment, rather than a separatereimbursement rate for drug usage. In addition, effective April 1, 2005,each ESRD facility’s rate is case-mix adjusted based on certain patientcharacteristics. Effective January 1, 2006, the base composite paymentrates were increased to $130.40 for independent ESRD facilities and $134.53 forhospital-based ESRD facilities. The drug add-on adjustment for 2006 is 14.5percent. The changes to Medicare reimbursement should improve the economics ofthe PHD System for clinics and could influence their decision to use the PHDSystem. Further changes in reimbursement are also under consideration by thegovernment, including the possible bundling of reimbursement for dialysistreatment, drugs and lab tests into a composite rate. We believe that these 

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changes may furtherimprove economics of the PHD System for clinics, but at this time the substanceand timing of any such changes are uncertain.

Service and supplies revenue and cost during the yearended December 31, 2005, directly relate to the number of PHD Systems inuse. As of December 31, 2005, there were 179 patients on the PHD System. Serviceand supplies revenue is contracted under a separate agreement with a dialysiscenter at an established monthly amount, which is not dependent on service timeincurred or materials used. Supplies, such as blood tubing sets, dialyzers andacid and bicarbonate preparations, are required to perform dialysis treatments.Service on the PHD System is for scheduled and unscheduled maintenance andrepairs, and is provided by our service technicians.

Aksys has programs with eight of the top ten dialysisproviders in the United States, and an increasing number of doctors and clinicadministrators are interested in home treatment programs. One trend we arewatching in our industry, however, is the consolidation of major providers.Ownership of dialysis clinics in the United States is highly concentrated andis expected to become further concentrated in the near future. Giving effect toDaVita’s acquisition of Gambro’s dialysis business and Fresenius’ acquisitionof Renal Care Group’s dialysis business, DaVita and Fresenius will controlapproximately 28% and 35% of the United States dialysis clinics, respectively. Eachof Fresenius and DaVita may choose to offer to patients in their dialysisclinics only the dialysis equipment manufactured by them or their affiliates orby competitors of Aksys with whom DaVita or Fresenius may have contractualrelationships. Aksys’ ability to market the PHD System to a significantpercentage of the dialysis clinics will depend on its ability to develop andmaintain relationships with one or both of these companies.

Our largest customers,DaVita, the Dialysis Centers of Lincoln and Northwest Kidney Center accountedfor 16%, 11% and 8%, respectively, of our revenues for the year ended December 31,2005. For the year ended December 31, 2004, our largest customers,Northwest Kidney Center, Dialysis Centers of Lincoln and Berkshire MedicalCenter accounted for 24%, 10% and 9%, respectively, of our revenues (by dollarvolume).

**Critical AccountingPolicies and Estimates**

The preparation offinancial statements requires management to make estimates and assumptions thataffect amounts reported therein. We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements:

*Revenue Recognition*

We recognize revenue in accordance with SEC StaffAccounting Bulletin (SAB) No. 101, *Revenue Recognition inFinancial Statements*, as amended by SAB No. 104, *Revenue Recognition*. Revenue is recognized when the followingconditions exist: (1) there is persuasive evidence of an arrangement, (2) theproduct has been delivered and accepted or services and supplies have beenprovided to the customer, (3) the sales price is fixed or determinable and(4) collectability is reasonably assured.

In accordance with Emerging Issues Task Force (EITF)Issue No. 00-21, *Accounting forRevenue Arrangements with Multiple Deliverables*, in arrangementswhere the Company charges a single monthly amount for the PHD System andservice and supplies, revenue is allocated to each element based on the fairvalue of the element. The revenue allocated to each element is recognizedseparately, as it is earned, in accordance with SAB 104.

We recognize revenue from product sales when the PHDSystem has been installed and a patient has started training. Services andsupplies are sold to customers in a monthly service agreement. Services andsupplies revenue is recognized uniformly over the term of the agreement andsuch revenue is not dependent on service time incurred or materials used.

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We also lease the PHDSystem to customers on a short-term basis (12 months or less) and long-termbasis (up to 24 months) and recognize revenue on these operating systemcontracts on a straight-line basis over the lease term. We have no contractswith distributors and sell our product directly to our customers through ourown sales force.

*Accrued Liabilitiesand Contingencies*

We are required to makecertain estimates and assumptions that affect the amounts recorded as accruedliabilities and contingencies. We base our estimates on historical experienceand on various other factors, such as changing business conditions andmanagement expectations that we believe to be reasonable to determine theamount of accrued liabilities and contingencies to be recorded. If actualresults differ from these estimates, additional expenses might be recorded.

*Product Warranty*

We provide maintenance aspart of our service and supplies agreements with customers. When circumstancesare identified whereby the scope of service to the machine extends beyond thenormal cost of service and supply contracts, we perform a specific analysis todetermine the extent of service required. We record a loss to cost of salesonce the excess cost is probable and estimable.

*Deferred Tax AssetValuation*

We record our net deferredtax assets in the amount that we expect to realize based on projected futuretaxable income. In assessing the appropriateness of our valuation, assumptionsand estimates are required such as our ability to generate future taxableincome. In the event that we were to determine that we would be able to realizedeferred tax assets in the future in excess of our net recorded amount, anadjustment to the deferred tax asset would increase our income in the periodsuch determination was made.  Given ourhistorical losses and uncertainty with respect to our ability to generatetaxable income, we have established a full valuation allowance at December 31,2005 and 2004 to reduce the deferred tax assets to zero.

*Valuation ofInventories*

Inventories are stated atthe lower of weighted average cost or market. The weighted average cost ofinventory approximates the first-in, first-out method (FIFO) for allinventories. The medical devices industry is characterized by rapid developmentand technological advances that could result in obsolescence of inventory. Managementperforms periodic assessments to determine the existence of obsolete inventoryor to determine if there has been a decline in the market value of inventory,and records necessary provisions to reduce such inventory to the net realizablevalue.

*Impairment ofLong-Lived Assets*

We account for long-livedassets in accordance with SFAS No. 144, *Accountingfor the Impairment of Long-Lived Assets*. In accordance withStatement 144, long lived assets, such as property, plant and equipment, arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to estimated undiscounted future cash flows expected to begenerated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds the fair value of the asset.Assets to be disposed of would be separately presented in the consolidatedbalance sheet and reported at the lower of the carrying amount or fair valueless costs to sell, 

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andwould no longer be depreciated. The assets and liabilities of a disposed groupclassified as held for sale would be presented separately in the appropriateasset and liability sections of the balance sheet.

**Contractual Obligations**

Thefollowing table reflects a summary of our contractual cash obligations as of December 31,2005:

| **Contractual Cash Obligations** | ** ** | ** ** | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More Than  5 Years** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Long-Term Debt                             |       | $          | 16,100,000 |      | $          | 0                               |       | $                  | 16,100,000 |               | $          | 0                                |       |   | $ | 0 |   |   |
| Operating Leases                           |       | 3,762,267  |       | 603,043   |       | 1,169,932                       |       | 1,288,153          |       |               | 701,139    |                             |       |
| Royalties                                  |       | 1,525,588  |       | 250,000   |       | 500,000                         |       | 500,000            |       |               | 275,588    |                             |       |
| Purchase Obligations                       |       | 4,202,888  |       | 4,202,888 |       | 0                               |       | 0                  |       |               | 0          |                             |       |
| **Total  Contractual Cash Obligations**    |       | $          | 25,590,743 |      | $          | 5,055,931                       |       | $                  | 17,769,932 |               | $          | 1,788,153                        |       |   | $ | 976,727 |   |   |

 

We have a contractual obligation with the manufacturerof the PHD Systems to purchase additional parts at a total cost ofapproximately $3,603,000. We have placed a deposit with the vendor of $1,432,000as of December 31, 2005. In the fourth quarter of 2005, we recorded areserve to this deposit to reflect the uncertainty associated with this vendor’svoluntary petition for business reorganization under Chapter 11 of theU.S. Bankruptcy Code that was filed by this vendor in October 2005;however, we are pursuing the full amount of the deposit.

We have a research anddevelopment contract with a 90 day termination notice. Payments during the 90days will not exceed the average of the previous three months’ payments. Paymentsunder this contract were $200,000 for each month of the fourth quarter of 2005;therefore, the maximum 90 day obligation is $600,000.

**Off-Balance SheetArrangements**

We do not have anyoff-balance sheet arrangements, as such term is defined in applicableSecurities and Exchange Commission rules, that have or are reasonably likely tohave a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

**Results ofOperations**

***YearEnded December 31, 2005 Compared to Year Ended December 31, 2004***

Net loss for the year ended December 31, 2005 was$34,198,000 ($1.14 per share), compared with $27,683,000 ($0.93 per share), forthe year ended December 31, 2004. The factors contributing to theincreases in net loss are discussed below.

Our cost to manufacture the PHD system exceeds itsselling price, and our cost to service and supply active machines on a per-unitbasis exceeds the per-unit revenue generated by those machines. The first fullyear in which we recorded sales was 2003. As volumes increased from sevenactive machines at year-end 2002, to 179 active machines at year-end 2005, ournet loss has also increased. We expect to rely primarily on reductions in theproduction and service costs of the PHD System in order to realize a positivegross margin on sales. We expect to reduce our service costs by controlling thegeographic dispersion of our machines. This will require our servicetechnicians to travel less and be more efficient. We completed cost reductionsto the PHD System in late 2003 that reduced the cost of the machine byapproximately 25%. We continue to work diligently to achieve manufacturing andservice cost reductions on the PHD System. However, these cost reduction plansand efforts may not be successful, and we may not be able to achieve a positivegross margin on product sales or service of the PHD System in the future.

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Additional details as to our financial performance arediscussed below.

***Clinic PartnershipAgreements***   We added 10 clinic partnershipagreements in the year ended December 31, 2005, bringing the total numberof signed partnership agreements to 54. The activity level under our agreementsvaries from clinic to clinic and may decrease or stop at clinics outside of ourdesignated PHD Operating Districts. Some agreements are associated withmultiple clinics and have several patients using the PHD System. Conversely,some of our agreements may not be associated with any patients because they arenew and are beginning to develop the patient base, while other agreements maybe inactive. We consider an agreement to be inactive if there have not been anypatients for six months and we do not foresee adding any patients in the nearfuture. A typical agreement provides for an initial market assessment andallows a clinic to purchase or lease on a long-term basis multiple units overtime, with the option to purchase service and supplies at an additional charge.A customer may also enter into a short-term rental agreement. In order toqualify for Medicare reimbursement, the customer must become home certified. Weprovide training to the nurses in the clinics where the patients’ nephrologistis located. The nurses at the clinic then provide training to patients. Ourtechnicians and nurse educators are available for consultation during patienttraining.

***Revenue***   A summaryof revenue is presented in the following table.

| ** **            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|-----------------------|------------|-----------------------------|------------|-----------------------------|------------|-------------------|------------|-------------------|------------|
| Product—sales    |       |                        | $          | 516,000                     |       |              |       | $                 | 1,072,000  |   |   | $ | (556,000 | ) |   | (52 | )% |   |
| Product—rentals  |       |                        | 706,000    |                        |       |              | 386,000    |              |       | 320,000 |   |   | 83 | % |   |
| Service and  supplies |       |                        | 1,447,000  |                        |       |              | 958,000    |              |       | 489,000 |   |   | 51 | % |   |
| Total revenue         |       |                        | $          | 2,669,000                   |       |              |       | $                 | 2,416,000  |   |   | $ | 253,000 |   |   | 10 | % |   |

 

For the year ended December 31, 2005, revenue was$2,669,000, a 10% or $253,000 increase from revenue of $2,416,000 for the yearended December 31, 2004. Revenue generated from sales of the PHD Systemwas $516,000 for the year ended December 31, 2005, a decrease of $556,000or 52% from $1,072,000 for the year ended December 31, 2004. Revenue fromunits sold in 2005 in the United States and United Kingdom was $396,000and $120,000, respectively. Revenue from units sold in 2004 in the UnitedStates and United Kingdom was $797,000 and $275,000, respectively. While therehave been no material changes to our sales price per unit, the number of unitssold varies greatly from quarter to quarter as we are still in the earlycommercialization stages of the PHD System. While we have continued toincrease our customer base, increased competition in the home hemodialysismarket contributed to the increase in rentals and decrease in sales of ourmachine. In an effort to gain market acceptance of our relatively new product,we allow customers to rent the PHD System. Rentals are made pursuant toshort-term and long-term operating leases. We maintain ownership of the unitsand classify them as leased assets. Depreciation expense is recorded monthly.The expectation is that over time some of these rentals may convert to sales.Rental revenue for the year ended December 31, 2005 was $706,000, anincrease of $320,000 or 83% from $386,000 for the year ended December 31,2004. In 2005, we recognized revenue from operating leases of $698,000 in theUnited States and $8,000 in the United Kingdom. In 2004, werecognized rental revenue from operating leases of $379,000 in the UnitedStates and $7,000 in the United Kingdom

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Product revenue from units sold is recorded when thePHD System has been installed and a patient has started training whereas rentalrevenue from operating leases is recognized over the duration of the lease,starting when the machine is installed and the patient starts training. As aresult, changes in the number of units sold will have a more significant impacton revenue than changes in the number of rental units. We will continue toextend renting as an option to our customers as we continue to work to increasemarket acceptance of our product.

While there has been nomaterial change to our monthly rental price over the past two years, rentalrevenue and service and supplies revenue have increased as our patient base hascontinued to grow. Service and supply revenue is generated from patientutilization of each machine we have sold or rented.  The following table shows patient growth byquarter.

| **Date**                 | ** ** | ** ** | ** ** | **Number of Patients** | ** ** |
|--------------------------|------------|------------|------------|----------------------------------|------------|
| December 31,  2003  |       |       | 67         |                             |       |
| March 31,  2004     |       |       | 77         |                             |       |
| June 30,  2004      |       |       | 82         |                             |       |
| September 30,  2004 |       |       | 106        |                             |       |
| December 31,  2004  |       |       | 121        |                             |       |
| March 31,  2005     |       |       | 126        |                             |       |
| June 30,  2005      |       |       | 149        |                             |       |
| September 30,  2005 |       |       | 163        |                             |       |
| December 31, 2005   |       |       | 179        |                             |       |

 

The number of patients using the PHD System reflectedin the table above includes patients using the PHD System as a result of eithera sale or a rental transaction. Sales were made pursuant to an agreement with athird party leasing provider who leases directly to the dialysis provider, ormade directly by Aksys to the customer.

Our largest customers, DaVita, the Dialysis Centers ofLincoln and Northwest Kidney Center accounted for 16%, 11% and 8%,respectively, of our revenues (by dollar volume) for fiscal year 2005. In thefourth quarter of 2005, we determined that our cost structure exceeded thelevel required by our current near-term revenue opportunities. The coststructure for production of the PHD System exceeded and continues to exceed itsmarket price. Additionally, the continued uncertainty related to adequatethird-party reimbursements for dialysis treatment, especially from Medicare andMedicaid, caused us to re-evaluate our near-term growth opportunity and alignour cost structure accordingly. As a result, on December 6, 2005 weannounced a plan to realign our service network by designating geographicoperating districts which have shown the highest adoption rates for the PHDSystem. The plan includes several operational changes designed to significantlyreduce our cash burn rate and provide a more focused resource allocation. Weare focusing our sales and servicing efforts on these target markets. While ourdecision to realign our operating model through the designation of various PHDOperating Districts may strengthen our relationships with patients and clinicswithin designated areas, it may adversely affect our relationships outside ofthose areas.

Service and supplies sold directly relate to the PHDSystems in use. Service and supply revenue is contracted under a separateagreement with a dialysis center at an established monthly amount, or sold asindividually priced items. Supplies, such as blood tubing sets, dialyzers andacid and bicarbonate preparations, are required to perform dialysis treatments.Service on the PHD System is for scheduled and unscheduled maintenance andrepairs, and is provided by our service technicians. Service and suppliesrevenue totaled $1,447,000 in 2005, an increase of $489,000, or 51%, from$958,000 in 2004. The increase in revenue is attributed to the growth inproduct placement and service and supply agreements. Service and suppliesrevenue in the United States and United Kingdom for the year ended December 31,2005, 

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was $1,283,000 and$164,000, respectively. For the year ended December 31, 2004, service andsupplies revenue in the United States and United Kingdom was $851,000 and$107,000, respectively.

We are not dependent upon reimbursement from insuranceproviders as a source of revenue. Rather, we generate revenue fromdialysis centers, which provide dialysis services through the use of the PHDSystem. The dialysis center is reimbursed on a per treatment basis by theinsurance provider. Accordingly, reimbursement rates may influence customers’demand for our product and our pricing of the PHD System and relatedsupplies and service.

***Cost of sales*****  **A summary of cost of sales is presented in thefollowing table.

| ** **            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|-----------------------|------------|-----------------------------|------------|-----------------------------|------------|-------------------|------------|-------------------|------------|
| Product—sales    |       | $                           | 5,716,000  |                        | $          | 4,314,000         |       | $                 | 1,402,000  |   |   | 32 | % |   |
| Product—rentals  |       | 2,529,000                   |       | 481,000                     |       | 2,048,000         |       |              | 426        | % |   |
| Service and  supplies |       | 6,680,000                   |       | 5,868,000                   |       | 812,000           |       |              | 14         | % |   |
| Total cost of sales   |       | $                           | 14,925,000 |                        | $          | 10,663,000        |       | $                 | 4,262,000  |   |   | 40 | % |   |

 

Total cost of sales for fiscal 2005 was $14,925,000compared to $10,663,000 in fiscal 2004, an increase of $4,262,000 or 40%.

*Productsales cost of sales*   Product sales cost of saleswas $5,716,000 for the year ended December 31, 2005, an increase of$1,402,000 or 32% from $4,314,000 for the year ended December 31, 2004. During2005, we increased our product warranty reserve by $1,261,000 and increased thereserve for obsolete parts purchased by the manufacturer of the PHD system by$1,038,000. In 2004, we recorded warranty expense of $652,000 to replace acertain component part. Also in 2004, we recorded an expense for obsoleteinventory of $201,000. The net increase in expense for warranty and obsoleteinventory in 2005 was $1,446,000. Additionally, we recorded a reserve todeposits with vendors in the fourth quarter of 2005 to reflect the uncertaintyassociated with the bankruptcy petition filed by a specific vendor; however, weare pursuing the full value of the deposit. The PHD System is manufactured byDelphi. On October 8, 2005, Delphi and its parent corporation filed avoluntary petition for business reorganization under Chapter 11 of theU.S. Bankruptcy Code. The ultimate effect of the bankruptcy on our relationshipwith Delphi is unclear. We have a Uniform Commercial Code financing statementon file with the Colorado Secretary of State with respect to certain partsinventory that is located at Delphi’s warehouses. We have had ongoingdiscussions with Delphi regarding our accounts payable balance to them, ourcash deposit and certain parts inventory located at Delphi’s warehouses. In thefirst quarter of 2006, we received correspondence from Delphi advising us oftheir decision to stop further shipments of PHD Systems and parts until theseitems have been resolved. We plan to continue our discussions with Delphi andbelieve that we have a sufficient inventory of parts and machines on hand toenable us to continue operations pending resolution of this matter. If Delphirejects our manufacturing agreement in connection with its bankruptcyproceeding or we are unable to resolve our open issues with Delphi on a timelybasis, we would be forced to establish new manufacturing and/or parts sourcingrelationships which could expose us to a number of risks and uncertainties.

These increases to product sales cost of sales arepartially offset by a decrease in the inventory adjustment to value the PHDmachines produced and purchased at the lower of cost or market of $237,000 from$568,000 recorded in 2004 to $331,000 recorded in 2005. The cost of producingthe PHD System is currently in excess of its market price. We expect to relyprimarily on reductions in the production costs of the PHD System in order torealize a positive gross margin on sales of the PHD System. In addition, thecost of units sold to customers decreased by $637,000, proportionate to thedecrease in revenue from units sold.

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*Productrentals cost of sales**  *Productrentals cost of sales was $2,529,000 for the year ended December 31, 2005,an increase of $2,048,000 or 426% from $481,000 for the year ended December 31,2004. During the first quarter of 2005, we made a decision to replace certainolder machines in leased assets with newer models. The previous useful lifeestimate has been revised for these machines. An impairment charge of$1,370,000 was recorded in 2005 to product rentals cost of sales to adjust thecarrying amount of these rental machines to fair value. In addition,depreciation expense increased because of an increase in the number of machineswithin leased assets. Depreciation expense increased by $416,000 or 114%,from $364,000 for 2004 to $780,000 for 2005.

*Serviceand supplies**  *Serviceand supplies costs for year ended December 31, 2005 were $6,680,000, anincrease of $812,000 or 14% from $5,868,000 for the year ended December 31,2004. Service and supplies costs have increased compared to 2004 because ofadditional patients using the PHD system. The increase primarily relates toincreases in field service personnel to service PHD machines and in theclinical support staff necessary to train the customers’ nursing staff. Personnelcosts for the year ended December 31, 2005 were $3,617,000, an increase of$636,000 or 21% from $2,981,000 for the year ended December 31, 2004. Inaddition, the cost of consumable supplies increased with additional units inservice. The cost of supplies was $998,000 in 2005, an increase of $533,000 or115% from $465,000 in 2004. Additionally, we recorded a reserve of $118,000 in2005 for estimated obsolescence of replacement parts in inventory. These 2005increases were offset partially by a decrease in scrap of $310,000, a decreasein parts used of $122,000, from $1,351,000 in 2004 to $1,228,000 in 2005, and adecrease in spending for manufacturing support of $104,000, from $414,000 in2004 to $309,000 in 2005.

The cost of services and supplies is currently inexcess of their market price as local presence of field service personnel isrequired in each geographical area that PHD Systems are sold. We are beginningto focus our selling efforts in certain geographic areas to reduce travel timeand the number of technicians required to support the machines. We expect thatas PHD machines are placed in closer geographical proximity, the per-unit costof services will decrease. In addition, we are working to improve theperformance of our machines. As performance improves, we expect that fewerservice calls will be required which should further reduce the per-unit cost ofservice. Performance of our machine, however, may not improve. If performanceof our machine does not improve, we may not be able to reduce the per-unit costof service.

We continue to work diligently to achievemanufacturing and service cost reductions; however, we cannot be certain thatsuch cost reduction plans or efforts will be successful, or that we will beable to achieve a positive gross margin on sales or service of the PHD Systemin the future.

***Operating expenses***   Operatingexpenses for the year ended December 31, 2005 were $20,810,000, anincrease of $1,945,000 or 10%, from $18,865,000 for the year endedDecember 31, 2004. Fluctuations in each specific area are discussed below.

*Researchand development expenses*   For the year endedDecember 31, 2005, research and development expenses were $8,069,000, anincrease of $1,385,000 or 21% from $6,684,000 for the year endedDecember 31, 2004. The increase was primarily due to costs associated withadvancing PHD performance and new product development.

*Salesand marketing expenses*   For the year endedDecember 31, 2005, sales and marketing expenses were $4,532,000, adecrease of $260,000 or 5% from $4,792,000 for the year ended December 31,2004. The decrease was due primarily to a reduction in spending for marketingpromotions and a decrease in personnel expenses. These decreases were offsetpartially by increases in marketing-related consulting, travel, convention andother project expenses.

General and administrative expenses   For the yearended December 31, 2005, general and administrative expenses were$8,048,000, an increase of $659,000 or 9% from $7,389,000 for the year 

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ended December 31, 2004. The increase is due toincreases in contract labor for information technology, recruiting andprofessional fees, and facilities expenses. Facilities expenses increasedcompared to 2004 because in 2004 we re-negotiated the lease for our officespace. We had previously recorded a liability to straight-line the future rentpayments. When we signed the new lease we recognized the remaining balance ofthe deferred rent, $88,000.

*Restructuringcharges*   In the fourth quarter of 2005, werecorded restructuring charges of $161,000, consisting of employee severancepayments. We executed a reduction in force, eliminating 44 positions across allareas of the Company. We paid $125,000 of the severance payments in the fourthquarter of 2005 and the remaining $36,000 during the first quarter of 2006. Wedid not record a restructuring charge during 2004.

***Other income andexpense***   For the year ended December 31,2005, other net expense increased by $648,000 or 139% to a net expense of$1,114,000 from a net expense of $466,000 in the prior year. The increase innet expense is due primarily to the recognized loss on available-for-salesecurities of $335,000 during 2005, as well as an increase in interest on notespayable and the line of credit during 2005. The increase in net expense isoffset partially by higher interest income on investment securities due tohigher yields in 2005 and the investments being held for nearly 12 months in2005, as compared to five months in 2004.

*Income tax expense*   Incometax expense for the year ended December 31, 2005 decreased by $88,000 to$18,000, from $106,000 in the prior year. The tax expense recorded in the thirdquarter of 2005 and 2004 relates to AMT tax paid because of the taxable incomegenerated from the settlement with the Durus fund in 2004.

**Results ofOperations**

***YearEnded December 31, 2004 Compared to Year Ended December 31, 2003***

Net loss for the year ended December 31, 2004 was$27,683,000 ($0.93 per share), compared with $22,282,000 ($0.79 per share), forthe year ended December 31, 2003.

***Revenue***   Forthe year ended December 31, 2004, revenue was $2,416,000, a 62% increasefrom revenue of $1,491,000 for the year ended December 31, 2003. Revenuegenerated from sales of the PHD System remained flat from year to year,with $1,072,000 and $1,076,000 recorded in 2004 and 2003, respectively. Thenumber of units sold varies greatly from quarter to quarter as we are still inthe early commercialization stages of the PHD System. In an effort to gainmarket acceptance of our relatively new product, we allow customers to rent thePHD System. Rental revenue for the year ended December 31, 2004 was$386,000, an increase of $269,000 or 230% from $117,000 for the year ended December 31,2003.

Revenue from product sales recorded in fiscal 2004 was$797,000 for PHD Systems sold in the United States and $275,000 for PHDSystems sold in the United Kingdom. In fiscal 2003, revenue from productsales in the United States and United Kingdom was $993,000 and $83,000,respectively. The sales recorded were made directly with the dialysis provideror pursuant to an agreement with a third party leasing provider who leasesdirectly to the dialysis provider.

We also recognized revenue under short-term andlong-term operating leases in 2004 and 2003. We maintain ownership of the unitsand classify them as capital assets. Depreciation expense is recorded monthly.Revenue from product rentals in the United States and United Kingdom for theyear ended December 31, 2004 was $379,000 and $7,000, respectively. Forthe year ended December 31, 2003 revenue from product rentals in theUnited States was $117,000. There was no product rental revenue in the United Kingdomin 2003.

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Our largest customers, Northwest Kidney Center, theDialysis Centers of Lincoln and Berkshire Medical Center, accounted for 24%,10% and 9%, respectively of our revenues (by dollar volume) for fiscal year2004.

Service and supplies sold during fiscal 2004specifically relate to the PHD Systems in use. Service and supply revenue iscontracted under a separate agreement with a dialysis center at an establishedmonthly amount. Supplies, such as blood tubing sets, dialyzers and acid andbicarbonate preparations, are required to perform dialysis treatments. Serviceon the PHD System is for scheduled and unscheduled maintenance and repairs, andis provided by our service technicians 24 hours a day, seven days a week. Serviceand supplies revenue totaled $958,000 for fiscal 2004, an increase of $659,000,or 220%, from $299,000 in 2003. The increase in revenue is attributed to thegrowth in product placement and service and supply agreements. Service andsupplies revenue in the United States and United Kingdom for the year ended December 31,2004 was $851,000 and $107,000, respectively. For the year ended December 31,2003 service and supplies revenue in the United States and United Kingdom was$275,000 and $24,000, respectively.

Whilethere have been no material changes to our monthly rental price over the pasttwo years, rental revenue and service and supply revenue have increased as ourpatient base has continued to grow. The following table shows patient growth byquarter.

| **Date**                 | ** ** | ** ** | ** ** | **Number of Patients** | ** ** |
|--------------------------|------------|------------|------------|----------------------------------|------------|
| December 31,  2003  |       |       | 67         |                             |       |
| March 31,  2004     |       |       | 77         |                             |       |
| June 30,  2004      |       |       | 82         |                             |       |
| September 30,  2004 |       |       | 106        |                             |       |
| December 31, 2004   |       |       | 121        |                             |       |

 

We are not directly dependent upon reimbursement frominsurance providers as a source of revenue. Rather, we generate revenue fromdialysis centers, which provide dialysis services through the use of the PHDSystem. The dialysis center is reimbursed on a per treatment basis by theinsurance provider. Accordingly, reimbursement rates may influence customers’demand for our product and our pricing of the PHD System and related suppliesand service.

***Cost of sales***   Totalcost of sales for fiscal 2004 was $10,663,000 compared to $7,692,000 in fiscal2003, an increase of $2,971,000 or 39%. Product sales cost of sales for 2004remained relatively flat, with $4,314,000 recorded in 2004 compared to$4,239,000 recorded in 2003. Included in product sales cost of sales for 2004is an inventory adjustment in the amount of $568,000, in order to value the PHDmachines in inventory at the lower of cost or market. The 2003 inventory costadjustment was $1,431,000. The number of units manufactured decreased from 127in 2003 to 83 in 2004. During 2004, we determined that we had sufficientinventory on hand to meet demand and reduced production accordingly. Sixfinished machines that will be used in a future research study were expensed toproduct cost of sales in the quarter ended December 31, 2004 at a cost of$231,000. Other product cost of sales increased by $875,000 or 54% in 2004compared to 2003, to $2,498,000 from $1,623,000. A portion of the increase,$89,000, is due to potential obsolescence of parts purchased by themanufacturer of the PHD system. An additional $652,000 is due to a reserveestablished in the quarter ended December 31, 2004 for replacement ofmajor components of machines already produced. The remainder of the increase isdue to increases in freight and royalties. Product rental cost of salesconsisted of depreciation expense on rental machines, which increased to$481,000 for the year ended December 31, 2004 from $110,000 in 2003, anincrease of $371,000 or 337%. The increase is due to additional machines inuse.

Service and supplies costs were $5,868,000 in 2004, a$2,525,000 or 76% increase from $3,343,000 in 2003. The increase is due toadditional units in service during 2004 compared to 2003. The cost of consumablesupplies and replacement parts increases with additional units in service. Thecost of field 

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service personnel toinstall and service the PHD machines and for clinical support staff necessaryto train the customers’ nursing staff is also related to the number of units inservice. These personnel costs increased $1,096,000 during the year ended December 31,2004 compared to 2003. In addition, a $324,000 reserve for potentially obsoletesupplies was recorded during the year ended December 31, 2004.

*Researchand development expenses*   For the year ended December 31,2004, research and development expenses increased 22% to $6,684,000 from$5,474,000 million for the year ended December 31, 2003. The increaseof $1,210,000 in 2004 was primarily attributable to product enhancement andimprovement and new product development of the next generation of home dialysismachines.

*Salesand marketing expenses*   Sales and marketingexpenses increased 14% or $603,000, to $4,792,000 in 2004, from $4,189,000 in2003. The increase is attributable to personnel additions, advertising andmarketing promotions in 2004 associated with the scaling up of thecommercialization of the PHD System.

Advertising costs are expensed as incurred. Advertisingexpense for the years ended December 31, 2004 and 2003, was $720,000 and$608,000 and, respectively.

***Generaland administrative expenses***   For the year ended December 31, 2004, generaland administrative expenses increased $712,000 to $7,389,000, an 11% increasefrom $6,677,000 for the year ended December 31, 2003. The increase isprimarily a result of the costs incurred to comply with the Sarbanes-Oxley Actof 2002. We also experienced an increase in insurance expenses in 2004 ascompared to 2003.

*Interest income andexpense*   For the year ended December 31,2004, interest income was $664,000, an increase of $406,000 or 157% from$258,000 for the year ended December 31, 2003. The increase is due tohigher cash and investment balances in 2004 than 2003. Interest expense was$1,131,000 for the year ended December 31, 2004, compared with no interestexpense in 2003. Interest expense consisted primarily of the amortization ofdebt discount on the Durus fund notes payable.

**Liquidity andCapital Resources**

***FinancingNeeds***

Our capitalrequirements have been, and will continue to be, significant. Our capitalrequirements will depend on many factors, including without limitation:

·       thecost of servicing and supporting PHD systems in use;

·       manufacturingand associated costs;

·       costsassociated with marketing and operating, distribution, patient training andsupport networks;

·       continuedprogress in research and development; and

·       thecosts involved with protecting our proprietary rights.

During 2006, we expect to use approximately $16 millionand $18 million in our operations, including service and support of thePHD Systems being used by patients today. Resources will also be directedtoward using the PHD System’s platform technology to develop our nextgeneration product. We believe cash and liquid investments of $7,756,000(including the receivable for the settlement of the sale of long-term investmentsecurities) at December 31, 2005, combined with the expected proceeds fromthe Durus fund financing, are only sufficient to finance our operations into2007.

In 2006, we will seek to raise the additional capitalrequired to fund commercial activities in 2007. There can be no assurance thatwe will be able to raise the capitalwe will need on terms acceptable to us, or at all. Also, due to the recenttrading prices of our common stock, completion of a financing could be 

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moredifficult and could result in significant dilution to the ownership interestsof the Durus fund and our other existing stockholders.

We received a letter dated as of March 31, 2006,in which the Durus fund stated its intention, and confirmed its ability, toprovide financing necessary to fund our operations at least through January 1,2007. However, this letter does not represent a legally binding commitment ofthe Durus fund to provide the Company with any financing, and the letterfurther provides that there are no third party beneficiaries to the letter.

If we are unable to obtainadditional financing on acceptable terms, our ability to operate our businesswill be materially and adversely impacted and our liquidity would be severelyimpaired, giving rise to substantial doubt regarding our ability to continue asa going concern beyond 2006. We have already taken certain steps to restructureour business and conserve cash, including the reduction in force during thefourth quarter of 2005. In the event we are not able to raise capital for ouroperations in 2007, we may need to take additional steps to reduce ouroperations.

***CashFlows***

We have financed our operations to date primarilythrough public and private sales of equity securities and proceeds from oursettlement with the Durus fund. At December 31, 2005, we had cash and cashequivalents of $535,000, plus a receivable from the settlement ofavailable-for-sale securities of $7,221,000. In addition, at December 31,2005, we had restricted long-term investments of $750,000. We believe thatinflation generally has not had a material impact on our operations orliquidity to date.

Net cash used in operating activities was $27,068,000in fiscal 2005 compared to $33,393,000 in fiscal 2004 and $22,671,000 in fiscal2003. Cash used in operating activities decreased in 2005 compared to 2004 by$6,325,000 primarily because deposits with vendors decreased by $1,899,000 in2005 compared to an increase of $3,358,000 during 2004. In 2004, we paid a$3,409,000 deposit to the manufacturer of the PHD System for partspurchased on our behalf to be used in production. During 2005, we reduced thedeposit by $1,977,000 for parts purchased and parts used in production. In2005, accounts payable and accrued liability balances increased by $2,253,000while those balance had decreased by $2,658,000 during 2004, a change of$4,911,000. In 2004, accounts payable balances decreased due to paymentsrelated to increased PHD production in the last quarter of 2003. Payment forthese machines was not made until 2004. In 2005, accounts payable and accruedliability balances increased because of additional product warranty reserves in2005 and because of manufacturing activity in the quarter ended December 31,2005. Decreases in cash used for operations relating to deposits with vendorsand accounts payable and accrued liabilities were partially offset by anincrease to the net loss in 2005 compared to 2004. The net loss, excludingnon-cash expenses of $5,541,000 and $1,916,000 for 2005 and 2004, respectively,increased by $2,889,000. In addition, beginning in the fourth quarter of 2005,cash used in operating activities decreased as part of our overall initiativeto reduce costs and decrease our monthly cash burn rate.

Net cash provided by investing activities was $21,399,000in fiscal 2005 compared to cash used in investing activities of $24,948,000 infiscal 2004. In 2005, we used cash from investments to fund operations. In2004, we invested the proceeds from the settlement with the Durus fund ininvestment grade securities. Net cash used in financing activities was$3,215,000 in fiscal 2005 compared to cash provided by financing activities of$52,362,000 in fiscal year 2004. In 2005, we repaid a $3,400,000 line of creditbalance. Cash provided by financing activities in 2004 resulted from thesettlement from the Durus fund and obtaining the $3,400,000 line of credit.

Net cash used in operating activities was $33,393,000in fiscal 2004 compared to $22,671,000 in fiscal 2003. Cash used in operatingactivities increased in 2004 compared to 2003 by $10,722,000 because in 2004the net loss, excluding non-cash interest expense, depreciation and otherexpenses, increased by $4,205,000. In addition, in 2004 we increased our cashdeposits with vendors by $3,261,000 compared to 

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2003. Also, accountspayable and accrued liabilities decreased by $2,658,000 in 2004 while thosebalances increased by $3,596,000 in 2003, a change in cash of $6,254,000. Theseincreases were offset by a decreased spending on inventory in 2004 of $2,862,000in 2004 as compared to 2003.

The increase in the net loss during 2004 was due toincreased units in service at a loss on each unit, increased spending toimprove PHD performance and develop new products, and an increase in sales andmarketing activities. The increase in deposits with vendors relates to adeposit of $3,409,000 paid to the manufacturer of the PHD System for partspurchased on our behalf to be used in future production, pursuant to ouragreement with that vendor. Accounts payable decreased $3,305,000 in 2004compared to 2003 due to increased PHD production in the last quarter of 2003. Paymentfor these machines was not made until 2004. Accrued and other liabilitiesincreased in 2004 by $647,000 compared to 2003. This increase is due to a reserveestablished in the quarter ended December 31, 2004 for replacement ofmajor components of machines already produced. In 2004, we spent $1,731,000 oninventory compared to $4,593,000 in 2003. The decrease in spending on inventoryis attributable to a decrease in the market value of finished units on hand at December 31,2004 compared to 2003 and a decrease in spare parts inventory. Other sourcesand uses of cash were consistent in 2004 compared to 2003

Net cash used in investingactivities was $24,948,000 in fiscal 2004 compared to cash provided byinvesting activities of $5,518,000 in fiscal 2003. In 2004, we invested theproceeds from the settlement with the Durus fund in investment grade securities.In 2003, we used cash from investments to fund operations. Net cash provided byfinancing activities was $52,362,000 and $31,597,000 in fiscal years 2004 and2003, respectively. Cash provided by financing activities in 2004 resulted fromthe settlement with the Durus fund and obtaining a $3,400,000 line of credit. Cashprovided from financing activities in 2003 resulted from the issuance of commonstock.

***RecentFinancing Activities***

***Transactionwith the Durus fund***

The following summaries of our settlement andtransaction with the Durus fund and the Artal fund do not purport to becomplete and are subject to and qualified in their entirety by reference to the(i) settlement agreement (the “Settlement Agreement”), amendment to ourrights agreement, registration rights agreement and note purchase agreementwhich are filed as exhibits to our Current Report on Form 8-K filedwith the Securities and Exchange Commission on February 24, 2004, (ii) SecuritiesPurchase Agreement and bridge loan agreement which were filed as exhibits toour Current Report on Form 8-K filed with the Securities andExchange Commission on April 3, 2006, **(**iii**) **the amendment to our Settlement Agreement and secondamendment to our rights agreement filed as exhibits to this Annual Report on Form 10-Kand (iv) the form of investor rights agreement, form of warrant agreement,form of loan agreement and form certificate of designation of rights,preferences, privileges and restrictions of Series B Convertible PreferredStock filed as exhibits to the Durus Fund’s Schedule 13D/A on April 5,2006,****each of which is deemed to beincorporated herein in its entirety.

***Settlement Summary.******  ***As previouslydisclosed, in February 2004 we settled all our outstanding claims againstthe Durus fund and other defendants for an aggregate payment to us of $48.7 million.We had filed a lawsuit in August 2003 after learning that the Durus fund,Scott Sacane, Durus Capital Management, LLC (“Durus Capital”), Durus CapitalManagement (N.A.), LLC (“Durus Capital (N.A.)”) and the Artal fund had acquiredover 70% of our outstanding common stock. We refer to the Durus fund,Mr. Sacane, Durus Capital, Durus Capital (N.A.) and the Artal fundcollectively as “defendants” and individually as a “defendant.”

*Backgroundto the Litigation.*   In April 2003, weentered into an agreement with Mr. Sacane and Durus Capital relating toshares of our common stock they then controlled through the Durus fund (the“April 2003 Agreement”). We entered into the April 2003 Agreement afterwe learned that certain of the 

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defendants had accumulated a position in our commonstock in excess of the 15% ownership level that would potentially trigger ourshareholder rights agreement, referenced on Exhibit 4.2 hereto (the “Shareholder Rights Agreement”).

Pursuant to the terms of the April 2003Agreement, Mr. Sacane and Durus Capital represented that they: (1) thenowned 5,238,248 shares (approximately 19.5%) of our outstanding common stock, (2) crossedthe 15% ownership level inadvertently, and (3) held this investment in theCompany in the ordinary course of business and not for the purpose or with theeffect of changing or influencing the control of the Company. In addition, theyagreed to reduce their holdings to below 15% ownership over a two-year periodand not to purchase any additional shares of our common stock until such timeas their ownership was less than 15% of the shares then-outstanding (andthereafter not in excess of 15% without the consent of our board of directors).

After the close of business on July 24, 2003, Mr. Sacaneinformed us that he, together with the other defendants, had accumulated inexcess of 19 million shares of our common stock in transactions he described asinadvertent. In a Schedule 13D filed with the SEC on July 28, 2003, thedefendants disclosed that they owned 21,831,218 shares, or approximately 73%,of our then-outstanding common stock. The Durus fund owned 21,333,118 of theseshares and the Artal fund owned 498,100.

In August 2003, we filed a lawsuit against thedefendants in the United States District Court for the District of Connecticut.Our lawsuit sought injunctive relief and damages arising from the defendants’alleged violation of federal securities laws and the alleged breach of the April 2003Agreement. In addition, our lawsuit sought recovery of short-swing tradingprofits under Section 16(b) of the Securities Exchange Act of 1934.

In January 2004, we settled the Section 16(b) claimagainst the defendants for $4.6 million. In February 2004, we settledall other claims against the defendants, and received as part of thatsettlement an additional $34.1 million in cash, of which $16.1 million wasin exchange for unsecured subordinated promissory notes. In May 2004, wereceived a final payment of $10.0 million in connection with the effectivenessof a registration statement we filed with the Securities and ExchangeCommission covering the securities owned by the Durus fund and the Artal fund.

*Summaryof the Settlement.*   Pursuant to the SettlementAgreement, the Durus fund, among other things, agreed to pay us $28 million incash (in addition to the $4.6 million paid by the Durus fund in respect ofthe Section 16(b) claim) to settle the remaining claims in ourlawsuit and release any other potential claims against the defendants. Inaddition, we filed a registration statement with the Securities and ExchangeCommission which was declared effective on May 17, 2004 and the defendantsagreed that they would not seek to exercise control over the Company and thatthey would not hold the shares of our common stock with the purpose or intentof changing or influencing the control or management of the Company. As notedbelow, as part of our transaction with the Durus fund, we have released theDurus fund from this and other restrictive covenants in the settlement.

As part of the settlement, we also entered into a notepurchase agreement with the Durus fund and the Artal fund whereby the Durusfund and the Artal fund purchased approximately $15.8 million (the “OutstandingNotes”) and $0.3 million (the “Remaining Notes”, and collectively with theOutstanding Notes the “Notes”), respectively, of non-interest bearing unsecuredsubordinated promissory notes from us. Under the terms of the SettlementAgreement the Notes became due and payable after the later of (1) August 30,2005 and (2) the first trading day on which the holders of the Notes ownless than 10% of our then-outstanding common stock. In addition, under theSettlement Agreement we were entitled to use shares of our common stock torepay the principal amount owing under the Notes in certain circumstances. Asnoted below, upon closing of the Securities Purchase Agreement, the OutstandingNotes will be cancelled and exchanged for new Loan Notes, Series BPreferred Stock and Warrants, each as defined below.

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As a result of the settlement with the Durus fund, wehad an income tax obligation of $123,000 for the year ended December 31,2004. At December 31, 2005, the net operating losses available to offsetfuture taxable income were approximately $162.6 million. Net operatingloss carryforwards will be used to cover a portion of any tax triggered underthe alternative minimum tax.

The net operating losscarryforwards expire at various dates beginning in 2015. As a result of theannual limitation, a portion of these carryforwards may expire beforeultimately becoming available to reduce federal income tax liabilities. Givenour historical losses and uncertainty with respect to our ability togenerate taxable income, there is a full valuation allowance for our deferredtax assets at December 31, 2005.

***Transaction Summary***

*Securities PurchaseAgreement*

On March 31, 2006, we entered into the SecuritiesPurchase Agreement with the Durus fund pursuant to which the Durus fund, at asubsequent closing, in exchange for $5 million principal amount ofOutstanding Notes, will acquire newly issued shares of our Series BPreferred Stock, $0.01 par value (the “Series B Preferred Stock”)convertible into 5 million shares of our common stock at a conversionprice of $1.00 per share and warrants (the “Warrants”) to purchase 5 millionshares of our common stock at an exercise price of $1.10 per share. The Series BPreferred Stock has voting rights, and the Durus fund will be entitled to vote,on an as converted basis, together with the holders of our common stock as asingle class with respect to any matter upon which holders of our common stockhave the right to vote (provided, however, that for voting purposes, theconversion price of the Series B Preferred Stock is equal to the closingprice of the common stock on the Nasdaq Capital Market on the date of theSecurities Purchase Agreement). In addition, holders of the Series BPreferred Stock shall be entitled to elect one director to our Board ofDirectors. As the only holder of the Series B Preferred Stock immediatelyfollowing the closing of the Securities Purchase Agreement, the Durus fundalone shall exercise this right, along with the Durus fund’s right to designatea majority of the members of our Board of Directors under the terms of theInvestor Rights Agreement described below. The Durus fund’s shares of Series BPreferred Stock will have an aggregate liquidation preference of $5 million,accrue dividends at the rate of 10% per annum and become redeemable after sevenyears at the option of the holders of a majority of the voting power of theshares of Series B Preferred Stock then outstanding or at the option ofthe Durus fund at an earlier date upon the occurrence of specified triggerevents. We are required to obtain the consent of the holders of at leasttwo-thirds of the outstanding shares of Series B Preferred Stock prior totaking certain actions.

Following the closing ofthe Securities Purchase Agreement, the Durus fund has the option to invest, byitself or with other investors designated by the Durus fund, up to anadditional $15 million in cash for additional shares of Series BPreferred Stock and Warrants having essentially the same terms as the Series BPreferred Stock and Warrants acquired by the Durus fund at the closing. If theDurus fund (by itself or with other investors) invests the maximum additional$15 million in cash for such additional shares of Series B PreferredStock and Warrants, such additional shares of Series B Preferred Stockwill be convertible into 15 million shares of common stock at a conversionprice of $1.00 per share and the additional Warrants will be exercisable topurchase 15 million shares of common stock at an exercise price of $1.10per share.

*Loan Agreements*

At the time of entering into the Securities PurchaseAgreement, we also entered into and closed a bridge loan agreement with theDurus fund (the “Bridge Loan Agreement”), pursuant to which the Durus fund lent$5 million in cash to us in exchange for $5 million in principal amount ofour senior secured notes (the “Bridge Notes”). The Bridge Notes bear interestat the rate of 7% per annum, and the entire principal 

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amount of the Bridge Notesis due and payable on January 1, 2007, unless prepaid or rolled over intolonger term senior secured notes of the Company as contemplated by theSecurities Purchase Agreement. The Bridge Loan Agreement contains a number ofreporting and other affirmative and negative covenants, including operationalcontrols over expenditures which may be exercised by the Durus fund. To secureour obligations under the terms of the Bridge Loan Agreement and the BridgeNotes, we have granted the Durus fund a security interest in all of our property,including our intellectual property.

At the closing of theSecurities Purchase Agreement, the Durus fund will enter into a new loanagreement (the “Loan Agreement”) with us pursuant to which the Durus fund willexchange the Bridge Notes (plus accrued interest thereon) and approximately$10.8 million in principal amount of Outstanding Notes for approximately$15.8 million in aggregate principal amount of our senior secured notesbearing interest at 7% per annum and payable in full on December 31, 2007(the “Loan Notes”). Under the Loan Agreement, the Durus fund will also makeavailable to us a $5 million standby line of credit (the “Line of Credit”)until December 31, 2006, which we will be able to use to fund our ongoingoperations if we are unable to obtain financing from other sources and variousfunding conditions are satisfied. The Loan Agreement contains a number ofaffirmative and negative covenants and grants certain operational controls overexpenditures to the Durus fund. Our obligations under the Loan Agreement andthe Loan Notes will also be secured by a security interest in all of ourproperty, including our intellectual property.

*Other Actions*

We undertook and agreed to undertake certain actionsin connection with the entering into and closing of the Securities PurchaseAgreement.

*Amendmentof Settlement Agreement and Shareholder Rights Agreement.*   OnMarch 31, 2006, we amended the Settlement Agreement to release the Durusfund and the Artal fund from certain standstill and other restrictive covenants,including to eliminate the requirement that the Durus fund significantly reduceits ownership of shares of our common stock by May 2006 and to terminatethe proxy granted to the Company by the Durus fund under the terms of theSettlement Agreement, which proxy granted the Company the power to vote theDurus fund’s shares of our common stock in proportion to the votes cast byother holders of shares of our common stock in matters requiring a stockholdervote. By releasing the Durus fund from the standstill restrictions in theSettlement Agreement, the Durus fund is free to acquire the shares of Series BPreferred Stock and the Warrants at the closing of the Securities PurchaseAgreement and to exercise the option to acquire additional shares of Series BPreferred Stock and Warrants, as provided in the Securities Purchase Agreement.In addition, the Durus fund is no longer prohibited from acquiring more sharesof our common stock or other securities or making any solicitation of proxiesregarding the voting of shares of our common stock. Furthermore, in connectionwith the entering into of the Securities Purchase Agreement, we took actions toamend our Shareholder Rights Agreement to exempt from the application thereof tothe transactions contemplated by the Securities Purchase Agreement, and toeliminate the Rights Agreement.

*Appointmentof Durus fund Designee to our Board of Directors and Appointment of New CEO.*   Atthe time of the execution and delivery of the Securities Purchase Agreement,the Board of Directors of the Company increased the size of the Board to sevenand appointed Shodhan Trivedi, a member of the board of directors of the Durusfund, and Laurence P. Birch to our Board of Directors. Our Board ofDirectors also replaced William Dow with Laurence Birch as interim Presidentand Chief Executive Officer.

*Investor Rights Agreement.*   Asa condition to the closing of the Securities Purchase Agreement, we have agreedto enter into an investor rights agreement with the Durus fund and the Artalfund (the “Investor Rights Agreement”) which requires that our Board ofDirectors consist of seven members and grants the Durus fund the right todesignate four of the seven Board members (inclusive of the Board memberdesignated by the Durus fund as holder of the Series B Preferred Stock)and to approve the 

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selection of ourChairman of the Board, Chief Executive Officer and Chief Financial Officer. Underthe terms of the Investor Rights Agreement, the Durus fund’s designees to theBoard of Directors shall be entitled to serve on the executive committee of theBoard, and the Company may not take certain actions without the approval of theBoard of Directors, including the affirmative vote of the Board membersdesignated by the Durus fund. The Investor Rights Agreement also grants theDurus fund and the Artal fund certain registration rights with respect to thesale of shares of our common stock into the open market, as well as providingthat the Durus fund shall have a right of first refusal in the event that theCompany proposes to sell itself, or greater than 30% of its fully dilutedcapital stock, to a third party, or the Company otherwise accepts a bona fideoffer from a third party to acquire the Company or such number of shares of theCompany’s capital stock, on the same terms and conditions, including price, asthe terms and conditions applying to the third party. The Investor RightsAgreement will require us to use our best efforts to register the shares heldby the Durus fund and the Artal fund in one or more shelf registrationstatements and to keep these registration statement(s) effective until theearlier of (i) the date as of which the Durus fund and the Artal fund maysell all of their securities in any period of three months under Rule 144of the Securities Act of 1933, as amended, and (ii) the date on which theDurus fund and the Artal fund shall have sold all of their securities coveredby the registration statement. The Investor Rights Agreement will amend andsupersede the registration rights agreement which we previously entered withthe Durus fund in February 2004.

***Transactionwith the Fusion Capital Fund II, LLC***

On January 13, 2006, we entered into a commonstock purchase agreement (“Fusion Capital Agreement”) with Fusion Capital FundII, LLC (“Fusion Capital”). Funding under the Fusion Capital Agreementcommences once the Securities and Exchange Commission declares effective aregistration statement relating to the transaction and will continue over a 25-monthperiod. If this financing is pursued, we would be required to have aregistration statement declared effective prior to September 30, 2006. Underthe Agreement, as long as the market price of our common stock remains above$0.10 and certain other conditions are satisfied, we are permitted to sell toFusion Capital up to $40,000 of common stock on each market trading day, up toan aggregate of $20,000,000 of common stock.

We have the right to decrease the daily amount to bepurchased by Fusion Capital at any time effective upon one trading day’s notice.In addition, we have the right to increase the daily purchase amount if themarket price of our common stock increases. For every $0.10 increase in the “thresholdprice” (defined as the lowest sale price of our common stock during the fivetrading days immediately preceding the notice to increase the daily purchaseamount) above $0.95, we have the right to increase the daily purchase amount byan additional $4,000.

In addition to the daily purchase amount, we may electto require Fusion Capital to purchase up to $250,000 of our common stock on anysingle trading day, provided that the share price is above $1.00 during the tentrading days prior thereto. This amount may be increased to up to $1,000,000 ifspecified increases in our share price occur.

Fusion Capital may terminate the agreement with usupon the occurrence of an event of default, which includes a material adversechange in our business or the failure of our common stock to be listed on theNasdaq National Market, the Nasdaq Capital Market or the Nasdaq OTC BulletinBoard. In addition, Fusion Capital has the right to terminate the agreementwith us if sales under the agreement have not commenced by September 30,2006. We have the right to terminate the agreement at any time effective uponone trading day’s notice.

In connection with theagreement, in January 2006, we issued 2,170,543 shares of common stock toFusion Capital as a commitment fee. Such shares were issued in reliance uponexemption from registration provided by Regulation D and/or Section 4(2) ofthe Securities Act of 1933, as amended.

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***Listingof Company’s Common Stock on the Nasdaq Capital Market***

On November 14,2005, we received a letter from the Nasdaq noting that we had failed to complywith the minimum $10 million of stockholders’ equity required by Marketplace Rule 4450(a),Maintenance Standard 1 and the alternative listing requirements of Marketplace Rule 4450(b),Maintenance Standard 2 relating to market value of listed securities (andrelated assets and revenue tests) and market value of publicly held shares. On December 16,2005, we were notified by the Nasdaq that for the last 30 consecutivebusiness days the bid price of our common stock closed below the minimum $1.00per share required by Marketplace Rule 4450(a)(5). On December 27,2005, we received a letter from the Nasdaq denying our request for continuedlisting on the Nasdaq National Market. In response to this letter, on December 30,2005 we requested a hearing before the Nasdaq Listing QualificationsPanel to review the Nasdaq staff’sdetermination. We subsequently received notification from the Nasdaq ListingQualification Panel that our common stock would begin trading on theNasdaq Capital Market on February 14, 2006.

TheNasdaq Capital Market has its own standards for continued listing, includingMarketplace Rule 4310(c)(2)(B), which requires us to have a minimum of$2,500,000 in stockholders’ equity or $35,000,000 market value of listedsecurities or $500,000 of net income from continuing operations for the mostrecently completed fiscal year or two of the three most recently completedfiscal years. In addition, continued listing on the Nasdaq Capital Marketrequires satisfying the $1.00 minimum closing bid price imposed by Marketplace Rule 4450(a)(5).There can be no assurance that we will sustain compliance with these standards.In particular, we do not currently have a minimum of $2,500,000 instockholders’ equity and we did not have $500,000 of net income from continuingoperations for the most recently completed fiscal year or two of the three mostrecently completed fiscal years, but the current market value of our listedsecurities does exceed $35,000,000.

***RecentAccounting Pronouncements***

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 123 (Revised), *Share-Based Payment* (SFAS No. 123R),to be effective for interim or annual periods beginning after June 15,2005. On April 14, 2005, the Securities and Exchange Commission amendedthe compliance dates to require SFAS No. 123R to be effective for fiscalyears beginning after June 15, 2005. SFAS No. 123R supersedes APBOpinion No. 25 and requires all share-based payments to employees,including grants of employee stock options, to be recognized as compensationcosts over the requisite service period based on fair values measured on therespective grant dates. The FASB has concluded that companies could adopt thenew standard in one of two ways: the modified prospective transition method andthe modified retrospective transition method. Using the modified prospectivetransition method, a company would recognize share-based employee compensationcost from the beginning of the fiscal period in which the recognitionprovisions are first applied as if the fair-value-based accounting method hadbeen used to account for all employee awards granted, modified or settled afterthe effective date and to any awards that were not fully vested as of theeffective date. Using the modified retrospective method, a company wouldrecognize employee compensation cost for periods presented prior to theadoption of the proposed standard in accordance with the original provisions ofSFAS No. 123; that is, an entity would recognize employee compensationcost in the amounts reported in the pro forma disclosures currently required bySFAS No. 123. A company would not be permitted to make any changes tothose amounts upon adoption of the proposed standard unless those changesrepresent a correction of an error (and are disclosed accordingly). For periodsafter the date of adoption of the proposed standards the modified prospectivetransition method described above would be applied.

We have adopted the requirements of SFAS No. 123Reffective January 1, 2006, utilizing the modified prospective transitionmethod. The effect of adopting the new Standard on reported earnings isdependent on the number of options granted in the future, the terms of thoseawards and their fair values. We 

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anticipate that the effectof adopting SFAS No. 123R will increase total stock-based compensationexpense in 2006 by approximately $1.5 million to $1.8 million.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs*. SFAS No. 151is an amendment of Accounting Research Bulletin No. 43, Chapter 4.SFAS No. 151 clarifies the accounting for abnormal amounts of idlefacility expense, freight, handling costs and wasted material. SFAS No. 151is effective for inventory costs incurred during fiscal years beginning after June 15,2005. We have adopted the requirements of SFAS No. 151 effective January 1,2006. The adoption did not have a material effect on our financial position,results of operations or cash flows.

In May 2005, the FASB issued FASB Statement No. 154,*Accounting Changes and Error**Corrections.* Statement 154establishes, unless impracticable, retrospective application as the requiredmethod for reporting a change in accounting principle in the absence ofexplicit transition requirements specific to a newly adopted accountingprinciple. This Statement will be effective for the Company for all accountingchanges and any error corrections occurring after January 1, 2006.

**Item 7A.**                Quantitativeand Qualitative Disclosure About Market Risk.

**Interest Rate Risk**

Our investments are notmade for trading purposes. Our investments are generally made in U.S. governmentand federal agency bonds and high-grade commercial paper and corporate bonds.Interest rate risk with respect to our investments is not significant assubstantially all of such investments are in short-term U.S. dollar cashequivalents, which are by their nature less sensitive to interest ratemovements. At December 31, 2005, all investments have been converted tocash and liquid investments.  Imputedinterest on the long-term notes payable was calculated using an estimatedinterest rate for a similar instrument, since no objective market exists forthis particular obligation. A 1% change in interest rates would not have amaterial effect on our results of operations.

**Exchange Rate Risk**

We have a sales office in the United Kingdom, andtherefore transact a portion of our business in British pounds. A 10% change inthe exchange rate of the U.S. dollar with respect to the British poundwould not have a material effect on our financial condition or results ofoperations. We do not use any hedges or other derivative financial instrumentsto manage or reduce exchange rate risk.

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**Item 8.**                        FinancialStatements and Supplementary Data.

|                                                     |                                                                                                                                                       | **Page** |   |
|----------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|--------|
| Report of Independent  Registered Public Accounting Firm |                                                                                                                                                       | 61       |   |
| Consolidated  Financial Statements:                      |                                                                                                                                                       |     |   |
| ·                                                   | Consolidated  Balance Sheets at December 31, 2005 and 2004                                                                                            |     | 62     |   |
| ·                                                   | Consolidated Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                                                           |     | 63     |   |
| ·                                                   | Consolidated Statements of Stockholders’ Equity  (Deficit) and Comprehensive Income (Loss) for the years ended  December 31, 2005, 2004 and 2003 |     | 64     |   |
| ·                                                   | Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                                                           |     | 65     |   |
| ·                                                   | Notes to Consolidated Financial Statements                                                                                                                 |     | 66     |   |

 

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***Report of Independent Registered Public AccountingFirm***

The Board of Directors and StockholdersAksys, Ltd.:

We have audited the accompanying consolidated balancesheets of Aksys, Ltd. and subsidiaries as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity (deficit) and comprehensive income (loss), and cash flows for each ofthe years in the three-year period ended December 31, 2005. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Aksys, Ltd.and subsidiaries as of December 31, 2005 and 2004, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.

KPMGLLP

Chicago, IllinoisApril 13, 2006

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**AKSYS, LTD. AND SUBSIDIARIESConsolidated Balance SheetsDecember 31, 2005 and 2004**

| ** **                                                                                                                                                                | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                |       |                  |       |   |   |
| Current assets:                                                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                 |       | $                     | 534,954    |   | $ | 9,419,324 |   |
| Short-term held-to-maturity investments                                                                                                                                   |       | —                |       | 15,030,779 |   |
| Restricted short-term investments                                                                                                                                         |       | —                |       | 6,666,666 |   |
| Accounts receivable, less allowance for doubtful  accounts of $0 and $14,739 at December 31, 2005 and 2004,  respectively                                       |       | 338,369               |       | 233,406 |   |
| Other receivables                                                                                                                                                         |       | 7,615,607             |       | 125,373 |   |
| Inventories                                                                                                                                                               |       | 3,639,493             |       | 5,716,320 |   |
| Prepaid expenses                                                                                                                                                          |       | 150,390               |       | 134,739 |   |
| Deposits with vendors, net                                                                                                                                                |       | 875,361               |       | 3,467,785 |   |
| Total current assets                                                                                                                                                      |       | 13,154,174            |       | 40,794,392 |   |
| Long-term available-for-sale investments                                                                                                                                  |       | —                |       | 7,568,475 |   |
| Restricted long-term investment                                                                                                                                           |       | 750,000               |       | 600,000 |   |
| Leased assets, net                                                                                                                                                        |       | 3,963,688             |       | 2,390,831 |   |
| Property and equipment, net                                                                                                                                               |       | 1,222,572             |       | 1,533,091 |   |
| Other assets                                                                                                                                                              |       | 65,513                |       | 58,652 |   |
| Total assets                                                                                                                                                              |       | $                     | 19,155,947 |   | $ | 52,945,441 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                   |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                      |       |                  |       |   |   |
| Accounts payable                                                                                                                                                          |       | $                     | 3,735,123  |   | $ | 1,635,050 |   |
| Accrued liabilities                                                                                                                                                       |       | 3,173,161             |       | 2,853,257 |   |
| Deferred revenue                                                                                                                                                          |       | 114,120               |       | 253,575 |   |
| Short-term line of credit                                                                                                                                                 |       | —                |       | 3,400,000 |   |
| Restructuring accrual                                                                                                                                                     |       | 36,325                |       | — |   |
| Current portion of capital lease obligation                                                                                                                               |       | 32,884                |       | — |   |
| Other liabilities                                                                                                                                                         |       | 31,209                |       | 41,344 |   |
| Total current liabilities                                                                                                                                                 |       | 7,122,822             |       | 8,183,226 |   |
| Other long-term liabilities                                                                                                                                               |       | 200,278               |       | 117,014 |   |
| Notes payable                                                                                                                                                             |       | 15,065,823            |       | 13,637,770 |   |
| Capital lease obligations, less current portion                                                                                                                           |       | 71,747                |       | — |   |
| Total liabilities                                                                                                                                                         |       | 22,460,670            |       | 21,938,010 |   |
| Commitments and contingencies                                                                                                                                             |       | —                |       | — |   |
| Stockholders’ equity  (deficit):                                                                                                                                     |       |                  |       |   |   |
| Preferred stock, par value $0.01 per share,  1,000,000 shares authorized, 0 shares issued and outstanding in  2005 and 2004                                     |       | —                |       | — |   |
| Common stock, par value $0.01 per share,  50,000,000 shares authorized; 29,972,911 and 29,891,537 shares  issued and outstanding in 2005 and 2004, respectively |       | 299,729               |       | 298,915 |   |
| Additional paid-in capital                                                                                                                                                |       | 187,185,871           |       | 187,248,679 |   |
| Accumulated other comprehensive income                                                                                                                                    |       | 20,096                |       | 72,326 |   |
| Accumulated deficit                                                                                                                                                       |       | (190,810,419          | )          | (156,612,489 | ) |
| Total stockholders’ equity (deficit)                                                                                                                                 |       | (3,304,723            | )          | 31,007,431 |   |
| Total liabilities  and stockholders’ equity (deficit)                                                                                                                |       | $                     | 19,155,947 |   | $ | 52,945,441 |   |

 

See accompanying notes to consolidated financial statements.

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**AKSYS, LTD. AND SUBSIDIARIESConsolidated Statements of Operations Years ended December 31, 2005, 2004 and 2003**

| ** **                                    | ** ** | **Year ended December 31,** | ** **  |
|-----------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                    | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                      |       |                                       |        |   |   |   |   |
| Product sales                                 |       | $                                          | 516,666     |   | $ | 1,071,738 |   | $ | 1,075,696 |   |
| Product rentals                               |       | 705,809                                    |        | 385,966 |   | 117,010 |   |
| Service and supplies                          |       | 1,446,514                                  |        | 958,355 |   | 298,757 |   |
| Total revenue                                 |       | 2,668,989                                  |        | 2,416,059 |   | 1,491,463 |   |
| Cost of sales:                                |       |                                       |        |   |   |   |   |
| Product sales                                 |       | 5,715,535                                  |        | 4,313,855 |   | 4,239,091 |   |
| Product rentals                               |       | 2,529,478                                  |        | 481,326 |   | 110,000 |   |
| Service and supplies                          |       | 6,680,065                                  |        | 5,867,759 |   | 3,343,102 |   |
| Total cost of  sales                          |       | 14,925,078                                 |        | 10,662,940 |   | 7,692,193 |   |
| Operating  expenses:                          |       |                                       |        |   |   |   |   |
| Research and development                      |       | 8,068,829                                  |        | 6,684,465 |   | 5,474,220 |   |
| Sales and marketing                           |       | 4,532,240                                  |        | 4,791,684 |   | 4,188,939 |   |
| General and administrative                    |       | 8,047,843                                  |        | 7,388,863 |   | 6,676,665 |   |
| Restructuring charges                         |       | 161,453                                    |        | — |   | — |   |
| Total operating  expenses                     |       | 20,810,365                                 |        | 18,865,012 |   | 16,339,824 |   |
| Operating loss                                |       | (33,066,454                                | )           | (27,111,893 | ) | (22,540,554 | ) |
| Other income and  expense:                    |       |                                       |        |   |   |   |   |
| Interest income                               |       | 745,932                                    |        | 664,454 |   | 258,076 |   |
| Interest expense                              |       | (1,524,446                                 | )           | (1,130,538 | ) | — |   |
| Loss on sale of available-for-sale securities |       | (335,162                                   | )           | — |   | — |   |
| Total other  income and expense               |       | (1,113,676                                 | )           | (466,084 | ) | 258,076 |   |
| Net loss before  income tax expense           |       | (34,180,130                                | )           | (27,577,977 | ) | (22,282,478 | ) |
| Income tax  expense                           |       | (17,800                                    | )           | (105,512 | ) | — |   |
| Net loss                                      |       | $                                          | (34,197,930 | ) | $ | (27,683,489 | ) | $ | (22,282,478 | ) |
| Net loss per share, basic and diluted         |       | $                                          | (1.14       | ) | $ | (0.93 | ) | $ | (0.79 | ) |
| Weighted average  shares outstanding          |       | 29,932,705                                 |        | 29,825,659 |   | 28,218,819 |   |

 

See accompanying notes to consolidated financial statements.

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**AKSYS, LTD. AND SUBSIDIARIESConsolidated Statements of Stockholders’ Equity (Deficit) and ComprehensiveIncome (Loss)Years ended December 31, 2005, 2004 and 2003**

| ** **                                         | ** ** | **Common Stock** | ** ** | **Additional  paid-in** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|-------------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **capital**                           | ** ** | **income**      | ** ** | **deficit**       | ** ** | **income (loss)**        | ** ** | **equity (deficit)** | ** ** |
| **Balance at  December 31, 2002**             |       | 25,500,097            |       | $                       | 255,001    |                                  | $          | 120,030,647     |       |              | $          | 8,503                         |       |   | $ | (106,646,522 | ) |   |   |   |   |   | $ | 13,647,629 |   |   |
| Comprehensive  income (loss):                      |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | — |   |   |   | — |   |   |
| Net loss                                           |       | —                |       | —                  |       | —                                |       |            | —     |              |       | (22,282,478                   | )          |   | (22,282,478 | ) |   |   | (22,282,478 | ) |   |
| Foreign currency translation adjustment            |       | —                |       | —                  |       | —                                |       |            | 11,774     |              |       | —                        |       |   | 11,774 |   |   |   | 11,774 |   |   |
| Comprehensive loss                                 |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | (22,270,704 | ) |   |   | — |   |   |
| Issuance of common stock                           |       | 4,135,529             |       | 41,335                  |       | 30,879,499                            |       |            | —     |              |       | —                        |       |   | — |   |   |   | 30,920,834 |   |   |
| Exercise of stock options                          |       | 148,310               |       | 1,483                   |       | 700,319                               |       |            | —     |              |       | —                        |       |   | — |   |   |   | 701,802 |   |   |
| Issuance of shares to Employee Stock Purchase Plan |       | 18,968                |       | 190                     |       | 128,311                               |       |            | —     |              |       | —                        |       |   | — |   |   |   | 128,501 |   |   |
| **Balance at  December 31, 2003**             |       | 29,800,904            |       | $                       | 298,009    |                                  | $          | 151,738,776     |       |              | $          | 20,277                        |       |   | $ | (128,929,000 | ) |   |   |   |   |   | $ | 23,128,062 |   |   |
| Comprehensive  income (loss):                      |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | — |   |   |   | — |   |   |
| Net loss                                           |       | —                |       | —                  |       | —                                |       |            | —     |              |       | (27,683,489                   | )          |   | (27,683,489 | ) |   |   | (27,683,489 | ) |   |
| Unrealized gain on investments                     |       | —                |       | —                  |       | —                                |       |            | 12,219     |              |       | —                        |       |   | 12,219 |   |   |   | 12,219 |   |   |
| Foreign currency translation adjustment            |       | —                |       | —                  |       | —                                |       |            | 39,830     |              |       | —                        |       |   | 39,830 |   |   |   | 39,830 |   |   |
| Comprehensive loss                                 |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | (27,631,440 | ) |   |   | — |   |   |
| Contribution from legal settlement                 |       | —                |       | —                  |       | 35,148,669                            |       |            | —     |              |       | —                        |       |   | — |   |   |   | 35,148,669 |   |   |
| Issuance of common stock                           |       | 56,308                |       | 563                     |       | 182,438                               |       |            | —     |              |       | —                        |       |   | — |   |   |   | 183,001 |   |   |
| Exercise of stock options                          |       | 2,254                 |       | 23                      |       | 15,440                                |       |            | —     |              |       | —                        |       |   | — |   |   |   | 15,463 |   |   |
| Issuance of shares to Employee Stock Purchase Plan |       | 32,071                |       | 320                     |       | 163,356                               |       |            | —     |              |       | —                        |       |   | — |   |   |   | 163,676 |   |   |
| **Balance at  December 31, 2004**             |       | 29,891,537            |       | $                       | 298,915    |                                  | $          | 187,248,679     |       |              | $          | 72,326                        |       |   | $ | (156,612,489 | ) |   |   |   |   |   | $ | 31,007,431 |   |   |
| Comprehensive  income (loss):                      |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | — |   |   |   | — |   |   |
| Net loss                                           |       | —                |       | —                  |       | —                                |       |            | —     |              |       | (34,197,930                   | )          |   | (34,197,930 | ) |   |   | (34,197,930 | ) |   |
| Unrealized loss on investments                     |       | —                |       | —                  |       | —                                |       |            | (12,219    | )                 |       | —                        |       |   | (12,219 | ) |   |   | (12,219 | ) |   |
| Foreign currency translation adjustment            |       | —                |       | —                  |       | —                                |       |            | (40,011    | )                 |       | —                        |       |   | (40,011 | ) |   |   | (40,011 | ) |   |
| Comprehensive loss                                 |       | —                |       | —                  |       | —                                |       |            | —     |              |       | —                        |       |   | (34,250,160 | ) |   |   | — |   |   |
| Adjustment to legal settlement                |       | —                |       | —                  |       | (250,000                              | )          |            | —     |              |       | —                        |       |   | — |   |   |   | (250,000 | ) |   |
| Issuance of common stock                           |       | 1,268                 |       | 13                      |       | 2,987                                 |       |            | —     |              |       | —                        |       |   | — |   |   |   | 3,000 |   |   |
| Issuance of shares to Employee Stock Purchase Plan |       | 80,106                |       | 801                     |       | 184,205                               |       |            | —     |              |       | —                        |       |   | — |   |   |   | 185,006 |   |   |
| **Balance at December 31, 2005**              |       | 29,972,911            |       | $                       | 299,729    |                                  | $          | 187,185,871     |       |              | $          | 20,096                        |       |   | $ | (190,810,419 | ) |   |   |   |   |   | $ | (3,304,723 | ) |   |

 

See accompanying notes to consolidated financial statements.

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**AKSYS, LTD. AND SUBSIDIARIESConsolidated Statements of Cash FlowsYears ended December 31, 2005, 2004 and 2003**

| ** **                                                                               | ** ** | **Year ended December 31,** | ** **  |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                               | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| **Cash flows from operating  activities:**                                               |       |                                       |        |   |   |   |   |
| Net loss                                                                                 |       | $                                          | (34,197,930 | ) | $ | (27,683,489 | ) | $ | (22,282,478 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:        |       |                                       |        |   |   |   |   |
| Impairment charge                                                                        |       | 2,063,694                                  |        | — |   | — |   |
| Depreciation and amortization                                                            |       | 1,417,317                                  |        | 829,955 |   | 565,006 |   |
| Loss on disposal of assets                                                               |       | 293,910                                    |        | — |   | — |   |
| Non-cash interest expense                                                                |       | 1,428,053                                  |        | 1,086,082 |   | — |   |
| Loss on available-for-sale security                                                      |       | 335,162                                    |        | — |   | — |   |
| Issuance of stock in exchange for services received                                      |       | 3,000                                      |        | — |   | 154,570 |   |
| Changes  in assets and liabilities:                                                      |       |                                       |        |   |   |   |   |
| Accounts receivable                                                                      |       | (104,963                                   | )           | 105,026 |   | (211,621 | ) |
| Other receivables                                                                        |       | (269,140                                   | )           | (120,297 | ) | 125,053 |   |
| Inventories                                                                              |       | (2,026,805                                 | )           | (1,730,762 | ) | (4,592,875 | ) |
| Prepaid expenses and other assets                                                        |       | (22,512                                    | )           | (51,131 | ) | 8,877 |   |
| Deposits with vendors                                                                    |       | 1,898,542                                  |        | (3,358,244 | ) | (97,543 | ) |
| Accounts payable                                                                         |       | 2,100,073                                  |        | (3,305,279 | ) | 2,968,973 |   |
| Deferred revenue                                                                         |       | (139,455                                   | )           | 187,762 |   | 64,487 |   |
| Accrued restructuring charges                                                            |       | 36,325                                     |        | — |   | — |   |
| Accrued expenses and other liabilities                                                   |       | 116,449                                    |        | 647,498 |   | 626,540 |   |
| Net cash used in operating activities                                                    |       | (27,068,280                                | )           | (33,392,879 | ) | (22,671,011 | ) |
| **Cash  flows from investing activities:**                                               |       |                                       |        |   |   |   |   |
| Purchases of investments                                                                 |       | —                                     |        | (47,253,385 | ) | (17,659,774 | ) |
| Purchases of restricted long-term investments                                            |       | (150,000                                   | )           | — |   | — |   |
| Proceeds from maturities and sales of investments                                        |       | 28,918,539                                 |        | 22,777,328 |   | 23,438,108 |   |
| Pending settlement of security sales                                                     |       | (7,221,094                                 | )           | — |   | — |   |
| Purchases of property and equipment                                                      |       | (148,541                                   | )           | (471,690 | ) | (260,216 | ) |
| Net cash provided by (used in) investing activities                                      |       | 21,398,904                                 |        | (24,947,747 | ) | 5,518,118 |   |
| **Cash  flows from financing activities:**                                               |       |                                       |        |   |   |   |   |
| (Repayment) proceeds from short-term line of credit                                      |       | (3,400,000                                 | )           | 3,400,000 |   | — |   |
| Proceeds from issuance of notes payable                                                  |       | —                                     |        | 16,100,000 |   | — |   |
| Proceeds from issuance of common stock                                                   |       | 185,006                                    |        | 362,140 |   | 31,596,567 |   |
| Proceeds from Durus settlement                                                           |       | —                                     |        | 32,500,357 |   | — |   |
| Net cash (used in) provided by financing activities                                      |       | (3,214,994                                 | )           | 52,362,497 |   | 31,596,567 |   |
| Net increase (decrease) in cash and cash equivalents                                     |       | (8,884,370                                 | )           | (5,978,129 | ) | 14,443,674 |   |
| Cash and cash equivalents at beginning of year                                           |       | 9,419,324                                  |        | 15,397,453 |   | 953,779 |   |
| Cash and cash equivalents at end of year                                                 |       | $                                          | 534,954     |   | $ | 9,419,324 |   | $ | 15,397,453 |   |
| **Supplemental  information relating to net cash flows from operating activities:** |       |                                       |        |   |   |   |   |
| Cash paid for interest expense                                                           |       | $                                          | 96,393      |   | $ | 44,455 |   | $ | — |   |
| Cash paid for income taxes                                                               |       | 17,800                                     |        | 105,512 |   | — |   |
| Non-cash transfers  of inventories to leased assets and property and equipment      |       | 4,103,632                                  |        | 2,009,880 |   | 1,279,128 |   |

 

See accompanying notes to consolidated financial statements.

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2005, 2004 and 2003**

**(1)**          Summaryof Significant Accounting Policies

***Organization and Nature of Business***

Aksys, Ltd. (the Company) was originallyincorporated in Illinois on January 18, 1991. In March 1993, theCompany merged into a Delaware corporation. During the quarter ended September 30,2002, the Company commenced commercial activities and was no longer consideredto be in the development stage. The Company is involved in the sale andmarketing of its sole product, the PHD System. In addition, the Companycontinues devoting some of its efforts to product development. The Companyoperates in one industry segment and substantially all of its long-lived assetsare located in the United States.

Certain reclassifications have been made to the prioryear consolidated financial statements in order to conform to the 2005presentation.

The Company has revised its presentation of itsconsolidated statements of cash flows for 2004 and 2003 to include non-cash inventorytransfer activity as supplemental information rather than present the transfersof machines to leased assets and property and equipment as increases in cashflows from operating activities and decreases in cash flows from investingactivities. The Company presents initial machine purchases as decreases in cashflows from operating activities. The Company does not consider the changes tobe material to the 2004 and 2003 consolidated financial statements.

A summary of thesignificant accounting policies applied in the preparation of the accompanyingconsolidated financial statements of the Company follows:

***(a)****          Principlesof Consolidation*

On April 18, 1996,the Company established a subsidiary in Tokyo, Japan, and on August 8,1998, the Company established a subsidiary in the United Kingdom. Theconsolidated financial statements include the financial statements of theCompany and its wholly owned subsidiaries. All significant inter-companytransactions and balances have been eliminated in consolidation.

***(b)****           Useof Estimates*

Preparation of theconsolidated financial statements requires management of the Company to makeestimates and assumptions relating to the reported amount of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the consolidated financial statements and the reported amounts of revenueand expenses during the period. Actual results could differ from thoseestimates.

***(c)****            Cashand Cash Equivalents*

Cash and cash equivalentsof $535,000 and $9,419,000 at December 31, 2005 and 2004, respectively,consist of certain highly liquid investments with maturities of less than threemonths when purchased.

***(d)****           InvestmentSecurities*

On December 30, 2005, the Company sold all of itsunrestricted long-term investment securities for an aggregate amount ofapproximately $7,221,000. Since this transaction did not settle until January 3,2006, the proceeds are recorded as part of “Other Receivables” on theconsolidated balance sheet at December 31, 2005. The Company recorded aloss of $335,000 on the accompanying consolidated statement of operations forthe year ended December 31, 2005 related to this transaction.

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As of December 31, 2005 all investments wereconverted to cash and liquid investments. As of December 31, 2004, allinvestments consisted of certificates of deposit, U.S. government securities,U.S. government agency securities and investment grade corporate debtsecurities, each with a term less than or equal to five years.

The Company accounts for its investments usingStatement of Financial Accounting Standards (SFAS) No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*. This standard requires that certain debt and equitysecurities be adjusted to market value at the end of each accounting period.

The Company classifies its debt securities in one oftwo categories: held-to-maturity or available-for-sale. Held-to-maturity debtsecurities are those securities in which the Company has the ability and intentto hold the security until maturity. All other securities are classified asavailable-for-sale.

Held-to-maturity debt securities are recorded atamortized cost, adjusted for the amortization or accretion of premiums ordiscounts. Unrealized holding gains and losses, net of the related tax effect,on available-for-sale securities are excluded from earnings and are reported asa separate component of accumulated other comprehensive income until realized. Realizedgains and losses from the sale of available-for-sale securities are determinedon a specific-identification basis.

A decline in the market value of anyavailable-for-sale or held-to-maturity security below cost that is deemed to beother-than-temporary results in a reduction in carrying amount to fair value. Theimpairment is charged to earnings and a new cost basis for the security isestablished. To determine whether an impairment is other-than-temporary, theCompany considers whether it has the ability and intent to hold the investmentuntil a market price recovery and considers whether evidence indicating thecost of the investment is recoverable outweighs evidence to the contrary.

Premiums and discounts are amortized or accreted overthe life of the related held-to-maturity or available-for-sale security as anadjustment to yield using the effective-interest method. Dividend and interestincome are recognized when earned.

The majority of short andlong-term investments are classified as held-to-maturity because the Companyhas the ability and intent to hold these securities until maturity. At December 31,2004, the one exception was a long-term U.S. government agency security with amarket value of approximately $7,568,000 that was classified asavailable-for-sale. Monthly changes to the market value of this security wereincluded in accumulated other comprehensive income.

***(e)****            Inventories*

Inventories are stated atthe lower of weighted average cost or market. The weighted average cost ofinventory approximates the first-in, first-out method (FIFO) forall inventories.

***(f)****             Long-LivedAssets*

Property, equipment and leased assets are recorded atcost and depreciated using the straight-line method over the estimated usefullives of the assets, ranging from three to seven years. Leasehold improvementsare amortized over the shorter of the lease term or estimated useful life ofthe asset. The Company leases PHD Systems to customers on a short-term basis(12 months or less) or long-term basis (up to 24 months). Leasedassets include PHD Systems currently under operating leases and machines held forfuture leases. Additions and improvements are capitalized, and expenditures forrepairs and maintenance are charged to operations as incurred. PHD machinesused as sales demonstration models or for internal training are included inequipment and depreciated over their useful life.

The Company accounts for long-lived assets inaccordance with SFAS No. 144, *Accounting for theImpairment of Long-Lived Assets*. In accordance with Statement 144,long lived assets, such as property, 

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plant and equipment, arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to estimated undiscounted future cash flows expected to begenerated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds the fair value of the asset.Assets to be disposed of would be separately presented in the consolidatedbalance sheet and reported at the lower of the carrying amount or fair valueless costs to sell, and would no longer be depreciated. The assets andliabilities of a disposed group classified as held for sale would be presentedseparately in the appropriate asset and liability sections of the balancesheet.

All machines purchased bythe Company are first recorded as inventory since their ultimate use is notdetermined upon completion of production. Upon determination of use, theCompany transfers the assets from inventory to either leased assets or propertyand equipment depending on whether they are to be leased to customers or usedas demonstration models or for internal testing and training.

***(g)****           ProductWarranty*

The Company providesmaintenance as part of its service and supplies agreements with customers. Whencircumstances are identified whereby the scope of service to the machineextends beyond the normal cost of service and supply contracts, The Companyperforms a specific analysis to determine the extent of service required. TheCompany records a loss to cost of sales once the excess cost is probable andestimable.

***(h)****          RevenueRecognition*

The Company recognizes revenue in accordance with SECStaff Accounting Bulletin (SAB) No. 101, *RevenueRecognition in Financial Statements*, as amended by SAB No. 104*,Revenue Recognition*. Revenue is recognized when the followingconditions exist: (1) there is persuasive evidence of an arrangement, (2) theproduct has been delivered and accepted or services and supplies have beenprovided to the customer, (3) the sales price is fixed or determinable and(4) collectability is reasonably assured.

In accordance with Emerging Issues Task Force (EITF)Issue No. 00-21, *Accounting forRevenue Arrangements with Multiple Deliverables*, in arrangementswhere the Company charges a single monthly amount for the PHD System andservice and supplies, revenue is allocated to each element based on the fairvalue of the element. The revenue allocated to each element is recognizedseparately, as it is earned, in accordance with SAB 104.

The Company recognizes revenue from product sales whenthe PHD System has been installed and a patient has started training. Servicesand supplies are sold to customers under a monthly service agreement. Servicesand supplies revenue is recognized uniformly over the term of the agreement andsuch revenue is not dependent on service time incurred or materials used.

The Company also leasesthe PHD System to customers on a short-term basis (12 months or less) andlong-term basis (up to 24 months) and recognizes revenue on theseoperating system contracts on a straight-line basis over the lease term. TheCompany has no contracts with distributors and sells its product directly toits customers through its own sales force.

***(i)****             Researchand Development Costs*

Research and developmentcosts are charged to expense when incurred.

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***(j)****              IncomeTaxes*

Deferred tax assets andliabilities are recognized for the future tax consequences attributable to thedifference between the financial statement carrying amount of existing assetsand liabilities and their respective tax bases and operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin income in the period that includes the enactment date. A valuation allowanceis provided against deferred tax assets which are not more likely than not tobe realized.

***(k)****           Computationof Net Loss per Share*

Net loss per share isbased on the weighted average number of shares outstanding with commonequivalent shares from stock options and warrants excluded from the computationbecause their effect is antidilutive. At December 31, 2005, 2004 and 2003,the number of common equivalent shares from stock options and warrants excludedfrom the computation were 3,338,602, 2,800,111 and 2,239,088, respectively.

***(l)****              Stock-BasedCompensation*

TheCompany applies the intrinsic value based method of accounting prescribed byAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations includingFASB Interpretation No. 44, *Accounting for CertainTransactions involving Stock Compensation*, an interpretation of APBOpinion No. 25, to account for its fixed plan stock options. Under thismethod, compensation expense is recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price. SFAS No. 123,*Accounting for Stock Based Compensation*and SFAS No. 148, *Accounting for Stock-BasedCompensation—Transition and Disclosure*, an amendment of FASBStatement No. 123, established accounting and disclosure requirementsusing a fair value based method of accounting for stock based employeecompensation plans. As permitted by existing accounting standards, the Companyhas elected to continue to apply the intrinsic value based method of accountingdescribed above, and has adopted only the disclosure requirements of SFAS No. 123,as amended. The following table illustrates the effect on net losses if thefair value based method had been applied to all outstanding and unvested awardsin each period.

| ** **                                                                                                                | ** ** | **2005**   | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Net loss as  reported                                                                                                     |       | $          | (34,197,930 | )          | $          | (27,683,489 | )          | $ | (22,282,478 | ) |
| Add: Total stock-based  employee compensation expense determined under fair value based method for  all awards  |       | (1,931,810 | )           | (1,202,525 | )          | (1,022,439  | )          |
| Pro forma net  loss                                                                                                       |       | $          | (36,129,740 | )          | $          | (28,886,014 | )          | $ | (23,304,917 | ) |
| Basic and diluted  loss per share as reported                                                                             |       | $(1.14     | )           | $(0.93     | )          | $(0.79      | )          |
| Pro forma basic and  diluted loss per share                                                                               |       | $(1.21     | )           | $(0.97     | )          | $(0.83      | )          |

 

***(m)****       RecentlyIssued Accounting Pronouncements*

In December 2004, the FASB issued SFAS No. 123(revised 2004), *Share-Based Payment*,which addresses the accounting for transactions in which an entity exchangesits equity instruments for goods or services, with a primary focus ontransactions in which an entity obtains employee services in share-basedpayment transactions. This Statement is a revision to Statement 123 andsupersedes APB Opinion No. 25, *Accountingfor Stock Issued to Employees,*and its related implementationguidance. This Statement will require measurement of the cost of employeeservices received in exchange for stock compensation based on the grant-datefair value of the employee stock options. Incremental compensation costsarising from 

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subsequent modificationsof awards after the grant date must be recognized. The Company will adopt thisStatement on January 1, 2006 under the modified prospective method of application.Under that method, the Company will recognize compensation costs for new grantsof share-based awards, awards modified after the effective date, and theremaining portion of the fair value of unvested awards at the adoption date.The Company estimates that compensation costs for share based awards recognizedin accordance with Statement 123R will be approximately $1.5 millionto $1.8 million in 2006.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs,*which clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial. Under this Statement such items will be recognized as current-periodcharges. In addition, the Statement requires that allocation of fixedproduction overhead to the costs of conversion be based on the normal capacityof production facilities. This Statement will be effective for the Company forinventory costs incurred on or after January 1, 2006. The adoption of thisStatement did not have a material effect on the Company’s financial position,results of operations or cash flows.

In May 2005, the FASBissued SFAS No. 154,*Accounting Changesand Error**Corrections.*Statement 154 establishes, unless impracticable, retrospective applicationas the required method for reporting a change in accounting principle in theabsence of explicit transition requirements specific to a newly adoptedaccounting principle. This Statement will be effective for the Company for allaccounting changes and any error corrections occurring after January 1,2006.

***(n)****          Translationof Foreign Currency*

The Company follows thetranslation policy as provided by SFAS No. 52, *ForeignCurrency Translation,*in translating the financial statements of itsoperation in the United Kingdom from British pounds to U.S. dollars. Accordingly,assets and liabilities are translated at the rate of exchange at the balancesheet date. Income and expenses are translated at the average exchange rateprevailing throughout the year. Resulting cumulative translation adjustmentshave been recorded as a separate component of stockholders’ equity (deficit).

***(o)****           ComprehensiveIncome (Loss)*

The Company follows SFAS No. 130, *Reporting Comprehensive Income*. Comprehensive income (loss)includes net income (loss), foreign currency adjustments and unrealized gainsor losses on available for sale securities. Comprehensive income (loss) ispresented in the consolidated statements of stockholders’ equity (deficit).

Thecomponents of accumulated other comprehensive income (loss) are as follows:

| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Unrealized gain  on available-for-sale securities |       | $                     | —     |   | $ | 12,219 |   |
| Foreign currency  translation adjustments         |       | (20,096               | )          | 60,107 |   |
| Total                                             |       | $                     | (20,096    | ) | $ | (72,326 | ) |

 

***(p)****           AdvertisingCosts*

Advertising costs areexpensed as incurred. Advertising expense for the years ended December 31,2005, 2004 and 2003 was $158,000, $720,000 and $608,000, respectively.

***(q)****           FairValue of Financial Instruments and Concentration of Customers and Credit Risk*

Financial instruments consist principally of cash andcash equivalents, marketable securities, accounts receivable, accounts payableand notes payable. Other than notes payable, the estimated fair value of these 

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instruments approximates their carrying value due tothe short period of time to their maturities. The fair value of the Company’snotes payable is not practicable to estimate as debt with similar terms andremaining maturities is not currently available to the Company. A quoted marketprice is not available, and the Company has not obtained or developed avaluation model necessary to make the estimate due to the related costs.

During 2005 and 2004, the Company maintained cashbalances in excess of federally insured limits. The funds were with a majormoney center bank. The cash balance with the bank at December 31, 2005 and2004 was $532,000 and $1,088,000, respectively.

The Company’s largest customers, DaVita, the DialysisCenters of Lincoln and Northwest Kidney Center accounted for 16%, 11% and 8%,respectively, of its revenues (by dollar volume) for the year ended December 31,2005. For the year ended December 31, 2004, the Company’s largestcustomers, Northwest Kidney Center, the Dialysis Centers of Lincoln andBerkshire Medical Center accounted for 24%, 10% and 9%, respectively, of itstotal revenue.

Since the Company’s inception, substantially alleffort has been devoted to the development of the PHD System. The Companyexpects to be entirely dependent for the foreseeable future on sales of, andservices relating to, the PHD System for revenues. The Company’s dependence ona single product creates significant risk for the Company and its stockholders.

The Company currently relies on single contract manufacturersto manufacture each of the major components of the PHD System. Such contractorsare not employed or otherwise controlled by the Company and are generally freeto conduct their business at their own discretion. Although certain of theCompany’s contract manufacturers have entered into contracts to manufacturecomponents of the PHD System, such contracts can be terminated at any timeunder certain circumstances by the Company or by the contractors, and can bebreached at any time. Further, work stoppages and the slowing ofproduction at a single independent contractor would have a material adverseeffect on the Company’s results of operations.

There are also other risksinherent in using single sources of supply. The Company has not madealternative arrangements for the manufacture of the major components of the PHDSystem and the Company may not be able to implement acceptable alternativearrangements on a timely basis, or at all. It is likely that a significantinterruption in supply would result if the Company were required to utilize adifferent manufacturing contractor for any of the major components of the PHDSystem. The loss of the services of any of the Company’s contract manufacturerswould have a material adverse effect on its results of operations. In addition,the Company or its manufacturers may not be able to obtain, on a timely basis,components or other supplies necessary to manufacture or use the PHD System. Seediscussion of the Delphi MedicalSystems Corporation (“Delphi”) bankruptcy at Note 4.

**(2)**          Liquidityand Capital Resources

The Company’scapital requirements have been, and will continue to be, significant. TheCompany’s capital requirements will depend on many factors, including withoutlimitation:

·       thecost of servicing and supporting PHD System in use;

·       manufacturingand associated costs;

·       costsassociated with marketing, distribution, patient training and support networks;

·       continuedprogress in research and development

·       thecosts involved with protecting the Company’s proprietary rights.

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During 2006, the Company expects to use approximately$16 to $18 million in its operations, including service and support of thePHD Systems being used by patients today. Resources will also be directedtoward using the PHD System’s platform technology to develop the Company’s nextgeneration product. The Company believes that cash and liquid investments ofapproximately $7.8 million (including the receivable for the settlement ofthe sale of long-term investment securities) at December 31, 2005 as wellas proceeds from its transaction with the Durus Life Sciences Master Fund, Ltd.(“the Durus fund”) (see Note 20) are only sufficient to finance itsoperations into 2007.

In 2006, the Company will seek to raise the additionalcapital required to fund commercial activities in 2007. There can be noassurance that the Company will be able to raise the capital it will need onterms acceptable to the Company, or at all. Also, due to the recent tradingprices of the Company’s common stock, completion of a financing could be moredifficult and could result in significant dilution to the ownership interestsof the Durus fund and the other existing stockholders.

The Company has received a letter dated as of March 31,2006, in which the Durus fund stated its intention, and confirmed its ability,to provide financing necessary to fund the Company’s operations at leastthrough January 1, 2007. However, this letter does not represent a legallybinding commitment of the Durus fund to provide the Company with any financing,and the letter further provides that there are no third party beneficiaries tothe letter.

If the Company is unableto obtain additional financing on acceptable terms, its ability to operate itsbusiness will be materially and adversely impacted and its liquidity would beseverely impaired, giving rise to substantial doubt regarding its ability tocontinue as a going concern beyond 2006. The Company has already taken certain steps to restructure its business to conservecash, including a reduction in force during the fourth quarter of 2005. In theevent the Company is not able to raise capital for operations in 2007, it mayneed to take additional steps to reduce its operations.

**(3)**          Investments

During 2005, all investments matured or were sold. At December 31,2005, all investments were in cash or cash equivalents.

Thefollowing is a summary of investments as of December 31, 2004:

| ** **              | ** ** | **Long term available-for-sale securities at  December 31, 2004** | ** ** |
|-------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **              | ** ** | **Cost**                                                                                        | ** ** | **Net Unrealized  Holding Gain** | ** ** | **Fair Market Value** | ** ** |
| U.S. Government  Agency |       |                                                                                            | $          | 7,556,256 |   |   |   | $ | 12,219 |   |   |   | $ | 7,568,475 |   |   |
|                         |            |                                                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                       | ** ** | **Short term held-to-maturity securities at  December 31, 2004** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Amortized Cost**                                                                        | ** ** | **Gross Unrealized  Holding Losses** | ** ** | **Fair Market Value** | ** ** |
| Certificates of  Deposit         |       |                                                                                           | $          | 75,000 |   |   |   | $ | 0 |   |   |   | $ | 75,000 |   |   |
| U.S Treasury                     |       |                                                                                           | 9,490,587  |   |   |   | 7,187 |   |   |   | 9,483,400 |   |   |
| U.S. Government  Agency          |       |                                                                                           | 10,507,545 |   |   |   | 34,629 |   |   |   | 10,472,916 |   |   |
| Investment Grade  Corporate Debt |       |                                                                                           | 1,624,313  |   |   |   | 12,074 |   |   |   | 1,612,239 |   |   |
| Total                            |       |                                                                                           | $          | 21,697,445 |   |   |   | $ | 53,890 |   |   |   | $ | 21,643,555 |   |   |

 

As of December 31, 2004, the Company had anoutstanding line of credit of $3,400,000 with maximum available credit of$6,000,000. As of December 31, 2004, the Company had restricted short-terminvestments of $6,667,000 in order to satisfy the line of credit collateralrequirement. On September 27, 2005, the Company repaid its line of creditobligations. Repayment of the line of credit removed the collateral restrictionon the investment account.

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In addition, at December 31,2005 and 2004, the Company was required to hold a letter of credit secured bycash equivalents in the amount of $750,000 and $600,000, respectively, as asecurity deposit on the building lease. The restricted cash balance isclassified as a restricted long-term investment

**(4)**          Inventories

Inventoriesat December 31, 2005 and December 31, 2004, respectively, are asfollows:

| ** **                        | ** ** | **2005**  | ** ** | **2004** | ** ** |
|-----------------------------------|------------|-----------|------------|----------|------------|
| PHD  machines—finished goods |       | $         | 1,500,600  |     | $          | 4,504,500 |   |
| PHD machines  spare parts         |       | 1,202,485 |       | 876,396  |       |
| Consumables                       |       | 411,745   |       | 330,101  |       |
| Raw materials                     |       | 524,663   |       | 5,323    |       |
|                              |       | $         | 3,639,493  |     | $          | 5,716,320 |   |

 

The cost of producing the PHD System is currently inexcess of its market price. During the years ended December 31, 2005 and2004, inventory adjustments were recorded as product sales cost of sales in theamount of $331,000 and $568,000, respectively, in order to value the PHDmachines produced and purchased during the year in inventory at the lower ofcost or market.

At December 31, 2005 and 2004, the Company’sreserve for excess and obsolete parts and consumables inventory was $972,000and $340,000, respectively. The increase is due to the purchase of excess orobsolete production parts from the manufacturer of the PHD machine. During thefirst half of the year ended December 31, 2005, the Company estimated thatcertain production parts, purchased by the manufacturer of the PHD machine onthe Company’s behalf, had become obsolete. At that time, the Company had adeposit with the manufacturer and a reserve of $1,076,000 as a short-termliability to properly value the underlying parts. The Company purchased$1,977,000 of these production parts during the quarter ended September 30,2005, applied their cost against the deposit and reclassified $851,000 of theliability to the excess and obsolete inventory reserve to properly valueinventory on hand. The reserve is reduced in the period in which certain partsand consumable supplies are utilized or discarded.

The Company does not currently manufacture anycomponent of the PHD System or related consumables. With respect to the PHDSystem, the Company has contracted with Delphi, a contract manufacturer ofmedical devices, to assemble and produce the dialysis machine. Delphispecializes in the custom manufacturing of medical instrumentation and iscertified to ISO 13485 for manufacture of such products. ISO 13485 isan internationally recognized quality systems standard for the medical deviceindustry. Delphi is also FDA registered and quality system regulations (“QSR”)compliant. The contract automatically renews each February on an annual basisunless six-month advance notice is provided by either party to terminate thecontract or a party exercises its right to terminate for breach or undercertain other circumstances.

Delphi is the Company’s sole supplier of the PHDSystem, and conducts its manufacturing operations at a single location. TheCompany may identify additional manufacturing locations in the future, whetheror not owned by Delphi, to avoid having to rely on a single source andlocation. There can be no assurances that the Company will be able to do so onacceptable terms. The manufacturing of the Company’s products is subject toquality regulations and other requirements prescribed by regulatory agencies. Therecan be no assurance that Delphi or any other manufacturer of the Company’sproducts will continue to comply with applicable regulatory requirements orthat Delphi or any other manufacturer will be able to supply the Company withproducts in sufficient quantity or at all.

On October 8, 2005,Delphi and its parent corporation filed a voluntary petition for businessreorganization under Chapter 11 of the U.S. Bankruptcy Code. The ultimateeffect of the bankruptcy on 

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theCompany’s relationship with Delphi is unclear. The Company has a UniformCommercial Code financing statement on file with the Colorado Secretary ofState with respect to certain component inventory located at Delphi’swarehouses. In addition, as of December 31, 2005, the Company had a cashdeposit with Delphi of $1,432,000 as security for certain of the Company’spurchase obligations. The Company has recorded a reserve to reflect theuncertainty associated with the bankruptcy filing; however, the Company ispursuing the full value of the deposit. The Company has had ongoing discussionswith Delphi regarding its accounts payable balance, its deposit and certainparts inventory located at Delphi’s warehouses. In the first quarter of 2006,the Company received correspondence from Delphi advising it of their decisionto stop further shipments of PHD Systems and parts until these items have beenresolved. The Company plans to continue discussions with Delphi and believesthat it has a sufficient inventory of parts and machines on hand to enable itto continue operations pending the resolution of this matter.

**(5)**          Property,Equipment and Leased Assets

Property,equipment and leased assets at December 31, 2005 and 2004, respectively,are as follows:

| ** **                                            | ** ** | **Estimated  useful life** | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| Leased assets                                         |       | 5 years                    |       | $          | 4,901,329  |       | $          | 2,847,673 |   |
| Furniture and  fixtures                               |       | 7 years                    |       | 1,238,586  |       | 1,238,586  |       |
| Leasehold  improvements                               |       | 10 years                   |       | 1,171,147  |       | 1,146,511  |       |
| Equipment                                             |       | 3-7 years                  |       | 5,420,418  |       | 5,272,998  |       |
|                                                  |       |                            |       | 12,731,480 |       | 10,505,768 |       |
| Less accumulated  depreciation and amortization  |       |                            |       | (7,545,220 | )          | (6,581,846 | )          |
|                                                  |       |                            |       | $          | 5,186,260  |       | $          | 3,923,922 |   |

 

Leased assets at December 31,2005 were $4,901,000 with related accumulated depreciation of $938,000. At December 31,2004, leased assets were $2,848,000 with accumulated depreciation of $457,000.

**(6)**          Stockholders’Equity and Notes Payable

***Settlement with the Durus fund***

In February 2004, the Company settled all of itsoutstanding claims against the Durus fund and other defendants with the signingof a settlement agreement (“Settlement Agreement”). The Company had filed alawsuit in August 2003 after learning that the Durus fund , Scott Sacane,Durus Capital Management, LLC (“Durus Capital”), Durus Capital (N.A.), LLC(“Durus Capital (N.A.)”), and Artal Long Biotech Portfolio LLC (“the Artalfund”) had acquired over 70% of the Company’s outstanding common stock. TheDurus fund, Mr. Sacane, Durus Capital, Durus Capital (N.A.) and the Artalfund are collectively referred to as “defendants” and individually as a “defendant.”

*Backgroundto the Litigation.*   In April 2003, theCompany entered into an agreement with Mr. Sacane and Durus Capitalrelating to shares of its common stock they then controlled through the Durusfund (the “April 2003 Agreement”). The Company entered into the April 2003Agreement after it learned that certain of the defendants had accumulated aposition in its common stock in excess of the 15% ownership level that wouldpotentially trigger its shareholders rights agreement.

Pursuant to the terms of the April 2003Agreement, Mr. Sacane and Durus Capital represented that they: (1) thenowned 5,238,248 shares (approximately 19.5%) of the Company’s outstandingcommon stock, (2) crossed the 15% ownership level inadvertently, and (3) heldthis investment in the Company in the ordinary course of business and not forthe purpose or with the effect of changing or influencing the control of theCompany. In addition, they agreed to reduce their holdings to below 15%ownership over a 

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two-year period and not to purchase any additionalshares of the Company’s common stock until such time as their ownership wasless than 15% of the shares then-outstanding (and thereafter not in excess of15% without the consent of the Company’s board of directors).

After the close of business on July 24, 2003,Mr. Sacane informed the Company that he, together with the otherdefendants, had accumulated in excess of 19 million shares of theCompany’s common stock in transactions he described as inadvertent. In aSchedule 13D filed with the SEC on July 28, 2003, the defendantsdisclosed that they owned 21,333,118 of these shares and the Artal fund owned498,100.

In August 2003, the Company filed a lawsuitagainst the defendants in the United States District Court for the District ofConnecticut. The lawsuit sought injunctive relief and damages arising from thedefendants’ alleged violation of federal securities law and the alleged breachof the April 2003 Agreement. In addition, the lawsuit sought recovery of short-swingtrading profits under Section 16(b) of the Securities Exchange Act of1934.

In January 2004, the Company settled theSection 16(b) claim against the defendants for $4.6 million, onecount of the three-count complaint filed by Aksys against the defendants inU.S. District Court in Connecticut. In February 2004, the Company settledall other claims against the Durus Fund and other defendants for an aggregatepayment to the Company of $48.7 million, which includes the purchase bythe Durus Fund and another defendant of $16.1 million of promissory notes(“Notes”) and the earlier $4.6 million payment to settle claims underSection 16. In May 2004, the Company received a final payment of$10.0 million in connection with the effectiveness of a registrationstatement that was filed with the SEC covering the securities owned by Durusfund and the Artal fund. Under the registration rights agreement between theCompany and the Durus fund, the Company agreed to pay up to $500,000 in costswith respect to any shelf registration required to sell the shares held by theDurus fund. The Company has paid $100,000 for professional services throughDecember 31, 2005, and has a remaining accrued liability for the balanceof $400,000, as of December 31, 2005.

The Company has recorded a liability for servicesprovided by an investment banking firm in relation to the Durus Settlement. Theamount to be paid to the investment banking firm for these services is undernegotiation.

The $22.6 million cash payment received in the firstquarter of 2004, and the $10.0 million received during the second quarterof 2004 from the Durus settlement were considered to be capital contributionsand were recorded as an increase to additional paid-in capital. The Companyalso received $16.1 million in cash in exchange for zero-interest,long-term notes payable. As discussed in Note 20, $15.8 million ofthe outstanding Notes will be exchanged in connection with the Company’stransaction with the Durus fund. The Company imputed an interest rate of 10%,and discounted the Notes to $12.6 million. The $3.5 million discounton the Notes was also recorded as an increase to additional paid-in capital.

The outstanding Notes aresubordinated and junior in right of payment to all of the Company’s creditors,including trade creditors, and do not bear interest. The Company may repay theNotes in cash at any time. After the later of (1) August 30, 2005 and(2) the first trading day on which the holders of the Notes own less than10% of the Company’s then-outstanding common stock, the Company may repay theNotes in stock for a limited period of time. The holders of the Notes did notown less than 10% of the Company’s stock as of December 31, 2005. Anystock issued in repayment of the Notes will be entitled to registration rightspursuant to the registration rights agreement. The Notes will become due andpayable one year after the later of the two dates above and in no event laterthan February 23, 2009. If the Company elects to repay the Notes in stock,the number of shares that must be delivered for payment will be determinedbased on the average of the closing prices of the Company’s common stock on theNasdaq CapitalMarket over the twenty trading dayspreceding the election to repay in stock. The Notes will also become due andpayable in cash upon a change of control. In the event of a change of controlrepayment, in addition to repayment of the then-outstanding principal amount ofthe Notes, the Company is required 

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to payto the holders of the Notes an amount equal to (1) 5% of the considerationreceived by (a) the Company in the case of an asset sale transactionconstituting a change of control (net of corporate taxes, transaction expensesand indebtedness of the Company) or (b) the Company’s stockholders and theholders of the Notes in a merger or other type of transaction constituting achange of control, less (2) the principal amount to be repaid.

***Equity Line of Credit Agreement***

On January 22, 2003,the Company entered into a $15 million equity line of credit arrangementwith Kingsbridge Capital Limited (“Kingsbridge”). This arrangement superceded asimilar arrangement entered into between the Company and Kingsbridge on October 15,2002. Pursuant to the terms of the Amended and Restated Common Stock PurchaseAgreement between the Company and Kingsbridge, the Company could sell commonstock at its sole discretion over a 24-month period on a “when and ifneeded” basis, and Kingsbridge was required under the terms of the agreement topurchase this stock, subject to the satisfaction of certain conditionscontained in the agreement. During the year ended December 31, 2003, theCompany issued 2,489,408 shares of common stock to Kingsbridge under theequity line arrangement and received $15.0 million in proceeds. TheCompany received $1,150,000 when Kingsbridge exercised 200,000 warrants topurchase common stock at $5.75 per share in 2003. As of December 31, 2003,the Company had fully drawn the equity line with Kingsbridge and did not have asimilar arrangement with Kingsbridge.

***Issuance of Common Stock and Warrants***

At December 31, 2005, warrants for a total of1,098,930 shares of common stock were outstanding. These warrants have aweighted average exercise price of $6.14 and expire at various dates from 2006to 2015. There were no exercises of warrants in 2005. In 2004 there was oneexercise of 56,308 shares at a price of $3.25 per share.

On June 30, 2003, the Company issued 1,363,637 sharesof common stock to a single investor and received net proceeds of $13.8 million.In addition, the Company issued a warrant to purchase 204,546 shares ofstock at an exercise price of $13.75 per share. This warrant had a fair valueof $1,007,745 using the Black Scholes pricing model. The Company also issued awarrant to purchase 136,364 shares of common stock at an exercise price of$15.00 per share to an investment banking firm that acted as placement agent inthis transaction. This warrant had a fair value of $622,908 using the BlackScholes pricing model. The Company offered the foregoing securities in a publicoffering.

On November 1, 2005, the Company entered into aResearch, Development and License Agreement (the “Research, Development andLicense Agreement”) with DEKA Products Limited Partnership and DEKA Researchand Development Corp. (“DEKA”).

Under the Research, Development and License Agreement,DEKA will develop a next generation product for the Company consisting ofcertain hemodialysis equipment and related solution preparation processes. DEKAwill be compensated for its development work on a cost plus basis, which willbe generally determined based upon DEKA’s costs incurred and hours spent on theproject. The Company made a payment to DEKA of approximately $950,000 forservices performed through December 31, 2005. The Company is required tomake payments to DEKA of approximately $200,000 per month, subject to periodicreconciliation to DEKA’s actual costs incurred and hours spent pursuant to theproject. The Company retains the right to terminate this development work atany time. In addition, the Company will pay DEKA royalties based upon apercentage of net sales of products developed under the Research, Developmentand License Agreement (the “Product”) with the applicable percentage based uponthe number of patients using such Product.

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DEKA will own the intellectual property created ordeveloped in connection with the project, except that the Company shall owntitle to any and all intellectual property created and developed solely by theCompany independent of any assistance from DEKA as a result of the Company’sown development efforts. DEKA has granted the Company an exclusive worldwidelicense to use certain patents related to hemodialysis within a specified fieldof use and a nonexclusive worldwide license to use certain patents related tosolution preparation processes within a specified field of use. DEKA has alsogranted the Company a nonexclusive license to use certain technical informationrelated to hemodialysis and solution preparation processes within a specifiedfield of use. In most instances, termination of the DEKA Agreement would resultin the Company’s license under the DEKA Agreement terminating.

The Research, Developmentand License Agreement provided for the issuance to DEKA of warrants to purchase350,000 shares of the Company’s common stock (the “Warrants”). TheWarrants become exercisable upon achievement of the following milestones: (i) 100,000warrant shares shall vest upon a concept freeze of the Product (ii) 100,000warrant shares shall vest upon a prototype being built for the Product (iii) 100,000warrant shares shall vest upon transfer of the Product to a manufacturer and (iv) 50,000warrant shares shall vest upon commercial shipment of the Product. The Warrantshave a term of ten years. If specified dates which are targeted for reachingmilestones in the Research, Development and License Agreement are not achieved,warrants to purchase up to 120,000 shares of the Company’s common stockmay be forfeited by DEKA. If the milestones are not achieved, no warrants willvest. The exercise price of the Warrants is $1.62 per share, the average of thehigh and low trading price of the Company’s common stock on the Nasdaq NationalMarket System on the date of execution of the Research, Development and LicenseAgreement. In accordance with EITF 96-18, *Accounting for Equity Instruments That Are Issued to Other ThanEmployees for Acquiring, or in Conjunction with, Selling Goods or Services,*as the exercisability of the warrants is dependent on the achievement ofcounterparty performance, no expense was recorded for the year ended December 31,2005.

**(7)**          StockOption Plans

The Company established a nonqualified stock optionplan in 1993 (the “1993 Stock Option Plan”), which provides for the granting ofoptions to purchase shares of the Company’s common stock to employees,scientific advisory board members, other associates, and members of the boardof directors. In March 1996, the Company established the 1996 Stock AwardsPlan (together with the 1993 Stock Option Plan, the “Stock Plans”) to provideincentive awards to directors, employees and other key individuals in the formof stock options, SARs, restricted stock and performance grants. Options vestover various periods as set forth in agreements relating to a particular optiongrant and expire as determined by the board on an individual basis, but not toexceed 10 years. At the time the 1996 Stock Awards Plan was established,the 1993 Stock Option Plan was terminated, except with respect to options thenoutstanding. At December 31, 2005, 2,930,768 shares of common stockhave been reserved for issuance under the Stock Plans, including 691,096 sharesavailable for future grants under the 1996 Stock Awards Plan.

The per share weighted-average fair value of stock optionsgranted during 2005, 2004 and 2003 was $1.54, $5.17 and $4.63, respectively, onthe dates of grant using the Black Scholes option-pricing model with thefollowing weighted-average assumptions: 2005—expected dividend yield of 0%,expected volatility of 94.55%, risk-free interest rate averaging 3.90% and anexpected life of 5 years; 2004—expected dividend yield of 0%, expectedvolatility of 97.41%, risk-free interest rate averaging 2.28% and an expectedlife of 5 years; 2003—expected dividend yield of 0%, expected volatilityof 65.05%, risk-free interest rate averaging 2.07% and an expected life of 5 years.The number of options exercisable at December 31, 2005, 2004 and 2003 were1,539,499, 1,220,443 and 910,943, respectively.

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Stockoption activity during the periods indicated is as follows:

| ** **                         | ** ** | **Number**  of shares | ** ** | **Weighted-average**exercise price | ** ** |
|------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|
| Balance at December 31, 2002  |       | 1,373,210                  |       |                                    | $          | 6.22 |   |   |
| Granted                            |       | 274,000                    |       |                                    | 8.26       |   |   |
| Exercised                          |       | (148,310                   | )          |                                    | 4.80       |   |   |
| Canceled                           |       | (65,050                    | )          |                                    | 6.73       |   |   |
| Balance at December 31, 2003  |       | 1,433,850                  |       |                                    | 6.73       |   |   |
| Granted                            |       | 683,035                    |       |                                    | 7.00       |   |   |
| Exercised                          |       | (2,254                     | )          |                                    | 7.31       |   |   |
| Canceled                           |       | (63,450                    | )          |                                    | 6.98       |   |   |
| Balance at December 31, 2004  |       | 2,051,181                  |       |                                    | 6.81       |   |   |
| Granted                            |       | 349,351                    |       |                                    | 4.14       |   |   |
| Exercised                          |       | (1,268                     | )          |                                    | 2.37       |   |   |
| Canceled                           |       | (159,592                   | )          |                                    | 7.08       |   |   |
| Balance at  December 31, 2005 |       | 2,239,672                  |       |                                    | $          | 6.38 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**              | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding  at 12/31/05** | ** ** | **Weighted-Average  Remaining  Contractual Life** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Number  Exercisable  at 12/31/05** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $0.25 to $3.99                              |       |                         | 63,233     |                                      |       |   | 9.2 years |   |   |   | $ | 2.25 |   |   | 27,712 |   |   | $ | 2.13 |   |   |
| $4.00 to $5.00                              |       |                         | 393,367    |                                      |       |   | 7.6 years |   |   |   | 4.62 |   |   | 181,930 |   |   | 4.60 |   |   |
| $5.01 to $6.00                              |       |                         | 713,182    |                                      |       |   | 5.0 years |   |   |   | 5.33 |   |   | 607,857 |   |   | 5.35 |   |   |
| $6.01 to $7.50                              |       |                         | 669,165    |                                      |       |   | 7.4 years |   |   |   | 6.66 |   |   | 428,650 |   |   | 6.61 |   |   |
| $7.51 to $16.75                             |       |                         | 400,725    |                                      |       |   | 5.7 years |   |   |   | 10.15 |   |   | 293,350 |   |   | 10.08 |   |   |
| $0.25 to $16.75                             |       |                         | 2,239,672  |                                      |       |   |   |   |   |   | $ | 6.38 |   |   | 1,539,499 |   |   | $ | 6.46 |   |   |
|                                             |            |                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(8)**          EmployeeBenefit Plans

In 1995, the Company adopted a tax-qualified employeesavings and retirement plan (the “401(k) Plan”) covering all full-timeemployees. The 401(k) Plan provides a match of 100% of the employees’contributions up to 2% of an employee’s salary. Total expense for the yearsended December 31, 2005, 2004 and 2003 was $138,000, $115,000 and $85,000,respectively.

On March 4, 1996, the Company established the1996 Employee Stock Purchase Plan (the “1996 Stock Purchase Plan”) covering allemployees. The 1996 Stock Purchase Plan allowed employees to purchase Companycommon stock at a 15% discount to market, based on eligible payroll deductions.

On April 26, 2001,the Company established the 2001 Employee Stock Purchase Plan (the “2001 StockPurchase Plan”) covering all employees. The 2001 Stock Purchase Plan supercededthe Company’s 1996 Stock Purchase Plan. The 2001 Stock Purchase Plan allowsemployees to purchase Company common stock at a 15% discount to market, basedon eligible payroll deductions. There are four plan periods in each calendaryear, with each such plan period corresponding with a calendar quarter. Marketprice is calculated as the fair market value of the common stock as of the lasttrading day of such plan period less the discount to the market. A total of250,000 shares of common stock were reserved for issuance under the 2001Stock Purchase Plan. Total shares issued based on payroll withholdings for theyears ended December 31, 2005, 2004 and 2003 were 104,951 (34,120 issued January 2006),37,738 (9,738 issued 

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January 2005)and 16,394 (4,071 issued January 2004), respectively. As of December 31,2005, there were 26,118 shares remaining under the 2001 Stock PurchasePlan, after considering the shares issued in January 2006.

**(9)**          StockholderRights Plan

On October 28, 1996,the Company adopted a stockholder rights plan and declared a dividend to bemade to stockholders of record on November 8, 1996 of one preferred sharepurchase right on each outstanding share of the Company’s common stock. Thestockholder rights plan was adopted to preserve for the stockholders of theCompany the long-term value of the Company in the event of a takeover of theCompany or the purchase of a significant block of the Company’s common stockand to protect the Company and its stockholders against coercive takeovertactics. Prior to the time the rights become exercisable, the rights will beevidenced by the certificates representing shares of common stock of theCompany and will be transferable only in connection with the transfer of sharesof common stock. If a person acquires 15% of the Company’s common stock, therights will then be exercisable, and each right will entitle the holder thereofto purchase for an exercise price of $85.00 (subject to adjustment), shares ofthe Company’s common stock having a market value of twice such exercise price,valued as of the date of occurrence of such triggering event, subject to theright of the Company to exchange the rights for common stock of the Company ona one-for-one basis. The Company will be entitled to redeem the rights at $0.01per right at any time before public disclosure that a 15% position has beenacquired. The rights will expire on October 28, 2006, unless previouslyredeemed or exercised. As part of the Settlement Agreement with the Durus fund,as discussed in Note 20, the Company has taken actions to amend itsshareholder rights agreement so that it will not be applicable to the Durusfund or the transactions with the Durus fund and to eliminate its rightsagreement.

**(10)**   IncomeTaxes

As a result of the settlement with Durus, the Companyhad an income tax obligation for the year ended December 31, 2004. Netoperating loss carryforwards were used to cover a portion of the taxable incometriggered under the alternative minimum tax. The Company has recorded incometax expense of $18,000 and $106,000 for the years ended December 31, 2005and 2004, respectively. At December 31, 2005, the Company has operatingloss and other tax credit carryforwards for Federal income tax purposes ofapproximately $162,564,000 and $3,079,000. The operating loss carryforwardsexpire at various dates beginning in 2015. As a result of the annuallimitation, a portion of these carryforwards may expire before ultimatelybecoming available to reduce federal income tax liabilities. Changes in theCompany’s ownership would cause additional limitations on the amount of lossand credit carryforwards that can be utilized to offset income in the future.

Thenet deferred tax assets are summarized at December 31 as follows:

| ** **                           | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------------------|------------|-------------|------------|-------------|------------|
| Deferred tax assets:                 |       |        |       |        |       |
| Net operating loss carryforwards     |       | $           | 65,025,000 |        | $          | 51,895,000 |   |
| Research and other tax carryforwards |       | 3,079,000   |       | 2,961,000   |       |
| Other                                |       | 801,000     |       | 584,000     |       |
| Total deferred  tax assets           |       | 68,905,000  |       | 55,440,000  |       |
| Less valuation  allowance            |       | (68,905,000 | )          | (55,440,000 | )          |
| Net deferred  taxes                  |       | $           | —     |        | $          | — |   |

 

Given the Company’shistorical losses and uncertainty with respect to the Company’s ability togenerate future taxable income, management has established a valuationallowance of $68,905,000 at 

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December 31,2005 and $55,440,000 at December 31, 2004 to reduce the net deferred taxassets to zero. The increase (decrease) in the valuation allowance was$13,465,000 and $(1,930,000) in 2005 and 2004, respectively.

**(11)**   ContractualObligations

***Purchases***

The Company has a contractual obligation with Delphi,the manufacturer of the PHD System, to purchase the inventory that Delphipurchased for scheduled production of future PHD Systems. During 2004,Delphi purchased approximately $3,895,000 of parts on the Company’s behalf tobe used in future production. In 2004, the Company paid a deposit of $3,409,000to Delphi in consideration of purchase obligations. In addition, the Companyhad a reserve recorded as a short-term liability of $130,495 for potentialobsolescence of this pre-production inventory at December 31, 2004.

In 2005, the Company estimated that $1,076,000 ofcertain production parts had become obsolete and increased the reserve toproperly value the deposit. As the Company purchases and obtains title toproduction parts, the cost is applied to the deposit balance and the associatedshort-term liability is reclassified to the excess and obsolete inventoryreserve.

During 2005, the Company purchased $1,977,000 of theseproduction parts from Delphi. Of the parts purchased by the Company, $526,000were used in manufacturing, $926,000 were obsolete and $525,000 remain ininventory to be used in future manufacturing or as spare parts. A portion ofthe corresponding reserve on the deposit, $851,000, was transferred fromshort-term liabilities to the excess and obsolete inventory reserve to properlyvalue this inventory at December 31, 2005.

Delphi used approximately $928,000 of the parts inmanufacturing during the third and fourth quarters of 2005. The remainingparts, approximately $504,000, are available to be used in future production oras spare parts; however, they are potentially excess or obsolete and a reserveof $226,000 has been recorded as a short-term liability.

On October 8, 2005, Delphi and its parentcorporation filed a voluntary petition for business reorganization under Chapter 11of the U.S. Bankruptcy Code. The ultimate effect of the bankruptcy on theCompany’s relationship with Delphi is unclear. The Company has a UniformCommercial Code financing statement on file with the Colorado Secretary ofState with respect to certain component inventory that is located at Delphi’swarehouses. In addition, as of December 31, 2005, the Company had acash deposit with Delphi of $1,432,000 as security for certain purchaseobligations. The Company has recorded a reserve to reflect the uncertaintyassociated with the bankruptcy filing; however, the Company is pursuing thefull value of the deposit. The deposit balance after the reserve was $738,000at December 31, 2005.

During 2005, Delphi purchased additional parts to beused on the Company’s behalf. The Company has an obligation to purchase theseparts in the future but has not given Delphi a deposit for them. The totalamount of this contractual obligation as of December 31, 2005 is$3,603,000.

The Company will continue to monitor the potentialimpact of the bankruptcy on its business and financial relationship with Delphi(including its inventory and deposit relationship).

Under the Research,Development and License Agreement with DEKA (see Note 6, Stockholder’sEquity and Notes Payable), the Company may terminate the agreement on 90 daysadvance notice. During the 90 day notice period, the Company will continueto reimburse DEKA, but the monthly reimbursement amount will not exceed theaverage rate of the prior three months. As of December 31, 2005, thecontractual obligation to DEKA was $600,000.

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***Leases***

During September 1996, the Company entered into alease agreement, accounted for as an operating lease, for its offices andlaboratory research facilities. The term of the lease was ten years expiring inSeptember 2006. In November 2004, the Company amended its lease witha five year extension through December 2011. The Company also leasescertain equipment under operating leases. Included in research and developmentexpenses and general and administrative expenses for the years ended December 31,2005, 2004 and 2003 was $712,000, $612,000 and $656,000, respectively, for rentexpense under operating leases for certain equipment and the Company’s officesand research facilities.

TheCompany has commitments for future minimum rent payments under these operatinglease agreements, as follows:

| 2006                  |   | $       | 603,043   |   |
|-----------------------|--------|---------|-----------|--------|
| 2007                  |   | 582,918 |      |
| 2008                  |   | 587,014 |      |
| 2009                  |   | 618,139 |      |
| 2010                  |   | 670,014 |      |
| All subsequent  years |   | 701,139 |      |
|                  |   | $       | 3,762,267 |   |

 

***License Agreements***

TheCompany has been granted licenses to use certain technology in the developmentand sale of its products. Such license agreements provide for royalty paymentsto be made by the Company based on net sales over the life of any applicationbased on the patent rights. Minimum required payments under these agreementsare as follows:

| 2006                  |   | $       | 250,000   |   |
|-----------------------|--------|---------|-----------|--------|
| 2007                  |   | 250,000 |      |
| 2008                  |   | 250,000 |      |
| 2009                  |   | 250,000 |      |
| 2010                  |   | 250,000 |      |
| All subsequent  years |   | 275,588 |      |
|                  |   | $       | 1,525,588 |   |

 

Total royalty expense forthe years ended December 31, 2005, 2004 and 2003 was $251,667, $255,000,and $215,000, respectively.

**(12)**   ImpairmentCharge

In 2005, the Company determined that a design flawrequired certain PHD machines to be replaced throughout 2006, before the end oftheir previously estimated useful life. This change required an impairmentanalysis to be performed in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*.The estimated undiscounted future cash flows generated by these machines wereless than their carrying values. The Company recognized an impairment charge of$1,370,000, representing the difference between the carrying amount and thefair value, determined using the expected present value of future cash flows,as set forth in FASB Concepts Statement No. 7. The new asset value isbeing amortized over the remaining life. The impaired rental machines, whichwill be taken out of service and replaced with a new model of the machine, willbe disposed of, as they have no resale or residual value.

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The impairment charge is included in the “productrentals” cost of sales category of the Company’s consolidated statement ofoperations and the line “impairment charge” on the consolidated statement ofcash flows for the year ended December 31, 2005.

Additionally, the Companyhas revised the useful life of similar machines classified within property andequipment, which are utilized for internal training and testing purposes, anddepreciation has been accelerated on these machines.

**(13)**   ProductWarranty

The Company provides maintenance as part of itsservice and supplies agreements with customers. When circumstances areidentified whereby the scope of service to the machine extends beyond thenormal cost of service and supply contracts, the Company performs a specificanalysis to determine the extent of service required. The Company records aloss to cost of sales once the excess cost is probable and estimable.

During the fourth quarter of 2004, the Companydiscovered that one component part did not meet performance requirements andbegan to fail. At that time, a product warranty reserve of $652,000 wasestablished for replacement of this component part.

In 2005, the Company determined that in order tofulfill its product warranty obligation it was necessary to replace certain PHDmachines that were experiencing failures due to a design flaw. The Companyincreased its product warranty reserve by $1,261,000 based on its estimate ofthe costs required to replace these machines.

Thefollowing table identifies the Company’s product warranty activity for theyears ended December 31, 2004 and 2005:

| **Product Warranty**                                                         | ** ** | ** ** | ** ** | **Amount** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Establishment of  product warranty reserve during the fourth quarter of 2004 |       | $          | 652,000    |       |
| Product warranty  liability as of December 31, 2004                          |       | 652,000    |       |
| Amounts accrued  during the year ended December 31, 2005                     |       | 1,261,000  |       |
| Costs incurred                                                                    |       | (737,832   | )          |
| Product warranty  liability as of December 31, 2005                          |       | $          | 1,175,168  |       |

 

**(14)**   AccruedLiabilities

As of December 31,2005 and 2004, the total of accrued liabilities was $3,173,000 and $2,853,000,respectively. The details of the balances are identified in the followingtable.

| ** **                                      | ** ** | **Balance at**         | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| Accrued vendor  expenses                        |       |                        | $          | 260,645 |   |   |   | $ | — |   |   |
| Accruals relating  to original Durus settlement |       |                        | 1,149,664  |   |   |   | 899,664 |   |   |
| Accrued wages and  bonuses                      |       |                        | 249,634    |   |   |   | 1,056,098 |   |   |
| Accrued royalties                               |       |                        | 112,500    |   |   |   | 115,000 |   |   |
| Accrual for  warranty and obsolescence          |       |                        | 1,400,718  |   |   |   | 782,495 |   |   |
|                                            |       |                        | $          | 3,173,161 |   |   |   | $ | 2,853,257 |   |   |

 

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**(15)**   Commitmentsand Contingencies

In July 2004, an alleged short-seller of theCompany’s stock filed a lawsuit against the Durus fund and the Company in theFederal District for the State of Connecticut (Collier v. Aksys, Ltd. etal., District of Connecticut, Civil Action No. 3:04-CV-01232).The lawsuit is a purported class action filed on behalf of all short-sellers ofthe Company’s stock during the period of January 1, 2003 through July 24,2003. The Company was voluntarily dismissed as a party from this case and wasnot named as a defendant in the plaintiff’s subsequent amended complaint. Inlate 2005, the United States District Court in Connecticut dismissed Collier’sclaims as to all parties. Collier has filed an appeal with the United StatesCourt of Appeals for the Second Circuit. The Company is not a party to thoseproceedings.

In the ordinary course of business, the Company isparty to employment and other legal actions as plaintiff or defendant. Whilemanagement cannot determine with certainty the ultimate outcome of suchlawsuits, management believes that the Company is not involved in any currentlitigation proceedings which, should there be an unfavorable disposition,either individually or in aggregate, would have a material adverse effect onthe Company’s consolidated financial position, results of operations orliquidity.

The Company has agreed toindemnify certain of its contract manufacturers against certain liabilitiesresulting from the sale of the PHD System. It is not possible to predictthe maximum amount of future payments under the indemnification agreements dueto the conditional nature of the Company’s obligations. Historically, theCompany has not made any payments under these agreements. As of December 31,2005, management was not aware of any obligations arising under indemnificationagreements.

**(16)**   Restructuring

In the fourth quarter of 2005, the Company determinedthat its cost structure exceeded the level required by its current near-termrevenue opportunities. The cost structure for production of the PHD Systemexceeded and continues to exceed its market price. Additionally, the continueduncertainty related to adequate third-party reimbursements for dialysistreatment, especially from Medicare and Medicaid, caused the Company tore-evaluate its near-term growth opportunity and align its cost structureaccordingly. As a result, the Company executed a reduction in force,eliminating 44 positions across all areas of the Company. All employees werenotified of their termination on December 6, 2005 and were severed thatday. The Company paid $125,000 for severance payments during the fourth quarterof 2005. A short-term accrual of $36,000 was recorded at December 31, 2005representing the remaining severance payments, which were made by the end ofthe first quarter of 2006. The total restructuring charges recorded during 2005were $161,000.

Concurrent with thereduction in force, the Company’s Senior Vice Presidents and Chief ExecutiveOfficer agreed to take a temporary 20% deferral of base pay beginning February 1,2006. Additionally, the Company cancelled the 2005 bonus plan for all employeesand executive officers. The Company put a bonus plan in place for employeeswhose employment continues through each quarter of 2006, with the quarterlypayment based on a percentage of each employee’s base compensation. The totalamount of payments for 2006 is expected to be approximately $761,000. Neitherthe salary deferral nor the bonus plan is reflected in the accompanyingconsolidated financial statements as of December 31, 2005.

**(17)**   Lineof Credit and Letter of Credit

On June 17, 2004, the Company entered into a Lineof Credit Note (the “Line of Credit”), by and among the Company, as borrowerthereunder (the “Borrower”), and Bank One, NA, as lender. The Line of Creditprovided for an eighteen-month credit facility consisting of an aggregate $6.0 millionrevolving line of credit, which originally matured on December 31, 2005. TheLine of Credit bore interest at the bank’s prime rate or at LIBOR plus a marginof 0.75%. Under the Line of Credit, the Company and its 

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subsidiaries were subjectto restrictions on selling or transferring assets and making certaininvestments, including acquisitions. Proceeds from the Line of Credit were usedas a deposit to the manufacturer of the PHD System for parts purchased onthe Company’s behalf to be used in future production, pursuant to the agreementwith that vendor. At December 31, 2004, there was $3.4 millionoutstanding under the Line of Credit. The Company was required to maintain aminimum balance in its investment account as collateral for the Line of Credit.The amount of collateral required was dependant on the type of investments inthe account. As of December 31, 2004, 90% of the value of restrictedsecurities was required to cover the maximum available credit of $6.0 million.As of December 31, 2004, the Company had restricted short-term investmentsof $6.7 million in order to satisfy the line of credit collateralrequirement.

On September 27, 2005, the Company repaid itsline of credit obligations of $3.4 million. Repayment of the line ofcredit removed the restriction on this investment account.

In addition, at December 31,2005 and 2004, the Company was required to hold a letter of credit secured bycash in the amount of $750,000 and $600,000, respectively, as a securitydeposit on the building lease. The restricted cash balance is classified as arestricted long-term investment.

**(18)**   QuarterlyResults of Operations (Unaudited)

Thefollowing table sets forth the Company’s unaudited quarterly operating resultsfor the eight quarters ended December 31, 2005. This information has beenderived from the Company’s unaudited consolidated financial statements andincludes all adjustments, consisting only of normal recurring adjustmentsnecessary for a fair presentation of such information. Historical quarterlyoperating results are not indicative of results to be achieved in succeedingquarters or years and should not be relied upon as an indication of futureperformance.

| ** **                     | ** ** | **Three months ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **Dec. 31,  2005**          | ** ** | **Sep. 30,  2005** | ** ** | **June 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **June 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| Revenues                       |       | $                                | 827,213    |   | $ | 822,309 |   | $ | 485,178 |   | $ | 534,289 |   | $ | 654,070 |   | $ | 580,831 |   | $ | 499,175 |   | $ | 681,983 |   |
| Cost of sales                  |       | 3,230,184                        |       | 2,671,827 |   | 5,256,658 |   | 3,766,409 |   | 3,332,318 |   | 2,380,649 |   | 2,451,138 |   | 2,498,835 |   |
| Operating costs  and expenses: |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development       |       | 1,572,638                        |       | 1,987,730 |   | 2,471,493 |   | 2,036,968 |   | 1,758,452 |   | 1,710,880 |   | 1,553,573 |   | 1,661,560 |   |
| Sales and marketing            |       | 951,848                          |       | 1,127,396 |   | 1,205,871 |   | 1,247,125 |   | 1,286,032 |   | 1,064,685 |   | 1,284,692 |   | 1,156,275 |   |
| General and administrative     |       | 1,869,482                        |       | 1,829,733 |   | 2,013,935 |   | 2,334,693 |   | 2,050,854 |   | 1,560,821 |   | 1,580,682 |   | 2,196,506 |   |
| Restructuring charges          |       | 161,453                          |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Total operating expenses       |       | 4,555,421                        |       | 4,944,859 |   | 5,691,299 |   | 5,618,786 |   | 5,095,338 |   | 4,336,386 |   | 4,418,947 |   | 5,014,341 |   |
| Operating loss                 |       | (6,958,392                       | )          | (6,794,377 | ) | (10,462,779 | ) | (8,850,906 | ) | (7,773,586 | ) | (6,136,204 | ) | (6,370,910 | ) | (6,831,193 | ) |
| Other income and expense, net  |       | (469,869                         | )          | (206,048 | ) | (289,913 | ) | (147,846 | ) | (107,364 | ) | (167,842 | ) | (183,045 | ) | (7,833 | ) |
| Income tax expense             |       | —                           |       | (17,800 | ) | — |   | — |   | — |   | (105,512 | ) | — |   | — |   |
| Net loss                       |       | $                                | (7,428,261 | ) | $ | (7,018,225 | ) | $ | (10,752,692 | ) | $ | (8,998,752 | ) | $ | (7,880,950 | ) | $ | (6,409,558 | ) | $ | (6,553,955 | ) | $ | (6,839,026 | ) |
| Net loss per share             |       | $                                | (0.25      | ) | $ | (0.23 | ) | $ | (0.36 | ) | $ | (0.30 | ) | $ | (0.27 | ) | $ | (0.21 | ) | $ | (0.22 | ) | $ | (0.23 | ) |

 

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**(19)**   GeographicConcentration

TheCompany has a sales office, with revenue and assets, in the United Kingdom. TheCompany does not consider this office to be a reportable segment because thenature of the product and services, type of customer, methods of production anddistribution, and regulatory environment are similar in both geographiclocations. Information regarding sales and assets by geographic location ispresented in the table below. Revenues are attributed to each country based onthe location of customers.

| ** **     | ** ** | **Revenues** | ** ** | **Total Assets** | ** ** |
|----------------|------------|--------------|------------|-----------------------|------------|
| ** **     | ** ** | **2005**     | ** ** | **2004**              | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States  |       | $            | 2,377,395  |                  | $          | 2,026,316 |   | 1,384,134 |   | $ | 18,888,381 |   | $ | 52,660,475 |   |
| United Kingdom |       | 291,594      |       | 389,743               |       | 107,329 |   | 267,566 |   | 284,966 |   |
| Total          |       | $            | 2,668,989  |                  | $          | 2,416,059 |   | $ | 1,491,463 |   | $ | 19,155,947 |   | $ | 52,945,441 |   |
|                |            |              |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

The Company’s largest customers, DaVita, the DialysisCenters of Lincoln and Northwest Kidney Center accounted for 16%, 11% and 8%,respectively, of its revenues (by dollar volume) for the year endedDecember 31, 2005. For the year ended December 31, 2004, theCompany’s largest customers, Northwest Kidney Center, the Dialysis Centers ofLincoln and Berkshire Medical Center accounted for 24%, 10% and 9%,respectively, of its total revenue. All of these customers are located in theUnited States.

**(20)**   SubsequentEvents

***Transaction with the Durus fund***

*Securities PurchaseAgreement*

On March 31, 2006 the Company entered into asecurities purchase agreement (“Securities Purchase Agreement”) with the Durusfund pursuant to which the Durus fund, at a subsequent closing, in exchange for$5 million principal amount of outstanding Notes, will acquire newlyissued shares of the Company’s Series B Preferred Stock, $0.01 par value,convertible into 5 million shares of the Company’s common stock at aconversion price of $1.00 per share and warrants to purchase 5 millionshares of the Company’s common stock at an exercise price of $1.10 per share. TheSeries B Preferred Stock has voting rights, and the Durus fund will beentitled to vote, on an as converted basis, together with the holders of theCompany’s common stock as a single class with respect to any matter upon whichholders of the Company’s common stock have the right to vote (provided,however, that for voting purposes, the conversion price of the Series BPreferred Stock is equal to the closing price of the common stock on the NasdaqCapital Market on the date of the Securities Purchase Agreement). In addition,holders of the Series B Preferred Stock shall be entitled to elect one (1) directorto the Company’s Board of Directors. As the only holder of the Series BPreferred Stock immediately following the closing of the Securities PurchaseAgreement, the Durus fund alone shall exercise this right, along with the Durusfund’s right to designate a majority of the members of the Company’s Board ofDirectors under the terms of the Investor Rights Agreement described below. TheCompany’s shares of Series B Preferred Stock will have an aggregateliquidation preference of $5 million, accrue dividends at the rate of 10%per annum and become redeemable after seven years at the option of the holdersof a majority of the voting power of the shares of Series B PreferredStock then outstanding or at the option of the Durus fund at an earlier dateupon the occurrence of specified trigger events. The Company is required toobtain the consent of the holders of at least two-thirds of the outstandingshares of Series B Preferred Stock prior to taking certain actions.

Following the closing ofthe Securities Purchase Agreement, the Durus fund has the option to invest, byitself or with other investors designated by the Durus fund, up to anadditional $15 million in cash for additional shares of Series BPreferred Stock and warrants having essentially the same terms as the Series BPreferred Stock and warrants acquired by the Durus fund at the closing. If theDurus fund (by 

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itselfor with other investors) invests the maximum additional $15 million incash for such additional shares of Series B Preferred Stock and warrants,such additional shares of Series B Preferred Stock will be convertibleinto 15 million shares of common stock at a conversion price of $1.00 perShare and the additional warrants will be exercisable to purchase 15 millionshares of common stock at an exercise price of $1.10 per share.

***LoanAgreements***

At the time of entering into the Securities PurchaseAgreement, the Company also entered into and closed a bridge loan agreement (“BridgeLoan Agreement”) with the Durus fund, pursuant to which the Durus fund lent $5 millionin cash to the Company in exchange for $5 million in principal amount ofits senior secured notes (the “Bridge Notes”). The Bridge Notes bear interestat the rate of 7% per annum, and the entire principal amount of the BridgeNotes is due and payable on January 1, 2007, unless prepaid or rolled overinto longer term senior secured notes of the Company as contemplated by theSecurities Purchase Agreement. The Bridge Loan Agreement contains a number ofreporting and other affirmative and negative covenants, including operationalcontrols over expenditures which may be exercised by the Durus fund. To secureits obligations under the terms of the Bridge Loan Agreement and the BridgeNotes, the Company has granted the Durus fund a security interest in all of itsproperty, including its intellectual property.

At the closing of theSecurities Purchase Agreement, the Durus fund will enter into a new loanagreement (“Loan Agreement”) with the Company pursuant to which the Durus fundwill exchange the Bridge Notes (plus accrued interest thereon) andapproximately $10.8 million in principal amount of outstanding Notes forapproximately $15,800,000 in aggregate principal amount of the Company’s seniorsecured notes bearing interest at 7% per annum and payable in full on December 31,2007 (the “Loan Notes”). Under the Loan Agreement, the Durus fund will alsomake available to the Company a $5 million standby line of credit until December 31,2006, which line of credit can be used by the Company to fund its ongoingoperations if it is unable to obtain financing from other sources and variousfunding conditions are satisfied. The Loan Agreement contains a number ofaffirmative and negative covenants and grants certain operational controls overexpenditures to the Durus fund. The Company’s obligations under the LoanAgreement and the Loan Notes will also be secured by a security interest in allof its property, including its intellectual property.

***OtherActions***

The Company undertook and agreed to undertake certainactions in connection with the entering into and closing of the SecuritiesPurchase Agreement.

*Amendmentof Settlement Agreement and Rights Agreement.*   OnMarch 31, 2006, the Company amended the Settlement Agreement to releasethe Durus fund and the Artal fund from certain standstill and other restrictivecovenants contained therein, including to eliminate the requirement that theDurus fund significantly reduce its ownership of shares of the Company’s commonstock by May 2006 and to terminate the proxy granted to the Company by theDurus fund under the terms of the Settlement Agreement, which proxy granted theCompany the power to vote the Durus fund’s 21,216,664 shares of the Company’scommon stock in proportion to the votes cast by other holders of shares ofcommon stock in matters requiring a stockholder vote. By releasing the Durusfund from the standstill restrictions in the Settlement Agreement, the Durusfund is free to acquire the shares of Series B Preferred Stock and thewarrants at the closing of the Securities Purchase Agreement and to exercisethe option to acquire additional shares of Series B Preferred Stock andwarrants, as provided in the Securities Purchase Agreement, and the Durus fundis no longer prohibited from acquiring more shares of common stock or othersecurities of the Company or making any solicitation of proxies regarding thevoting of shares of common stock. In addition, in connection with the enteringinto of the Securities Purchase Agreement, the 

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Company took action toamend its Rights Agreement to exempt from the application thereof thetransactions contemplated by the Securities Purchase Agreement, and toeliminate the Rights Agreement.

*Appointmentof Durus fund Designee to the Company’s Board of Directors and Appointment ofNew CEO.*   At the time of the execution anddelivery of the Securities Purchase Agreement, the Board of Directors of theCompany increased the size of the Board to seven and appointed Shodhan Trivedi,a member of the board of directors of the Durus fund, to the Company’s Board ofDirectors. The Company’s Board of Directors also replaced William Dow withLaurence Birch as interim President and Chief Executive Officer of the Company.

*InvestorRights Agreement.*   As a condition to the closingof the Securities Purchase Agreement, the Company has agreed to enter into aninvestor rights agreement (“Investor Rights Agreement”) with the Durus fund andthe Artal fund which requires that the Company’s Board of Directors consist ofseven members and grants the Durus fund the right to designate four of theseven Board members (inclusive of the Board member designated by the Durus fundas holder of the Series B Preferred Stock) and to approve the selection ofthe Company’s Chairman of the Board, Chief Executive Officer and ChiefFinancial Officer. Under the terms of the Investor Rights Agreement, the Durusfund’s designees to the Board of Directors shall be entitled to serve on theexecutive committee of the Board, and the Company may not take certain actionswithout the approval of the Board of Directors, including the affirmative voteof the Board members designated by the Durus fund.

The Investor RightsAgreement also grants the Durus fund and the Artal fund certain registrationrights with respect to the sale of shares of common stock into the open market,as well as providing that the Durus fund shall have a right of first refusal inthe event that the Company proposes to sell itself, or greater than 30% of itsfully diluted capital stock, to a third party, or the Company otherwise acceptsa bona fide offer from a third party to acquire the Company or such number ofshares of the Company’s capital stock, the on the same terms and conditions,including price, as the terms and conditions applying to the third party. TheInvestor Rights Agreement will require the Company to use its best efforts toregister the shares held by the Durus fund and the Artal fund in one or moreshelf registration statements and to keep these registration statement(s) effectiveuntil the earlier of (i) the date as of which the Durus fund and the Artalfund may sell all of their securities in any period of three months under Rule 144of the Securities Act of 1933, as amended, and (ii) the date on which theDurus fund and the Artal fund shall have sold all of their securities coveredby the registration statement. The Investor Rights Agreement will amend andsupersede the Registration Rights Agreement which the Company previouslyentered into with the Durus fund in February 2004.

***Common Stock Purchase Agreement with Fusion CapitalFund II. LLC***

On January 13, 2006, the Company entered into acommon stock purchase agreement (“Fusion Capital Agreement”) with FusionCapital Fund II, LLC (“Fusion Capital”). Funding under the Fusion Capital Agreementcommences once the Securities and Exchange Commission declares effective aregistration statement relating to the transaction and will continue over a 25-monthperiod. The Company has not filed a registration statement with respect to thistransaction at this time. Under the Fusion Capital Agreement, as long as themarket price of the Company’s common stock remains above $0.10 and certainother conditions are satisfied, the Company is permitted to sell to FusionCapital up to $40,000 of common stock on each market trading day, up to anaggregate of $20,000,000 of common stock.

Under an amendment to the Fusion Capital Agreementdated January 27, 2006, the Company and Fusion Capital agreed that theCompany shall not effect any sale under the Fusion Capital Agreement and FusionCapital shall not have the right or obligation to purchase any shares of commonstock under the Fusion Capital Agreement to the extent that after giving effectto such purchase, the “Exchange Cap” has been reached. The “Exchange Cap” willbe deemed to have been reached if, at any time prior to the 

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shareholders of theCompany approving the transaction contemplated by the Fusion Capital Agreement,the shares purchased would, together with all shares previously purchased underthis Fusion Capital Agreement, exceed 5,998,405 shares of common stock (19.99%of the 30,007,031 outstanding shares of common stock as of the date of thisFusion Capital Agreement). The Company may, but shall be under no obligationto, request its shareholders to approve the transaction contemplated by thisFusion Capital Agreement.

The Company has the right to decrease the daily amountto be purchased by Fusion Capital at any time effective upon one trading day’snotice. In addition, the Company has the right to increase the daily purchaseamount if the market price of the Company’s common stock increases. For every$0.10 increase in the “threshold price” (defined as the lowest sale price ofthe Company’s common stock during the five trading days immediately precedingthe notice to increase the daily purchase amount) above $0.95, the Company hasthe right to increase the daily purchase amount by an additional $4,000.

In addition to the daily purchase amount, the Companymay elect to require Fusion Capital to purchase up to $250,000 of the Company’scommon stock on any single trading day, provided that the share price is above$1.00 during the ten trading days prior thereto. This amount may be increasedto up to $1,000,000 if specified increases in the Company’s share price occur.

Fusion Capital may terminate the Fusion CapitalAgreement upon the occurrence of an event of default, which includes a materialadverse change in the Company’s business or the failure of the common stock tobe listed on the Nasdaq National Market, the Nasdaq Capital Market or theNasdaq OTC Bulletin Board. In addition, Fusion Capital has the right toterminate the Fusion Capital Agreement if sales under the Agreement have notcommenced by September 30, 2006. The Company has the right to terminatethe Fusion Capital Agreement at any time effective upon one trading day’snotice.

In connection with theFusion Capital Agreement, in January 2006, the Company issued 2,170,543shares of common stock to Fusion Capital as a commitment fee. Such shares wereissued in reliance upon exemption from registration provided by Regulation Dand/or Section 4(2) of the Securities Act of 1933, as amended.

***Listing of Company’s Common Stock on the NasdaqCapital Market***

On November 14, 2005, theCompany received a letter from the Nasdaq noting that it had failed to complywith the minimum $10 million of stockholders’ equity required byMarketplace Rule 4450(a), Maintenance Standard 1 and the alternativelisting requirements of Marketplace Rule 4450(b), Maintenance Standard 2relating to market value of listed securities (and related assets and revenuetests) and market value of publicly held shares. On December 16, 2005, theCompany was notified by the Nasdaq that for the last 30 consecutive businessdays the bid price of its common stock closed below the minimum $1.00 per sharerequired by Marketplace Rule 4450(a)(5). On December 27, 2005, theCompany received a letter from the Nasdaq denying its request for continuedlisting on the Nasdaq National Market. In response to this letter on, December 30,2005, the Company requested a hearing before the Nasdaq Listing QualificationsPanel to review the Nasdaq staff’s determination. The Company subsequentlyreceived notification from the Nasdaq Listing Qualification Panel that theCompany’s common stock would be delisted from the Nasdaq National Market andwould begin trading on the Nasdaq Capital Market on February 14, 2006.

TheNasdaq Capital Market has its own standards for continued listing, includingMarketplace Rule 4310(c)(2)(B), which requires the Company to have aminimum of $2,500,000 in stockholders’ equity or $35,000,000 market value oflisted securities or $500,000 of net income from continuing operations for themost recently completed fiscal year or two of the three most recently completedfiscal years. In addition, continued listing on the Nasdaq Capital Marketrequires satisfying the $1.00 minimum closing bid price imposed by Marketplace Rule 4450(a)(5).There can be no assurance that the Company will sustain 

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compliance with these standards. In particular, theCompany does not currently have a minimum of $2,500,000 in stockholders’ equityand it did not have $500,000 of net income from continuing operations for themost recently completed fiscal year or two of the three most recently completedfiscal years, but the current market value of its listed securities does exceed$35,000,000. In the event the Company cannotsustain compliance with the Nasdaq Capital Market’s listing standards, itscommon stock will be delisted from the Nasdaq Capital Market and the Companymay be unable to list its common stock on another stock exchange or quotationservice. Such a delisting may make it difficult or impossible for stockholdersto sell their shares, for the Company to issue additional securities and toobtain additional financing in the future. A delisting may also result in amore limited amount of news and analyst coverage for the Company and could havea material adverse effect on the market price of its common stock.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

**Item 9A.**                Controlsand Procedures

*DisclosureControls and Procedures.*   As required by Rule 13a-15under the Securities Exchange Act, as of the end of the period covered by thisreport, we carried out an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures. This evaluation was carriedout under the supervision and with the participation of our management,including the Chief Financial Officer and interim President and Chief ExecutiveOfficer. Based on this evaluation, the Chief Financial Officer and interimPresident and Chief Executive Officer concluded that our disclosure controlsand procedures are effective.

Disclosure controls and procedures are designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act is recorded, processed, summarizedand reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the SecuritiesExchange Act is accumulated and communicated to management, including the ChiefFinancial Officer and interim President and Chief Executive Officer, to allowtimely decisions regarding required disclosure.

*Changes in InternalControl Over Financial Reporting.*   There havebeen no changes in our internal control over financial reporting that occurredduring the fourth quarter of 2005 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting. In accordance with Item 308 of Regulation S-Kand based upon the aggregate market value of our voting stock held bynon-affiliates as of June 30, 2005, this Annual Report on Form 10-Kdoes not contain an annual report of management on internal control overfinancial reporting or an attestation report of our independent registeredpublic accounting firm regarding management’s assessment of internal control offinancial reporting.

**Item 9B.**               OtherInformation

Not applicable.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant.

Information regarding the executive officers of theCompany is set forth above in Part I under “Business—Executive Officers.” TheBoard of Directors currently consists of seven directors divided into threeclasses, with each class serving a three-year term.

**Richard B. Egen, 66**                                                                                                                                                                                                                                                                                                                                  Directorsince November 1997

Richard B. Egen has been Chairman of the Board ofDirectors since May 1999. From January 1997 to July 2001, Mr. Egenserved as President and Chief Executive Officer of NephRx Corporation, abiotechnology company that is developing technology for kidney growth factors. FromJanuary through December 1996, Mr. Egen was an independentbusiness consultant. From 1989 to 1995, Mr. Egen was President and ChiefExecutive Officer of Clintec International, a joint venture owned by BaxterInternational Inc. and Nestlé S.A. Clintec International was engaged in thedevelopment of clinical nutrition products. Prior to working at ClintecInternational, Mr. Egen held various senior management positions duringhis fifteen-year career with Baxter International Inc. Mr. Egen serves asa director of Optical Sensors Incorporated.

**Laurence P. Birch, 46**                                                                                                                                                                                                                                                                                                                                             Directorsince March 2006

Mr. Birch was appointed to the Company’s Board ofDirectors and elected as interim President and Chief Executive Officer on March 31,2006. Mr. Birch joined the Company in February 2005 as Senior VicePresident and assumed the duties of Chief Financial Officer effective March 17,2005. From 2003 until he joined the Company, Mr. Birch served as ManagingDirector for Stratego Partners, a corporate cost management company. From 2002to 2003, he served as Chief Financial Officer of Seurat, Inc. From 2001 to2002, he served as Chief Financial Officer of Fieldglass, Inc. From 2000to 2001, he served as Senior Vice President and Chief Financial Officer ofTechnology Solutions, Inc. In 2000 he served as Chief Financial Officer ofBrigade, Inc. From 1999 to 2000, he served as Chief Financial Officer ofGateway Homecare, Inc. Mr. Birch has over fifteen years experience inthe healthcare sector which includes his fourteen years with BaxterInternational, Inc. and American Hospital Supply in various financialpositions. Mr. Birch received his Bachelor of Science degree in financefrom the University of Illinois, his Masters of Business Administration degreefrom the Kellogg Graduate School of Management at Northwestern University, andis a Certified Public Accountant.

**Lawrence D. Damron, 59**                                                                                                                                                                                                                                                                                                                          Director since August 2004

Lawrence D. Damron was appointed Senior VicePresident and Chief Financial Officer in May 2002, and became a member ofthe board of directors in August 2004. Effective March 17, 2005 Mr. Damronresigned from his position as Chief Financial Officer and effective May 1,2005 he resigned from his position as Senior Vice President. Mr. Damroncontinues to serve as a member of the board of directors and will provideconsulting services to us through April 2006. Mr. Damron has over 25years of experience in the healthcare sector. From June 1999 to December 2000,he served as the Chief Financial Officer for Everest Healthcare ServicesCorporation, a provider of dialysis and other blood treatment services. From July 1997until June 1999, he was Senior Vice President, Finance and Treasurer atEvanston Northwestern Healthcare. Mr. Damron was with Baxter Internationalsince 1985 in a number of key management positions including CorporateTreasurer from 1992 until 1997. From 1980 until 1985, he was with AmericanHospital Supply in a variety of financial positions. Mr. Damron receivedhis Bachelor of Arts degree in economics from the University of Cincinnati andhis Masters of Arts degree in international relations from the University ofSouthern California. He received his Masters of Business Administration fromHarvard University, and is a Certified Public Accountant. Mr. Damronserved as a Lieutenant in the U.S. Navy. He serves on the board of directors ofTrinity Health.

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**Alan R. Meyer, 52**                                                                                                                                                                                                                                                                                                                                                           Directorsince October 2001

Alan R. Meyer has been Chief Executive Officer,Founder and member of the board of directors of Ocularis Pharma, Inc., aspecialty pharmaceutical company, since March 2002. Also since March 2002,Mr. Meyer has been President of Salt Creek Associates, Inc., amanagement consulting firm. From November 2000 through February 2002,Mr. Meyer was an independent business consultant. From December 1992through October 2000, Mr. Meyer was the Executive Vice President,Chief Financial Officer and a member of the Board of Directors of PathoGenesisCorporation, a pharmaceutical company. From 1989 through 1992, Mr. Meyerwas a partner of The Kensington Group, a provider of management services tohealthcare companies. He was the Chief Financial Officer of Memtec NorthAmerica Corporation, an industrial filtration company, from 1987 through 1988. Heheld various management positions in corporate finance and corporatedevelopment at Baxter Healthcare Corporation from 1981 though 1987. From1977 through 1980, Mr. Meyer was a management consultant at Arthur Andersen & Co.

**Bernard R.Tresnowski, 72**                                                                                                                                                                                                                                                                                                                         Directorsince April 1996

Bernard R. Tresnowski served from December 1981until his retirement in December 1994 as the President and Chief ExecutiveOfficer of the Blue Cross and Blue Shield Association, the nationalcoordinating body for all Blue Cross and Blue Shield Plans. He has also heldvarious other leadership positions in the healthcare industry, includingPresident of the International Federation of Health Service Funds, Member ofthe Jackson Hole Group, Principal of the Dunlop Group of Six, Member of theSecretary of Health and Human Services Private/Public Sector Advisory Committeeon Catastrophic Illness, Co-Chairman of the Secretary of Health and HumanServices Work Group on Electronic Data Interchange and Member of the AmericanMedical Association National Health Policy Steering Committee. Mr. Tresnowskiis a director of Alexian Brothers Medical Center, the Medic Alert Foundationand Cancer Treatment Centers of America.

**Brian J. G. Pereira, M.D., 46**                                                                                                                                                                                                                                                                                                                   Directorsince May 2005

Dr. Pereira is currently the President and Chief ExecutiveOfficer of New England Health Care Foundation, Tufts-New England MedicalCenter, located in Boston, MA. He serves on several renal care-related boards,including The National Kidney Foundation, where he served as president from2002 to 2004. Dr. Pereira has published over 100 scientific papers andlectured extensively throughout the world. In addition to a medical degree, Dr. Pereirahas a Masters of Business Administration from the Kellogg Graduate School ofManagement, Northwestern University.

**Shodhan Trivedi, 47**                                                                                                                                                                                                                                                                                                                                                     Director since March 2006

Shodhan Trivedi was appointed to our Board ofDirectors on March 31, 2006. Mr. Trivedi is a graduate of the LondonSchool of Economics and holds a Masters degree from the University ofCalifornia, Los Angeles. He is a Chartered Financial Analyst (CFA) and a memberof the Toronto Society of Financial Analysts. Mr. Trivedi currentlyresides in Toronto, Ontario, Canada. Since June 1989, he has been thePresident of Opax Investments Inc., an asset allocation firm focused on theglobal hedge fund arena. Prior to June 1989, Mr. Trivedi was involvedin companies engaged in international trading and was based in the U.K., HongKong and Southern Africa. He currently serves on the Board of Directors ofseveral offshore hedge funds, including the Durus fund.

Stockholders who wish to communicatewith the Board, a Board Committee or an individual Director or Directors may doso by sending correspondence addressed to the Board of Directors, a BoardCommittee or such individual Director or Directors, c/o Corporate Secretary,Aksys, Ltd., Two Marriott Drive, Lincolnshire, IL 60069

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Section 16(a) of the Exchange Act requires theCompany’s directors and officers, and persons who own more than 10% of theCommon Stock, to file reports of ownership and changes in ownership of sharesof the Common Stock with the SEC. Directors, officers and greater than 10%stockholders are required by SEC regulations to furnish the Company with copiesof all Section 16(a) reports they file. Based solely upon a review of thecopies of such reports received by it, or written representations that no otherreports were required, the Company believes that, from January 1, 2005through December 31, 2005, its directors, executive officers and greaterthan 10% beneficial owners complied with the reporting requirements under Section 16(a).

**Committees andDirector’s Meetings**

The Board of Directors has three standing committees:the Audit Committee, the Compensation Committee, and the Nominating Committee.

***Audit Committee.*****  **The Audit Committee’s functions,among others, are to appoint the Company’s independent auditor and set thecompensation and oversee the work performed by the independent auditor;consider the adequacy of the Company’s internal controls and review anyproposed corrective actions; review and monitor the Company’s compliance withlegal and regulatory requirements; and discuss with management and theindependent auditors the Company’s annual and quarterly financial statementsand key accounting and/or reporting matters. The Audit Committee currentlyconsists of Messrs. Egen, Meyer and Pereira, with Mr. Meyer servingas chairman of the committee and as “audit committee financial expert” asdefined under SEC rules promulgated under the Sarbanes-Oxley Act of 2002.All current members of the Audit Committee are independent within the meaningof the regulations adopted by the SEC under the Sarbanes-Oxley Act of 2002 andthe requirements of the Nasdaq Stock Market regarding audit committeemembership. A copy of the Audit Committee’s charter is available on our websiteat *www.aksys.com*.

***CompensationCommittee.*****  **TheCompensation Committee is responsible for, among other things, approvingoverall compensation policy; determining and approving the compensation of thechief executive officer and other senior officers; approving appointments andpromotions of senior officers and key employees; and administering the Company’sstock-based, profit-sharing and incentive compensation plans, and grants ofawards thereunder. The Compensation Committee currently consists of Messrs. Egen,Meyer and Tresnowski, with Mr. Egen serving as chairman of the committee.All current members of the Compensation Committee are independent within themeaning of the requirements of the Nasdaq Stock Market regarding CompensationCommittee membership. A copy of the Compensation Committee’s charter isavailable on our website at *www.aksys.com.*

***NominatingCommittee.*****  **TheNominating Committee is responsible for, among other things, establishingcriteria for board membership; considering, recommending and recruiting candidatesto fill new positions on the board; reviewing candidates recommended bystockholders; and recommending the director nominees for approval by the boardand the stockholders. The Nominating Committee currently consists of Messrs. Egen,Pereira, and Tresnowski, with Mr. Tresnowski serving as chairman of thecommittee. All current members of the Nominating Committee are independent withthe meaning of the requirements of the Nasdaq Stock Market regarding NominatingCommittee membership. A copy of the Nominating Committee’s charter is availableon our website at *www.aksys.com.*The Nominating Committee does not have a written policy regarding stockholdernominations for director candidates. The committee will, however, considercandidates for director nominees put forward by stockholders. See “StockholderProposals and Nominations” for information on how stockholders may submitnominees for the Company’s Board of Directors.

***Board and Committee Meetings.******  ***The Board ofDirectors held 6 meetings during 2005. The Compensation Committee held 5meetings, the Audit Committee held 6 meetings and the Nominating 

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Committee held 7meetings in 2005. Each of the directors attended at least 75% of the meetings of the Board andthe committees on which they served.

**Policies onBusiness Ethics**

All of our employees, including the Chief ExecutiveOfficer and Chief Financial Officer, as well as our Directors, are required tocomply with the Company’s Code of Ethics to ensure that our business isconducted in a consistently legal and ethical manner. The Sarbanes-Oxley Act of2002 requires companies to have procedures for the receipt, retention andtreatment of complaints regarding accounting, internal accounting controls orauditing matters and to allow for the confidential, anonymous submission byemployees of concerns regarding questionable accounting or auditing matters.Aksys currently has these procedures in place, which are set forth in the Codeof Ethics. The full text of the Aksys Code of Ethics is posted on our web site,at *www.aksys.com,* under the “CorporateInformation—Corporate Governance” captions. We will disclose future amendmentsto, or waivers from, certain provisions of the Code of Ethics for our ChiefExecutive Officer and Chief Financial Officer, if any, on its web site withinfive business days following the date of the amendment or waiver, or suchearlier period of time that the SEC may require.

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**Item 11.**                 ExecutiveCompensation.

**COMPENSATION OFEXECUTIVE OFFICERS**

**SummaryCompensation Table**

Thetable below provides information relating to compensation for the ChiefExecutive Officer and the other five highest paid executive officers of theCompany earning $100,000 or more (collectively, the “Named Executive Officers”)during fiscal 2005. The amounts shown include compensation for services in allcapacities that were provided to the Company.

|                                        | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **          | ** ** | ** **            | ** ** | **Long-Term**             | ** ** | ** **           | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------|------------|---------------------|------------|-----------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **          | ** ** | ** **            | ** ** | **Compensation**          | ** ** | ** **           | ** ** |
| ** **                             | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **          | ** ** | ** **            | ** ** | **Awards**                | ** ** | ** **           | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Securities**      | ** ** | ** **            | ** ** |
| ** **                             | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **          | ** ** | **Other Annual** | ** ** | **Underlying**            | ** ** | **All Other**   | ** ** |
| Name and  Principal Position | ** ** | ** ** | ** ** | **Year**                     | ** ** | **Salary ($)** | ** ** | **Bonus ($)**    | ** ** | **Compensation ($)** | ** ** | **Options (#)** | ** ** | **Compensation ($)** | ** ** |
| William C. Dow                         |       | 2005       |       | $                            | 345,000    |                | $          | 129,375               |       |                      | 0          |                 |       |   | 20,000 |   |   |   | 0 |   |   |
| Former President and Chief             |       | 2004       |       | $                            | 345,000    |                | $          | 129,375               |       |                      | 0          |                 |       |   | 300,000 |   |   |   | 0 |   |   |
| Executive Officer(1)                   |       | 2003       |       | $                            | 335,000    |                | $          | 167,500               |       |                      | 0          |                 |       |   | 40,000 |   |   |   | 0 |   |   |
| Laurence P. Birch                      |       | 2005       |       | $                            | 210,301    |                | 0          |                  |       | 0                         |       |                 |       | 150,000 |   |   |   | 0 |   |   |
| Chief Financial  Officer and           |       | 2004       |       | 0                            |       | 0                   |       |                  | 0          |                      |       |                 | 0          |   |   |   | 0 |   |   |
| interim President  and Chief           |       | 2003       |       | 0                            |       | 0                   |       |                  | 0          |                      |       |                 | 0          |   |   |   | 0 |   |   |
| Executive  Officer(2)                  |       |       |       |                         |       |                |       |                  |       |                      |       |                 |       |   |   |   |   |   |   |
| Jerry D. Fisher(3)                     |       | 2005       |       | $                            | 219,313    |                | $          | 64,500                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Sr. Vice President                     |       | 2004       |       | $                            | 40,313     |                | 0          |                  |       | 0                         |       |                 |       | 75,000 |   |   |   | 0 |   |   |
| Chief Technology Officer               |       | 2003       |       | 0                            |       | 0                   |       |                  | 0          |                      |       |                 | 0          |   |   |   | 0 |   |   |
| Lawrence A. Rohrer(4)                  |       | 2005       |       | $                            | 220,967    |                | $          | 32,603                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Sr. Vice  President                    |       | 2004       |       | $                            | 217,350    |                | $          | 32,603                |       |                      | 0          |                 |       |   | 20,000 |   |   |   | 0 |   |   |
| Global Sales and  General              |       | 2003       |       | $                            | 125,682    |                | $          | 34,776                |       |                      | 0          |                 |       |   | 35,000 |   |   |   | 0 |   |   |
| Manager,  International                |       |       |       |                         |       |                |       |                  |       |                      |       |                 |       |   |   |   |   |   |   |
| Thomas F. Scully                       |       | 2005       |       | $                            | 211,313    |                | $          | 32,292                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Sr. Vice President                     |       | 2004       |       | $                            | 207,000    |                | $          | 32,292                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Manufacturing and                      |       | 2003       |       | $                            | 198,392    |                | $          | 53,419                |       |                      | 0          |                 |       |   | 7,500 |   |   |   | 0 |   |   |
| Operations                             |       |       |       |                         |       |                |       |                  |       |                      |       |                 |       |   |   |   |   |   |   |
| Nancy S. Schmelkin                     |       | 2005       |       | $                            | 211,313    |                | $          | 31,050                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Senior Vice  President                 |       | 2004       |       | $                            | 205,833    |                | $          | 55,200                |       |                      | 0          |                 |       |   | 5,000 |   |   |   | 0 |   |   |
| Marketing and  Customer                |       | 2003       |       | $                            | 176,154    |                | $          | 4,599                 |       |                      | 0          |                 |       |   | 27,500 |   |   |   | 0 |   |   |
| Care                                   |       |       |       |                         |       |                |       |                  |       |                      |       |                 |       |   |   |   |   |   |   |
|                                        |            |            |            |                              |            |                     |            |                       |            |                           |            |                      |            |  |  |  |  |  |  |  |  |  |  |

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(1)          Mr. Dowwas appointed President and Chief Executive Officer and a director of theCompany in September 1999, and served in these positions until March 31,2006.

(2)          Mr. Birchwas appointed to the Company’s Board of Directors and elected interim Presidentand Chief Executive Officer on March 31, 2006. Mr. Birch joined theCompany in February 2005 as Senior Vice President and assumed the dutiesof Chief Financial Officer effective March 17, 2005. Compensationinformation for fiscal year 2005 only includes compensation earned after Mr. Birchjoined the Company in February 2005.

(3)          Compensationinformation for fiscal 2004 only includes compensation earned after Mr. Fisherjoined the Company in October 2004.

(4)          Compensationinformation for fiscal 2003 only includes compensation earned after Mr. Rohrerjoined the Company in May 2003.

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**Stock Option Grants**

The following table setsforth certain information with respect to stock options granted to the NamedExecutive Officers during the fiscal year ended December 31, 2005.

**Option Grants In LastFiscal Year**

| ** **           | ** ** | **Individual Grants** | ** ** |
|----------------------|------------|----------------------------|------------|
| **Name**             | ** ** | ** **                 | ** ** | **Number of  Securities  Underlying  Options  Granted (#)** | ** ** | **Percent of  Total Options  Granted to  Employees in  Fiscal 2005** | ** ** | **Exercise Price   (Per Share)**(3) | ** ** | **Expiration  Date**(4) | ** ** | **Grant Date  Value**(5) | ** ** |
| William C. Dow(1)    |       |                       | 20,000     |   |   |   | 5.7 | % |   |   | $ | 4.65 |   |   |   | 02/28/15 |   |   |   | $ | 68,600 |   |   |
| Laurence P. Birch(2) |       |                       | 150,000    |   |   |   | 42.9 |   |   |   | 4.65 |   |   |   | 02/28/15 |   |   |   | 514,500 |   |   |
| Jerry D. Fisher      |       |                       | 5,000      |   |   |   | 1.4 |   |   |   | 4.65 |   |   |   | 02/28/15 |   |   |   | 17,150 |   |   |
| Lawrence A.  Rohrer  |       |                       | 5,000      |   |   |   | 1.4 |   |   |   | 4.65 |   |   |   | 02/28/15 |   |   |   | 17,150 |   |   |
| Thomas F. Sully      |       |                       | 5,000      |   |   |   | 1.4 |   |   |   | 4.65 |   |   |   | 02/28/15 |   |   |   | 17,150 |   |   |
| Nancy S. Schmelkin   |       |                       | 5,000      |   |   |   | 1.4 |   |   |   | 4.65 |   |   |   | 02/28/15 |   |   |   | 17,150 |   |   |
|                      |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Mr. Dow was appointedPresident and Chief Executive Officer and a director of the Company in September 1999,and served in these positions until March 31, 2006.

(2)          Mr. Birch wasappointed to the Company’s Board of Directors and elected interim President andChief Executive Officer on March 31, 2006. Mr. Birch joined theCompany in February 2005 as Senior Vice President and assumed the dutiesof Chief Financial Officer effective March 17, 2005. Compensationinformation for fiscal year 2005 only includes compensation earned after Mr. Birchjoined the Company in February 2005.

(3)          Options were granted atan exercise price equal to the closing price of the Company’s Common Stock onthe Nasdaq Stock Market on the grant date.

(4)          Options granted to theNamed Executive Officers are subject to vesting and, accordingly, may terminatebefore the dates indicated. Options generally vest over a four-year period.

(5)          The estimated presentvalue at grant date of options granted during fiscal 2005 has been calculatedusing the Black-Scholes options pricing model, based upon the followingassumptions: estimated time until exercise of five years; an average risk-freeinterest rate of 3.90%; a volatility rate of 94.55%; and an expected dividendyield of 0%. The approach used in developing the assumptions upon which theBlack-Scholes valuation was done is consistent with the requirements ofStatement of Financial Accounting Standards No. 123, “*Accountingfor Stock-Based Compensation*.”

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**Stock Option Holdings**

The following table setsforth information with respect to the Named Executive Officers concerning stockoptions held as of December 31, 2005.

**Aggregated FiscalYear-End Option Values**

| **Name**              | ** ** | ** ** | ** ** | **Number of  Shares  Acquired on   Exercise** | ** ** | **Value   Realized** | ** ** | **Number of Securities  Underlying Unexercised  Options at  Fiscal Year-End(#)  Exercisable/  Unexercisable** | ** ** | **Value of Unexercised  In-the-Money Options   at Fiscal Year-End(1)  Exercisable/  Unexercisable** | ** **        |
|-----------------------|------------|------------|------------|--------------------------------------------------------------|------------|---------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|-------------------|
| William C. Dow(1)     |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 634,500 / 197,500 |   |   |   | $ | -0- |   |   |
| Laurence P.  Birch(2) |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 0 / 150,000       |   |   |   | -0- |   |   |
| Jerry D. Fisher       |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 20,000 / 60,000   |   |   |   | -0- |   |   |
| Lawrence A.  Rohrer   |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 31,250 / 28,750   |   |   |   | -0- |   |   |
| Thomas F. Scully      |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 45,875 / 18,125   |   |   |   | -0- |   |   |
| Nancy S. Schmelkin    |       |       | —     |                                                         |       |                      | —     | ** **                                                                                                                             |       |                                                                                                                              | 39,375 / 23,125   |   |   |   | -0- |   |   |

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(1)          Mr. Dow was appointedPresident and Chief Executive Officer and a director of the Company in September 1999,and served in these positions until March 31, 2006

(2)          Mr. Birch wasappointed to the Company’s Board of Directors and elected interim President andChief Executive Officer on March 31, 2006. Mr. Birch joined theCompany in February 2005 as Senior Vice President and assumed the dutiesof Chief Financial Officer effective March 17, 2005. Compensation informationfor fiscal year 2005 only includes compensation earned after Mr. Birchjoined the Company in February 2005.

(3)          Optionsare considered “in the money” if the fair market value of the underlyingsecurities exceeds the exercise price of the options. The year-end valuesrepresent the difference between the fair market value of the Common Stocksubject to the options (the stock’s closing price as reported on the NasdaqNational Market was $.6527 on December 30, 2005), and the exercise priceof the options. As of December 31, 2005, (a) Mr. Dow had optionsto purchase 450,000 shares at $5.31 per share, 22,000 shares at$16.75 per share, 40,000 at $5.61 per share, 200,000 at $7.20 per share,100,000 shares at $6.01 per share, and 20,000 shares at $4.65 pershare; (b) Mr. Birch has options to purchase 150,000 shares at$4.65 per share; (c) Mr. Fisher has options to purchase 75,000 sharesat $5.10 per share and 5,000 shares at $4.65 per share; (d) Mr. Rohrerhad options to purchase 5,000 shares at $8.69 per share, 30,000 sharesat $8.69 per share, 5,000 shares at $7.20 per share, 15,000 shares at$5.07 per share and 5,000 shares at $4.65 per share; (e) Mr. Scullyhad options to purchase 1,500 shares at $4.82 per share, 40,000 sharesat $4.65 per share, 5,000 shares at $6.32 per share, 7,500 shares at$6.10 per share, 5,000 shares at $7.20 per share and 5,000 shares at$4.65 per share; and (f) Ms. Schmelkin had options to purchase 25,000 sharesat $5.08 per share, 2,500 shares at $6.10 per share, 25,000 shares at$10.07 per share, 5,000 shares at $7.20 per share, and 5,000 sharesat $4.65 per share.

**SeveranceAgreements**

The Company hasentered into severance, confidentiality and non-competition arrangements with Mr. Dowand certain of its executive officers.

Mr. Dow’s agreement provides for anon-competition period of two years following his resignation or termination bythe Company for cause or for one year following termination by the Companywithout cause or due to disability. Severance payments are provided for in theevent of termination without cause or due to a disability. Such severancepayments equal Mr. Dow’s aggregate base salary for the twelve 

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months before termination.Customary ownership of intellectual property and confidentiality provisions arealso contained in this agreement.

Mr. Birch’s agreement provides that in the eventthat Mr. Birch’s employment is terminated without cause, he is entitled toreceive severance pay equal to twelve months salary paid over a twelve monthperiod. In the event that Mr. Birch’s position is eliminated in connectionwith a change of control of the Company, he is entitled to receive a lump sumpayment equal to twelve months salary. While Mr. Birch is employed by theCompany and for one year thereafter, he is prohibited from competing with theCompany and soliciting its employees, customers, suppliers or other businessrelations.

Mr. Fisher’s agreement provides for anon-competition period of one year following the date of the termination of hisemployment. Severance payments are provided for in the event of terminationwithout cause or due to a disability. Such severance payments equal Mr. Dow’saggregate base salary for the six months before termination. Customaryownership of intellectual property and confidentiality provisions are alsocontained in this agreement

Mr. Rohrer’s agreement provides for anon-competition period of one year following the date of the termination of hisemployment. Severance payments are provided for in the event of terminationwithout cause or due to a disability. Such severance payments equal Mr. Rohrer’saggregate base salary for the six months before termination. Customaryownership of intellectual property and confidentiality provisions are alsocontained in this agreement.

Mr. Scully’s agreement provides for anon-competition period of two years following his resignation or termination bythe Company for cause or for one year following termination by the Companywithout cause or due to disability. Severance payments are provided for in theevent of termination without cause or due to a disability. Such severancepayments equal Mr. Scully’s aggregate base salary for the six monthsbefore termination. Customary ownership of intellectual property andconfidentiality provisions are also contained in this agreement.

Ms. Schmelkin’sagreement provides for a non-competition period of one year following the dateof the termination of her employment. Severance payments are provided for inthe event of termination without cause or due to a disability. Such severancepayments equal Ms. Schmelkin’s aggregate base salary for the six monthsbefore termination. Customary ownership of intellectual property andconfidentiality provisions are also contained in this agreement.

**CompensationDeferrals and Retention Payment Program**

**On December 8, 2005, theCompany’s Board of Directors voted to cancel the Company’s 2005 bonus program. Inaddition, the Company’s Senior Vice Presidents and Chief Executive Officercurrently are taking a temporary 20% deferral in base pay, which began onFebruary 1, 2006. The Company expects that such deferred compensation willbe repaid in 2006.**

**On December 6, 2005, the Companyannounced a plan to reduce the size of its workforce, and on December 8,2005, the Company’s Board of Directors also approved a retention paymentprogram for those employees who remain with the Company through quarterlyintervals in 2006. Payments under the retention program will be made quarterlyand will be based on a percentage of each employee’s base compensation.**

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**COMPENSATION OFDIRECTORS**

**EffectiveJanuary 1, 2003, non-employee board members receive $1,000 for each Boardmeeting they attend in person, or $500 for each Board meeting they attendtelephonically. Effective January 1, 2005 attendance at a committee meeting,other than committee meetings held on a regularly scheduled Board meeting day,are compensated at $500 per meeting.  Thefee applies to both in person and telephonic committee meetings.  The directors of the Company are alsoreimbursed for reasonable travel expenses incurred in attending Board and Boardcommittee meetings.  On the later of June30 of each year or the day next following each annual meeting of stockholdersof the Company, each non-employee director will receive an automatic option topurchase 8,000 shares of Common Stock. These options will vest and become exercisable in four equalinstallments on the first day of each calendar quarter that the director serveson the Board of Directors after the date of grant.  Unless earlier terminated, forfeited, orsurrendered pursuant to the plan, each option granted to non-employee directorswill expire on the tenth anniversary date of the grant.  In addition, a newly elected non-employeedirector will also receive, upon his or her election to the Board, an option topurchase 5,000 shares of Common Stock under our 1996 Stock Awards Plan.**

**On July6 2005, each non-employee director received an option to purchase 8,000 sharesof Common Stock, at a strike price of $2.062 and having the terms described above.**

**CompensationCommittee Interlocks and Insider Participation**

**None ofthe current members of the Compensation Committee is or has been an officer oremployee of the Company.  None of theexecutive officers serves, or served in 2005, as a member of the board ofdirectors or compensation committee of any entity that has one or moreexecutive officers serving on our board of directors or the CompensationCommittee.**

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**Item 12.      Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

**BENEFICIALOWNERSHIP OF COMMON STOCK**

Except as otherwise noted,the following table sets forth certain information as of March 20, 2006,as to the security ownership of those persons owning of record or known to theCompany to be the beneficial owner of more than five percent of the votingsecurities of the Company and the security ownership of equity securities ofthe Company by (1) each of the directors of the Company, (2) each ofthe Named Executive Officers in the Summary Compensation Table and (3) alldirectors and executive officers as a group. All information with respect tobeneficial ownership has been furnished by the respective director, executiveofficer or five percent beneficial owner, as the case may be. Unless otherwiseindicated, the persons named below have sole voting and investment power withrespect to the number of shares set forth opposite their names. Beneficialownership of the Common Stock referenced in the following table (includingthose shares of Common Stock which were issuable pursuant to the exercise ofoptions which vest within 60 days of March 20, 2006) has beendetermined for this purpose in accordance with the applicable rules andregulations promulgated under the Securities Exchange Act of 1934 (the “ExchangeAct”). Except as indicated below, the address for each such person is c/oAksys, Ltd., Two Marriott Drive, Lincolnshire, Illinois, 60069.

| **Name of Beneficial Owner**                        | ** ** | ** ** | ** ** | **Beneficially Owned** | ** ** | **Percentage Owned(1)** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|------------------------------|------------|
| Durus Life Sciences  Master Fund Ltd.(2)                      |       |       | 21,498,118 |                        |       |                         | 66.2       | % |   |
| Fusion Capital Fund II, LLC(3)                           |       |       | 2,170,543  |                        |       |                         | 6.8        | % |   |
| William C. Dow(4)                                             |       |       | 711,925    |                        |       |                         | 2.2        | % |   |
| Laurence P.  Birch(5)                                         |       |       | 30,019     |                        |       |                         | *          |   |   |
| Jerry D. Fisher(6)                                            |       |       | 39,528     |                        |       |                         | *          |   |   |
| Lawrence A.  Rohrer(7)                                        |       |       | 45,000     |                        |       |                         | *          |   |   |
| Thomas F. Scully(8)                                           |       |       | 64,649     |                        |       |                         | *          |   |   |
| Nancy S.  Schmelkin(9)                                        |       |       | 42,500     |                        |       |                         | *          |   |   |
| Lawrence D.  Damron(10)                                       |       |       | 260,849    |                        |       |                         | *          |   |   |
| Richard B. Egen(11)                                           |       |       | 94,500     |                        |       |                         | *          |   |   |
| Alan R.  Meyer(12)                                            |       |       | 53,250     |                        |       |                         | *          |   |   |
| Brian J.G.  Pereira(13)                                       |       |       | 21,333     |                        |       |                         | *          |   |   |
| Bernard R.  Tresnowski(14)                                    |       |       | 68,250     |                        |       |                         | *          |   |   |
| All  directors and executive officers as a group (13 persons) |       |       | 1,721,553  |                        |       |                         | 5.1        | % |   |

----

                * Less than one percent of the issued andoutstanding shares of Common Stock of the Company.

      (1) Based upon the number of shares of Common Stock outstanding as ofMarch 20, 2006.

      (2) As reported on a Schedule 13D filed with the Securities andExchange Commission on March 13, 2006 by Durus Life Sciences Master Fund Ltd.Includes 281,454 shares of Common Stock subject to immediately exercisableoutstanding warrants. The business address of the Durus Life Sciences MasterFund is c/o International Fund Services (Ireland) Ltd., 3rd Floor,Bishops Square, Redmonds Hill, Dublin 2, Ireland.

      (3) The business address of Fusion Capital Fund II, LLC is 222Merchandise Mart Plaza, Suite 9-112, Chicago, IL 60654.

      (4) Includes 670,333 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

      (5) Includes 20,000 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

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      (6) Includes 21,250 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

      (7) Includes 45,000 shares of Common Stock subject to options presentlyexercisable or exercisable within 60 days.

      (8) Includes 60,250 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

      (9) Includes 42,500 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

(10) Includes 249,460 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

(11) Includes 94,500 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

(12) Includes 53,250 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

(13) Includes 14,333 shares of Common Stock subject to optionspresently exercisable or exercisable within 60 days.

(14) Includes 68,250 shares of Common Stocksubject to options presently exercisable or exercisable within 60 days.

**Changes in Control**

See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources—Recent Financing Activities.”

**Item 13.**                 CertainRelationships and Related Transactions.

**See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Liquidity and CapitalResources—Recent Financing Activities.”**

**Item 14.**                 PrincipalAccountant Fees and Services

**INDEPENDENTREGISTERED PUBLIC ACCOUNTINGFIRM**

The Board of Directors, upon the recommendation of itsAudit Committee, has selected KPMG LLP (“KPMG”) to audit the consolidatedfinancial statements of the Company for the year ending December 31, 2006.Representatives of KPMG LLP are expected to be present at the AnnualMeeting for the purpose of making a statement, should they so desire, andrespond to stockholder questions.

Thefollowing table sets forth fees for professional services rendered by KPMG LLPto us for the audit of our annual financial statement for the years ended December 31,2005 and 2004, and fees for other services rendered by KPMG during thoseperiods.

| **Fees**            | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------|------------|------------|------------|----------|------------|----------|------------|
| Audit fees          |       | $          | 510,000    |     | $          | 397,955  |       |
| Audit-related  fees |       | 12,629     |       | 27,725   |       |
| Tax fees            |       | 19,125     |       | 48,349   |       |
| All other fees      |       | —     |       | —   |       |
| Total               |       | $          | 541,754    |     | $          | 474,029  |       |

* *

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*AuditFees.*   Annual audit fees relate to servicesrendered in connection with the audits of the consolidated financialstatements, reviews of our quarterly reports on Form 10-Q and theaudit of internal controls over financial reporting in 2004.

*Audit-RelatedFees.*   Audit-related fees include fees forconsultations concerning financial accounting and reporting matters, includingreview of registration statements filed with the SEC.

*Taxfees.*   Tax fees include fees for servicesrendered in connection with tax compliance, advice and planning.

*Allother fees.*   There were no other fees in 2005 or2004.

The Audit Committee has adopted a policy to pre-approve all audit andpermissible non-audit services provided by KPMG LLP. Under the policy, theAudit Committee must pre-approve services prior to the commencement of thespecified service. All services provided by KPMG LLP have beenpre-approved by the Audit Committee.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules.

**(a)**           ConsolidatedFinancial Statements:

**1.**                *ConsolidatedFinancial Statements.*

The following consolidated financial statements areincluded in Item 8 of this report:

Report of Independent Registered Public AccountingFirm

Consolidated Balance Sheets at December 31, 2005and 2004

Consolidated Statements of Operations for the yearsended December 31, 2005, 2004 and 2003

Consolidated Statements of Stockholders’ Equity(Deficit) and Comprehensive Income (Loss) for the years ended December 31,2005, 2004 and 2003

Consolidated Statements of Cash Flows for the yearsended December 31, 2005, 2004 and 2003

Notes to the ConsolidatedFinancial Statements

**2.**                *FinancialStatement Schedules.*

None.

**(b)**          Exhibits.

See “Exhibit Index” below.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized on the 28th day of April, 2006.
|        | **AKSYS, LTD.** |
|--------|-----------------|
|   | By              | /s/  LAURENCE P. BIRCH |
|   |            | Laurence P. Birch  Chief Financial Officer and interim  President and Chief Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant in thecapacities indicated on this 28th day of April, 2006.
|                                       | **Signature** | ** **                                                                           | ** ** |  | **Capacity** | ** ** |
|---------------------------------------|---------------|--------------------------------------------------------------------------------------|------------|--|--------------|------------|
| /s/ LAURENCE P.  BIRCH           |          | Chief Financial  Officer and interim President                                       |
| Laurence P.  Birch               |          | and Chief Executive  Officer (Principal Executive, Financial and Accounting Officer) |
| /s/ RICHARD B.  EGEN             |          | Chairman of the  Board of Directors                                                  |
| Richard B.  Egen                 |          |                                                                                 |
| /s/ LAWRENCE D.  DAMRON          |          | Director                                                                             |
| Lawrence D.  Damron              |          |                                                                                 |
| /s/ ALAN R.  MEYER               |          | Director                                                                             |
| Alan R.  Meyer                   |          |                                                                                 |
| /s/ BERNARD R.  TRESNOWSKI       |          | Director                                                                             |
| Bernard R.  Tresnowski           |          |                                                                                 |
| /s/ BRIAN J.G.  PERIERA, MD |          | Director                                                                             |
| Brian J.G.  Periera, MD     | ** **    | ** **                                                                           |
|                                  |          | Director                                                                             |
| Shodhan Trivedi                       | ** **    | ** **                                                                           |

 

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**AKSYS,LTD.EXHIBIT INDEX**
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                       |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Restated Certificate of Incorporation of  Aksys, Ltd.(18)                                                                                                                                                                                        |
| 3.2              |       | Amended and Restated By-Laws of Aksys, Ltd.(1)                                                                                                                                                                                                   |
| 4.1              |       | Form of certificate representing shares of  Common Stock, $.01 par value per share(1)                                                                                                                                                            |
| 4.2              |       | Rights Agreement, dated as of October 28, 1996,  by and between Aksys, Ltd. and First Chicago Trust Company of New  York(2)                                                                                                                 |
| 4.3              |       | First Amendment to Rights Agreement, dated as of  February 23, 2004, by and between Aksys, Ltd. and EquiServe Trust  Company, N.A., as successor rights agent to First Chicago Trust Company of  New York(3)                                |
| 4.4              |       | Second Amendment to Rights Agreement, dated as of  March 31, 2006, by and between Aksys, Ltd. and Computershare Trust  Company N.A., as successor rights agent to EquiServe Trust Company, N.A.**                                           |
| 4.5              |       | Note Purchase Agreement, dated as of  February 23, 2004, by and among Aksys, Ltd., Durus Life Sciences  Master Fund Ltd. and Artal Long Biotech Portfolio LLC (including  Form of Unsecured Subordinated Promissory Note)(3) |
| 4.6              |       | Registration Rights Agreement, dated as of  February 23, 2004, by and among Aksys, Ltd., Durus Life Sciences  Master Fund Ltd. and Artal Long Biotech Portfolio LLC(3)                                                            |
| 4.7              |       | Common Stock Purchase Warrant, dated as of  June 30, 2003, issued in favor of The Riverview Group, LLC(4)                                                                                                                                   |
| 4.8              |       | Common Stock Purchase Warrant, dated as of  June 30, 2003, issued in favor of Roth Capital Partners, LLC(4)                                                                                                                                 |
| 4.9              |       | Registration Rights Agreement, dated as of  January 13, 2006 between Aksys, Ltd. and Fusion Capital  Fund II, LLC(12)                                                                                                             |
| 4.10             |       | Form of  Certificate of Designation of Rights, Preferences, Privileges and  Restrictions of Series B Convertible Preferred Stock of  Aksys, Ltd.(19)                                                                                   |
| 4.11             |       | Form of  Investor Rights Agreement between Aksys, Ltd., Durus Life Sciences  Master Fund Ltd. and Artal Long Biotech Portfolio LLC(19)                                                                                            |
| 4.12             |       | Form of  Warrant Agreement between Aksys, Ltd. and the Warrant Agent(19)                                                                                                                                                                    |
| 10.1             |       | Aksys, Ltd. 1993 Stock Option Plan(1)                                                                                                                                                                                                            |
| 10.2             |       | Manufacturing Agreement, dated as of  January 23, 1996, between the Company and Texas Medical  Products, Inc.(1)                                                                                                                            |
| 10.3             |       | License Agreement, dated as of April 1, 1993,  between the Company and Zbylut J. Twardowski(1)                                                                                                                                                   |
| 10.4             |       | License Agreement, dated as of April 1, 1993,  between the Company and Cynthia P. Walters(1)                                                                                                                                                     |
| 10.5             |       | Form of Indemnification Agreement(1)                                                                                                                                                                                                             |
| 10.6             |       | License Agreement, dated as of March 11, 1996,  between the Company and Allergan, Inc.(1)                                                                                                                                                   |
| 10.7             |       | Lease for Property at Two Marriott Drive(5)                                                                                                                                                                                                           |
| 10.7(a)          |       | First Amendment to Lease for Property at Two  Marriott Drive, dated as of November 12, 2004 between Transwestern Great  Lakes, L.P., and Aksys, Ltd.(11)                                                                               |
| 10.8             |       | Severance, Confidentiality and Post-Employment  Restrictions Agreement, dated as of October 4, 1999 Between the Company  and William C. Dow(6)                                                                                                   |
| 10.9             |       | Manufacturing Agreement, dated as of  February 28, 2003, Between the Company and Peak Industries, Inc.(7)                                                                                                                                   |
| 10.10            |       | Aksys, Ltd. 1996 Stock Awards Plan, as  amended(8)                                                                                                                                                                                               |
| 10.11            |       | Aksys, Ltd. 2001 Employee Stock Purchase  Plan(8)                                                                                                                                                                                                |

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| 10.12 |   | Settlement Agreement and Mutual Release, dated as of  February 23, 2004, by and among Aksys, Ltd., Durus Life Sciences  Master Fund Ltd., Scott Sacane, Durus Capital Management, LLC,  Durus Capital Management (N.A.), LLC and Artal Long Biotech Portfolio LLC(3) |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13 |   | Codevelopment and Licensing Agreement, dated as of  June 21, 1999, between the Company and Teijin Limited(9)                                                                                                                                                                                  |
| 10.14 |   | Stock Purchase Agreement, dated as of  January 7, 1998, between the Company and Teijin Limited(9)                                                                                                                                                                                             |
| 10.15 |   | Development and Licensing Agreement, dated as of  November 21, 2000, with Teijin Limited(9)                                                                                                                                                                                                   |
| 10.16 |   | Employment letter between Aksys, Ltd. and  Laurence Birch(11)                                                                                                                                                                                                                                 |
| 10.17 |   | Incentive Stock Option Agreement between  Aksys, Ltd. and Laurence Birch dated as of February 28, 2005(13)                                                                                                                                                                               |
| 10.18 |   | Research, Development and License Agreement among  Aksys, Ltd., DEKA Products Limited Partnership and DEKA Research and  Development Corp.dated as of October 24, 2005.(14)                                                                                                              |
| 10.19 |   | Common Stock Purchase Agreement, between  Aksys, Ltd. and Fusion Capital Fund II, LLC dated as of  January 13, 2006(15)                                                                                                                                                        |
| 10.20 |   | First Amendment to Common Stock Purchase Agreement,  between Aksys, Ltd. and Fusion Capital Fund II, LLC dated as  of January 27, 2006 (16)                                                                                                                                    |
| 10.21 |   | Securities  Purchase Agreement between Aksys, Ltd. and Durus Life Sciences Master  Fund Ltd. dated as of March 31, 2006(17)                                                                                                                                                         |
| 10.22 |   | Bridge  Loan Agreement between Aksys, Ltd. and Durus Life Sciences Master  Fund Ltd. dated as of March 31, 2006(17)                                                                                                                                                                 |
| 10.23 |   | Bridge  Guarantor Security Agreement between Aksys, Ltd. and Durus Life Sciences  Master Fund Ltd. dated as of March 31, 2006**                                                                                                                                                     |
| 10.24 |   | Bridge  Security Agreement between Aksys, Ltd. and Durus Life Sciences Master  Fund Ltd. dated as of March 31, 2006**                                                                                                                                                               |
| 10.25 |   | Bridge  Patent and Trademark Security Agreement between Aksys, Ltd. and Durus  Life Sciences Master Fund Ltd. dated as of March 31, 2006**                                                                                                                                          |
| 10.26 |   | Subsidiary  Guarantee between Aksys International Inc. and Durus Life Sciences Master  Fund Ltd. Dated as of March 31, 2006**                                                                                                                                                            |
| 10.27 |   | First  Amendment to Settlement Agreement and Mutual Release between Aksys, Ltd.  and Durus Life Sciences Master Fund Ltd. dated as of March 31,  2006**                                                                                                                             |
| 10.28 |   | Form of  Loan Agreement between Aksys, Ltd. and Durus Life Sciences Master  Fund Ltd.(19)                                                                                                                                                                                                |
| 21    |   | Subsidiaries of Aksys, Ltd.(10)                                                                                                                                                                                                                                                               |
| 23    |   | Consent of KPMG LLP*                                                                                                                                                                                                                                                                          |
| 31.1  |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002*                                                                                                                                                                                                                     |
| 32.1  |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002*                                                                                                                                                                                                                     |

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                * Filed herewith.

         ** Previously filed.

      (1) Incorporated by reference to the Company’s Registration Statement onForm S-1 (Registration No. 333-2492).

      (2) Incorporated by reference to the Company’s Registration Statement onForm 8A12G, filed on November 5, 1996.

      (3) Incorporated by reference to the Company’s Current Report on Form 8-K,filed on February 24, 2004.

      (4) Incorporated by reference to the Company’s Current Report on Form 8-K,filed on July 2, 2003.

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      (5) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 1997.

      (6) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 1999.

      (7) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2002.

      (8) Incorporated by reference to the Company’s Proxy Statement for its2004 Annual Meeting of Stockholders.

      (9) Incorporated by reference to the Company’s Registration Statement onForm S-3 (Registration No. 102651).

(10) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2003.

(11) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004

(12) Incorporated by reference to the Company’s current Report on Form 8-K,filed on March 2, 2005.

(13) Incorporated by reference to the Company’s Quarterly Report on Form 10-Qfor the quarter ended June 30, 2005.

(14) Incorporated by reference to the Company’s Quarterly Report on Form 10-Qfor the quarter ended September 30, 2005.

(15) Incorporated by reference to the Company’s current Report on Form 8-K,filed on January 17, 2006.

(16) Incorporated by reference to the Company’s current Report on Form 8-K,filed on January 27, 2006.

(17) Incorporated by reference to the Company’s current Report on Form 8-K,filed on April 3, 2006.

(18) Incorporated by reference to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 1996.

(19) Incorporated by reference to Durus Life Sciences Master Fund Ltd.’sSchedule 13D/A, filed on April 5, 2006.

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