**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

| **(Mark One)** |                                                                                                         |
|----------------|--------------------------------------------------------------------------------------------------------------|
| 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** |

 

**thetransition period from             to               **

Commission file number 0-28290

**AKSYS, LTD.**

(Exact name of registrantas specified in its charter)

| **Delaware**                              |   | **36-3890205**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer Identification  No.) |
| incorporation or  organization)           |   |                                  |
|                                      |   |                                  |
| **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)                                                                     |

 

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

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o    No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o                    Accelerated filer o                    Non-acceleratedfiler x

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

The aggregate market valueof the voting stock held by non-affiliates of the registrant was approximately$15,635,000 as of June 30, 2005, based on the closing sale price of $1.99as reported by the Nasdaq National Market. This calculation of market value hasbeen made for the purpose of this report only and should not be considered asan admission or conclusion by the registrant that any person is or is not infact an affiliate of the registrant.

As of March 20, 2006, the registrant had32,177,574 shares of Common Stock issued and outstanding.

DOCUMENTSINCORPORATED BY REFERENCE: Portions of the registrant’s definitive proxystatement, which will be filed within 120 days after December 31, 2005 areincorporated by reference into Part III of this Form 10-K.

 

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**AKSYS, LTD.**

**INDEXTO ANNUAL REPORT ON FORM 10-K**

|                   | ** ** |                                                                                                  | ** ** | **Page No.** |
|-------------------|------------|--------------------------------------------------------------------------------------------------|------------|-------------------|
| **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.                                                                          |       | 90                |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters. |       | 90                |
| Item 13.          |       | Certain Relationships and Related Transactions                                                   |       | 90                |
| Item 14.          |       | Principal Accountant Fees and Services                                                           |       | 90                |
| **PART IV**  |       |                                                                                                  |       | 91                |
| Item 15.          |       | Exhibits, Financial Statement Schedules                                                          |       | 91                |
| **SIGNATURES**    |       | 92                                                                                               |
| **EXHIBIT INDEX** |       | 93                                                                                               |

 

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**PART I**

**Item 1.        Business**

**Note onForward-Looking Information**

Certain statements in this Annual Report onForm 10-K and in future filings made by us with the Securities andExchange Commission and in our written and oral statements made by or with theapproval of an officer of ours constitute “forward-looking statements” withinthe meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, and we intend thatsuch forward-looking statements be subject to the safe harbors created thereby.The words “believes”, “expects”, “estimates”, “anticipates”, “will be” andsimilar words or expressions identify forward-looking statements made by us oron our behalf. These forward-looking statements reflect our views as of thedate they were made with respect to future events and financial performance,but are subject to many uncertainties and factors that may cause our actualresults to be materially different from any future results expressed or impliedby such forward-looking statements. We believe factors that could cause such adifference include, but are not limited to, the following: (i) our abilityto obtain additional capital on acceptable terms and in a sufficient amount torun our business; (ii) uncertainties regarding our ability to maintaincompliance with the Nasdaq Capital Market’s continued listing requirements;(iii) uncertainty about the acceptance of the PHD System by both potentialusers and purchasers, including without limitation, patients, clinics and otherhealth care providers; (iv) risks related to uncertain unit pricing andproduct cost, which may not be at levels that permit us to be profitable;(v) risks related to quality control issues and consistency of serviceapplicable to the PHD System; (vi) market, regulatory reimbursement andcompetitive conditions; (vii) risks related to the failure to meetadditional development and manufacturing milestones for the current ornext-generation PHD System on a timely basis, including, without limitation,manufacturing and servicing cost reduction efforts; (viii) risks inherentin relying on third parties to manufacture the current PHD System or developthe next-generation PHD System; (ix) changes in QSR requirements;(x) risks and uncertainties relating to the DEKA agreement;(xi) risks and uncertainties relating to the Delphi Medical SystemsCorporation (“Delphi”) bankruptcy; and (xii) risks related to ourrelationship with the Durus Life Sciences Master Fund, Ltd. (“the Durus fund”)and its affiliates.

The forward-looking statements made in this reportspeak only as of the date that they are made. We do not undertake to publiclyupdate or revise our forward-looking statements even if experience or futurechanges make it clear that any projected results or events expressed or impliedtherein 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 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 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 EC certification for CE Mark approval pursuant to theMedical Device Directive of the European Economic Area. The certificationapproved the PHD System for home use. Such approval was required prior to thecommercialization of the PHD System 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 with theDurus fund. See “Management’s Discussion and Analysis of Financial Conditionand Results of Operations—Liquidity and Capital Resources—Recent FinancingActivities”.

**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 byinherited disorders, prolonged medical conditions such as diabetes andhypertension, or the long-term use of certain medications. ESRD is irreversibleand lethal if untreated. Life can be sustained only through transplantation ordialysis. Transplantation is severely limited due to the shortage of suitabledonors, the incidence of organ transplant rejection and the age and health ofmany ESRD patients. The vast majority (over 90%) of patients, therefore, mustrely on dialysis for the remainder of their lives.

We estimate that over $27.3 billion was spent in theU.S. during 2003 for the treatment of patients suffering from ESRD, of whichmore than $7 billion was directly related to dialysis treatment. Based upon informationpublished by United States Renal Data System (“USRDS”), the approximate numberof ESRD patients in the United States requiring dialysis treatments has grownfrom 66,000 at the end of 1982 to an estimated 325,000 at the end of 2003. Thecurrent estimated annual growth rate of ESRD patients in the U.S. isapproximately 5%. In addition, it is estimated that there were approximately565,000 dialysis patients in Europe and Japan at the end of 2004. We believethat the sustained growth in the ESRD population, especially in the UnitedStates, has been caused by (i) the aging of the population (the median ageof 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 vasculardiseases of the heart, there is a rise in vascular diseases of the kidney), and(vi) a possible increase in the use of medications that damage thekidneys.

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 responsible forpayment 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 originalexpectations. In an effort to hold down these costs, Congress, in 1983, cappedthe Medicare reimbursement rate for outpatient dialysis at approximately$21,000 per patient per year, and has approved only modest increases since then.The costs of operating 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 totaldollars allocated from the drug add-on adjustment remains constant. Using theupdated composite payment rates, the updated drug add-on adjustment is 12.9percent. The inflation adjustment of 1.4 percent is unchanged. Therefore, thetotal drug add-on adjustment for 2006 is 14.5 percent instead of the 14.7percent as indicated in CR416. Effective April 1, 2005, each ESRD facility’srate has been case-mix adjusted. Section 623(d) of the MMA requires abasic case-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 the overallcosts 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 Treatment Methods**

Hemodialysis andperitoneal dialysis are the two prevailing methods of dialysis.

***Hemodialysis***

USRDS states that nearly300,000 prevalent patients received 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 to fourhours. In each session, the patient’s blood is cleansed by circulation throughan 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 ofperitoneal dialysis, and all forms use the patient’s peritoneum, a largemembrane rich in blood vessels that surrounds many of the body’s internalorgans, as a filter to eliminate toxins and excess fluids from the patient’sblood. Dialysate, a blood-cleansing electrolyte solution, is infused through acatheter into the patient’s peritoneal cavity. Once this fluid absorbs thetoxins 

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andexcess water that are filtered from the blood through the peritoneum, it is drainedfrom the peritoneal cavity through a catheter. In the most common form ofperitoneal dialysis, Continuous Ambulatory Peritoneal Dialysis (“CAPD”), theprocess of exchanging dialysate into and out of the patient’s peritoneal cavityoccurs four times daily, seven days per week. The other form, ContinuousCycling Peritoneal Dialysis (“CCPD”), uses an instrument to automaticallyperform exchanges of solution through the peritoneal cavity overnight, whilethe patient sleeps. Both forms of treatment require strict aseptic technique.

***Limitations ofPrevailing 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) clinicaloutcomes, with the leading cause of death among ESRD patients beingcardiovascular disease, which many clinicians believe is caused in large partby oscillations in toxins, sodium and body fluid levels and by chronicinflammation, which is stimulated in part by the conventional hemodialysisprocess, (ii) total patient costs, resulting from the frequent need tohospitalize ESRD patients as well as the need to treat anemia and hypertensionwith medication and (iii) patient quality of life, with patients having tonot only suffer through these chronic and acute health problems and related “hangover”frequently following each treatment, but also to essentially devote three daysper week to the treatment regimen.

We believe that thesehealth problems are caused in part by inadequate doses and frequency ofdialysis. The amount of toxins removed from the blood during dialysis is widelyaccepted to be determined by a formula indicating that hemodialysis is mostefficient in the earlier stages of therapy. Thus, simply increasing theduration of a treatment session is not the most efficient way to improve thedose of hemodialysis. Rather, the efficiency of hemodialysis and the delivereddose can be improved with more frequent dialysis sessions of shorter duration. Morefrequent sessions also decrease the severe oscillations in toxin and hydrationlevels associated with the prevailing three times per week dialysis regimen andshould result in fewer side effects.

The clinical outcomes ofconventional dialysis have contributed to the significant patient treatmentcost. According to the USRDS, total annual treatment costs per dialysis patienthave risen from $39,800 in 1991 to $63,000 in 2003. The cost of hospitalizationon a fee for service basis represents the most significant component of thisincrease. While reimbursement for outpatient hemodialysis treatment (the “compositerate”) has been capped since 1983 with only modest increases, reimbursement forthe associated cost of care due to chronic and acute health problems and othercomplications continues to be reimbursed on a fee for service basis. Under thisreimbursement scheme, providers have an incentive to reduce the cost ofoutpatient dialysis rather than 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 fourexchanges of solution each day, which often causes patient “burnout” andnon-compliance with the 

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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 this treatment.

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 Hemodialysis as an Alternative**

We believe that increasingthe frequency of hemodialysis treatments while decreasing the length of eachtreatment session can significantly improve clinical outcomes and patientquality of life while reducing the total cost of managing ESRD patients. Wecompleted a clinical trial of the PHD System in November 2000, whereby atotal of 23 patients converted from three times per week dialysis at home to atreatment regimen of more frequent dialysis on the PHD System. Patients showedbetter clinical outcomes and improved quality of life on more frequentdialysis. Since then, more than 63,300dialysis treatments have been performed by patients on the PHD System,including treatments at home and at clinics during the patient’s trainingperiod.

Several other studies overthe past 35 years indicate thatincreasing the number of dialysis treatments per week leads to dramaticimprovements in patients. Several study centers report that most of the ESRDpatients who performed hemodialysis on a daily basis reported that dailyhemodialysis gave them a more positive attitude toward treatment and a higherquality of life. Neither we nor the PHD System was involved in the treatmentsreceived by patients in these other studies and we did not fund these studies. Moreover,patient selection for these studies was not randomized; we gathered the data ona retrospective 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 potentialbenefits of frequent hemodialysis, several barriers have prevented it frombecoming a widely-used treatment regimen. The most significant is the economicimplication of administering more frequent hemodialysis to patients from thetraditional three times per week dialysis. Under the current capped Medicarereimbursement level, dialysis providers cannot afford the additional costs thatwould be incurred in providing more frequent treatments in outpatientfacilities. Requiring more frequent visits to a dialysis treatment facilitywould also place additional burdens on a patient’s lifestyle.

There is also a perceptionthat vascular access complications arising from inserting the needles into thepatient’s blood access site may increase with daily treatment sessions. Thesecomplications are common in the clinical setting already and account for asignificant portion of the cost of treating patients. We believe that vascularaccess complications do not increase with more frequent hemodialysis sessionsin a home or self-care setting and such complications may in fact decrease. Thatbelief is based on our own clinical experience as well as several clinicalinvestigations that have been published in peer-reviewed medical journals. Mostof this data has been collected on patients whose blood access site is a nativearterio-venous fistula or a central venous catheter. There is less dataavailable on the complication rate when performing high-frequency hemodialysison patients using artificial blood vessel grafts, and there is no assurancethat such grafts or catheters will withstand daily treatment. There are anumber of approaches to vascular access that may enhance more frequenttreatments, including (i) the use of “single 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 

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implantedcentral venous catheters with titanium ports and (v) the practice of insertingneedles in the same site each day, which has been demonstrated to have severalbenefits according to publications by Dr. Zbylut J. Twardowski, a leadingdialysis researcher. 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 PHD System**

Byaddressing the many drawbacks of conventional hemodialysis systems, which haveprevented the widespread use of daily home hemodialysis, we believe ourproducts and services can be instrumental in improving clinical outcomes,decreasing the total treatment costs and improving quality of life for dialysispatients. The following chart describes how the PHD System addresses thedrawbacks presented when ESRD patients and helpers use conventional systems forhome 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 PHDSystem is a fully automated personal dialysis instrument designed to enableoperators to perform hemodialysis in a self-care setting, such as the patient’shome, on a frequent or daily basis. The PHD System is designed to reduce thepatient’s time and effort involved in performing each hemodialysis treatmentwith minimal assistance. Through a touch sensitive display screen withinstructions available on a graphic video display, the PHD System is designedto be less intimidating and easier to use than 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.The PHD 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 Supporting the PHD System**

To fully service hemodialysis patients, we havedeveloped a service network to provide support for patients and dialysisproviders in all aspects relating to the use and maintenance of the PHD System.Our service network provides the following: (i) delivery and installationof the PHD System, (ii) technical service through a 24 hour call centerand through field representatives who maintain and repair all components of thePHD System, (iii) delivery of consumables used in dialysis such as theartificial kidney and arterial and venous blood tubing (which are replacedperiodically), 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 torealign our 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 at home onthe PHD System. This study was conducted by the clinic’s own accountants andconcluded that with 25 patients dialyzing on the PHD, the clinic could achieve$92,000 more in total profit compared to if those patients were dialyzed in theclinic on a three times per week regimen. The study was limited however, andtherefore there can be no assurance that similar results would be realized byother 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 agreements that provide us with additional capitalto support 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”.

**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 treating ESRDpatients 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   Thetarget markets have a high density of potential patients, have demonstrated aninterest in providing home hemodialysis as an option for the patient populationand have a number of clinics that have received or applied for certification toprovide this service line 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 recognizedquality systems standard for the medical device industry. Delphi is also FDAregistered and quality system regulations (“QSR”) compliant. Our contract withDelphi automatically renews on an annual basis each February unless asix-month advance notice is provided by either party to terminate the contractor a party exercises its right to terminate the contract for breach or undercertain other circumstances.

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 andits parent corporation filed a voluntary petition for business reorganizationunder Chapter 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 dialysisequipment, disposables, and services are Fresenius Medical Care AG BaxterInternational, Inc., and Gambro AB. These competitors have more financial,scientific, and technical resources than do we, as well as more experience withrespect to manufacturing, product development, and marketing in the dialysismarket. We also compete with NxStage Medical, Inc.  One key factor for success in the market formore frequent home dialysis relates to the ability of a supplier to offer asystem that cost-effectively provides a broad range of patients with dialysistherapy meeting or exceeding DOQI guidelines. Today, our competitors meet thesestandards to varying degrees. We believe that clinical data shows that the PHDSystem provides an amount of dialysis that significantly exceeds theseguidelines.

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 that competitionin the home hemodialysis market will be based on these factors as well as onproducts being relatively easy to use, transport and maintain. Certain kidneydialysis 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 regulatesthe manufacture and distribution of medical devices in the United States.Noncompliance with 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 ofthe PHD System. We received full IDE approval in July 1999, and inSeptember 1999 began the clinical trial of the PHD System. Twenty-fivepatients participated in the trial at three centers. The protocol for the studycalled for patients to dialyze at home on existing hemodialysis equipment for10 weeks, followed by one 

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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.They also require investigation of any deficiencies in the manufacturingprocess or in the products produced and detailed record keeping. Manufacturingfacilities are therefore subject to FDA inspection on a periodic basis tomonitor compliance with QSRs. If violations of the applicable regulations arenoted during 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 and AccountabilityAct of 1996*(“HIPAA”) and Privacy Rules

**HIPAAand the rules promulgated thereunder require certain entities, referred toas covered entities, to comply with established standards, including standardsregarding the privacy and security of protected health information. HIPAAfurther requires that covered entities enter into agreements meeting certainregulatory requirements with their business associates, as such term is definedby HIPAA, which, among other things, obligate the business associates to safeguardthe covered entity’s protected health information against improper use anddisclosure. While not directly regulated by HIPAA, a business associate mayface significant contractual liability pursuant to such an agreement if thebusiness associate breaches the agreement or causes the covered entity to failto comply with HIPAA. In the course of our business operations, we have enteredinto several business associate agreements with certain of our customers thatare covered entities. Pursuant to the terms of these business associateagreements, we have agreed, among other things, not to use or further disclosethe covered entity’s protected health information except as**

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**permittedor required by the agreements or as required by law, to use reasonable safeguardsto prevent prohibited disclosure of such protected health information and toreport to the covered entity any unauthorized uses or disclosures of suchprotected health information. Accordingly, we incur compliance related costs inmeeting HIPAA-related obligations under business associate agreements to whichwe are a party. Moreover, if we fail to meet our contractual obligations undersuch agreements, we may incur significant liability. In addition, HIPAA’scriminal provisions could potentially be applied to a non-covered entity thataided and abetted the violation of, or conspired to violate HIPAA, although weare unable at this time to determine conclusively whether our actions could besubject to prosecution in the event of an impermissible disclosure of healthinformation to us. Also, many state laws regulate the use and disclosure ofhealth information, and are not necessarily preempted by HIPAA, in particularthose laws that afford greater protection to the individual than does HIPAA.Finally, in the event we change our business model and become a HIPAA coveredentity, we would be directly subject to HIPAA, its rules and its civil andcriminal penalties.**

***Anti-KickbackLaws***

**The federal healthcare programAnti-Kickback Statute prohibits persons from knowingly and willfullysoliciting, offering, receiving or providing remuneration, directly orindirectly, in exchange for or to induce either the referral of an individualfor, or the furnishing, arranging for or recommending a good or service for whichpayment may be made in whole or part under a federal healthcare program such asMedicare or Medicaid. The definition of remuneration has been broadlyinterpreted to include anything of value, including for example gifts,discounts, the furnishing of supplies or equipment, credit arrangements,payments of cash and waivers of payments. Several courts have interpreted thestatute’s intent requirement to mean that if any one purpose of an arrangementinvolving remuneration is to induce referrals or otherwise generate businessinvolving goods or services reimbursed in whole or in part under federalhealthcare programs, the statute has been violated. The law contains a fewstatutory exceptions, including payments to bona fide employees, certaindiscounts and certain payments to group purchasing organizations. Violationscan result in significant penalties, imprisonment and exclusion from Medicare,Medicaid and other federal healthcare programs. Exclusion of a manufacturerwould preclude any federal healthcare program from paying for its products. Inaddition, some enforcement officials have argued that kickback arrangements canprovide the basis for an action under the Federal Civil False Claims Act, whichis discussed in more detail below.**

**Governmentofficials have focused recent enforcement efforts on, among other things, thesales and marketing activities of healthcare companies, and recently havebrought cases against individuals or entities with personnel who allegedlyoffered unlawful inducements to potential or existing customers in an attemptto procure their business. Settlements of these cases by healthcare companieshave involved significant fines and/or penalties and in some instances criminalpleas. In addition to the Anti-Kickback Statute, many states have their ownkickback laws. Often, these laws closely follow the language of the federallaw, although they do not always have the same exceptions or safe harbors. Insome states, these anti-kickback laws apply with respect to all payers, includingcommercial health insurance companies.**

*False ClaimsStatutes*

Federal false claims lawsprohibit any person from knowingly presenting, or causing to be presented, afalse claim for payment to the federal government or knowingly making, orcausing to be made, a false statement to get a false claim paid. Manufacturerscan be held liable under false claims laws, even if they do not submit claimsto the government, if they are found to have caused submission of false claims.The Federal Civil False Claims Act also includes whistle blower provisions thatallow private citizens to bring suit against an entity or individual on behalfof the United States and to recover a portion of any monetary recovery. Many ofthe recent highly publicized settlements in the healthcare industry related tosales and 

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marketingpractices have been cases brought under the False Claims Act. The majority ofstates also have statutes or regulations similar to the federal false claimslaws, which apply to items and services reimbursed under Medicaid and otherstate programs, or, in several states, apply regardless of the payer. Sanctionsunder these federal and state laws may include civil monetary penalties,exclusion of a manufacturer’s products from reimbursement 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.*   OnNovember 1, 2005, we entered into a Research, Development and LicenseAgreement with DEKA Products Limited Partnership and DEKA Research andDevelopment Corp. The purpose of the DEKA Agreement is to develop a nextgeneration product consisting of certain hemodialysis equipment and relatedsolution preparation processes. DEKA is compensated for its development work ona cost plus basis, which is generally determined based upon DEKA’s costsincurred and hours spent on the project. We made a payment to DEKA ofapproximately $950,000 for services performed through December 31, 2005.We are required to make additional payments to DEKA of approximately $200,000per month, subject to periodic reconciliation to DEKA’s actual costs incurredand hours spent pursuant to the project. We have the right to terminate thisdevelopment work at any time with 90 days notice. In addition, we will pay DEKAroyalties based upon a percentage of net sales of products developed under theproject. Finally, we have agreed to issue to DEKA warrants to purchase 350,000shares of our common stock having an exercise price of $1.62 per share whichvest upon the achievement of certain milestones for the project. DEKA will ownthe intellectual 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 ofuse. 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-time employees, 22 of whom were employed in research anddevelopment capacities, 23 of whom were employed in the technical and clinicalservices area, 13 of whom were employed in sales and marketing efforts, 14 ofwhom were employed in the general and administrative area, 11 of whom wereemployed in manufacturing, operations and regulatory groups, and 4 of whom wereemployed in the United Kingdom 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 was appointed to the Company’s Board ofDirectors and elected as interim President and Chief Executive Officer onMarch 31, 2006. Mr. Birch joined the Company in February 2005 asSenior Vice President and assumed the duties of Chief Financial Officereffective March 17, 2005. From 2003 until he joined the Company, Mr. Birchserved as Managing Director for Stratego Partners, a corporate cost managementcompany. From 2002 to 2003, he served as Chief Financial Officer of Seurat, Inc.From 2001 to 2002, he served as Chief Financial Officer of Fieldglass, Inc.From 2000 to 2001, he served as Senior Vice President and Chief FinancialOfficer of Technology Solutions, Inc. In 2000 he served as Chief FinancialOfficer of Brigade, Inc. From 1999 to 2000, he served as Chief FinancialOfficer of Gateway Homecare, Inc. Mr. Birch has over fifteen yearsexperience in the healthcare sector which includes his fourteen years withBaxter International, 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**

**Mr. Damronwas appointed 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 was appointedSenior Vice President and Chief Technical Officer in October 2004. Mr. Fisher  has over 30 years of experience in thehealthcare sector. Prior to joining the Company, he served in various roleswith Baxter International, Inc. from 1970 to 2003. Mr. Fisher wasVice 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. Goldhaberwas appointed 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 his Bachelor ofScience degree in aeronautical engineering from the University of Notre Dame,his Masters of Science degree in Mechanical Engineering from NorthwesternUniversity, and his Masters of Business Administration degree from NorthernIllinois 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 Bachelor ofArts 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 was appointedSenior 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, includingVice President, Sales and Operations of the Renal Division. In that role, Mr. Scullywas involved principally in the design, development and management of the RenalDivision’s home care operations network. Mr. Scully received his Bachelorof Arts degree from the University of Notre Dame and his Master’s of Managementdegree from Northwestern University. Mr. Scully served as a Captain in theU.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 hasthe right to develop, manufacture, seek regulatory approval, and upon suchapproval, to market, rent and sell the PHD System in Japan. Teijin will payroyalties to us in the amount of 10% of all revenues received in connectionwith their sales and rentals of PHD Systems in Japan. Under the agreement, wehave an option to sell the PHD System in Japan, but our exercise of this optionwould cause the royalty rate to drop to 5%. To date there have not been any PHDSystem sales in Japan. Teijin is a leading Japanese manufacturer of syntheticfibers, chemicals and plastics, with annual sales of approximately $7.5billion, of which over $800 million is derived from pharmaceuticals and homehealth 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 publicreference room at 100 F Street, NE, Washington, D.C. 20549. Please call the SECat 1-800-SEC-0330 for information on the public referenceroom. The SEC maintains a web site (www.sec.gov) that contains annual,quarterly and current reports, proxy statements and other information thatissuers (including us) file electronically with the SEC.

We make available free ofcharge, through a direct link from our web site (www.aksys.com) to theSEC’s web site, our annual reports on Form 10-K, quarterly reportson Form 10-Q, current reports on Form 8-K, Forms 3, 4 and5 filed on behalf of directors and executive officers, and any amendments tothose reports filed or furnished pursuant to the Securities Exchange Act of1934 as soon as reasonably practicable after such documents are electronicallyfiled with, or furnished to, the SEC.

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**Item 1A.**                RiskFactors.

**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 to Our Business**

***As a result of our transaction with the Durus fundand the Durus fund’s current ownership position in our common and preferredstock, persons other than the Durus fund who own our common stock will own aminority of our common stock and will not be able to exercise voting controlover most matters put to a vote of stockholders.***

On March 31, 2006 we executed definitiveagreements for a financing transaction with the Durus fund. These documentsincluded an amendment to our existing settlement agreement with the Durus fundand Artal Long Biotech Portfolio LLC (the “Artal fund”) to release the Durusfund and the Artal fund from standstill and other restrictive covenants,including elimination of the requirement for the Durus fund to reduce itsownership in our common stock to 15% by May 2006 and the requirement that,on matters requiring the vote of the Company’s stockholders, the Durus fund andthe Artal fund vote their shares of the Company’s common stock in proportion tothe votes cast by all other holders of the Company’s common stock. By releasingthe Durus fund from these restrictions, the Durus fund is no longer prohibitedfrom acquiring our securities or making any solicitation of proxies to vote ourshares. In addition, we took actions to amend our shareholder rights agreementso that it will not be applicable to the Durus fund or the transactions withthe Durus fund and to eliminate our shareholder rights outstanding under ourrights agreement.

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 interestsmay not coincide with the interests of other holders of our common stock. TheDurus fund is in the business of making investments in companies and may, fromtime to time, acquire and hold interests in businesses that compete directly orindirectly with us. The Durus fund may pursue, for its own account, acquisitionopportunities that may be complementary to our business, and as a result, thoseacquisition opportunities may not be available to us. Such concentration ofownership could also have the effect of delaying, deterring or preventing achange in control of the Company that might otherwise be beneficial to minoritystockholders and may also discourage acquisition bids for the Company and limitthe amount certain investors may be willing to pay for shares of our commonstock.

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***We require additional capital to operate ourbusiness which, if not available to us, may prevent our ability to continueoperations and which, if raised, will dilute stockholder ownership interest inus or otherwise reduce the value of our common stock.***

Our capitalrequirements have been and will continue to be significant. To date, we haveraised approximately $152 million from equity offerings and have received approximately$53.7 million in payments and financings from the Durus fund, approximately $48.7million as part of the original settlement in 2004 and $5.0 million on March 31,2006 in the form of a short term loan. Our capital requirements will depend onmany factors, including without limitation:

·       the cost of servicing andsupporting PHD Systems in use;

·       manufacturingand associated costs;

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

·       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. We believeour cash and liquid investments (including the receivable for the settlement ofthe 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’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources—Recent Financing 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 throughJanuary 1, 2007. However, this letter does not represent a legally bindingcommitment of the Durus fund to provide the Company with any financing, and theletter further 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 maynot do business with us, may terminate business relationships with us or maynot extend business relationships.***

Due to our capitalconstraints, vendors and other third parties may decide not to conduct businesswith us, or may conduct business with us only on a cash basis and on otherterms that are less favorable than those customarily extended by them. In thatevent, our costs may increase. In addition, our capital constraints may make itdifficult for us to market the PHD System and related services to current andprospective customers. If we are unable to maintain relationships with existingclinics and/or develop relationships with new clinics, our future revenues willlikely 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, asubstantial 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 itstotal 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 significant amountof business from any of our large customers could have a material adverseeffect on our results of operations and financial condition if such businesswere not substantially replaced by additional business from existing or newcustomers. Additionally, our results of operations and financial conditioncould be materially adversely affected if any of our large customers experiencefinancial difficulties that cause them to delay, or fail to make, payments forgoods sold or leased to them.***

***If our currentmanufacturing agreement with Delphi Medical Systems Corporation (“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 Codefinancing statement on file with the Colorado Secretary of State with respectto certain component inventory located at Delphi’s warehouses. In addition, asof December 31, 2005, we had a cash deposit in the amount of $1,432,000with Delphi as security for certain of our purchase obligations. We haverecorded a reserve to reflect the uncertainty associated with the bankruptcyfiling; however, we are pursuing the full value of the deposit. We have hadongoing discussions with Delphi regarding our accounts payable balance, ourdeposit and certain parts inventory located at Delphi’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 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 historyof operating losses and a significant accumulated deficit, and we may notachieve or maintain profitability 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 producethe PHD System and deliver related services and supplies currently exceeds themarket price of the PHD System and related 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 failif we cannot successfully commercialize the PHD System; because we have onlyrecently begun this commercialization process, our success cannot be predictedand is uncertain. Our success is dependent on many variables entirely outsideof 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;

·       homehemodialysis, which is currently employed by only a small percentage ofpatients suffering from end-stage renal disease; and

·       dailyhemodialysis, which to our knowledge has never been a widely implementeddialysis alternative.

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 prepare itselffor the next treatment session. As such, it is very unlikely to be used in theprevailing method of outpatient hemodialysis, which generally involves treatingpatients three times per week for treatment sessions lasting between three andfour hours. In this prevailing method of hemodialysis, patients receivingtreatment on a given day are treated in shifts, with patients on succeedingshifts using dialysis machines employed during prior shifts.

A number of otherfactors will affect the future success and sales of our product. These factorsinclude:

·       theamount of government and private reimbursement for dialysis treatment;

·       whetherthe system will be safe or effective or whether it will be cost-effectiverelative to other dialysis 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 are unexpectedside effects, complications or other safety issues associated with dailyhemodialysis (or the PHD System) that may adversely affect the market for ourproducts and services.

***We are entirelydependent on the PHD System, our sole product.***

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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***Our strategy to develop a new generation of ourproduct under the DEKA Agreement involves a number of risks and uncertainties.***

Our strategy fordevelopment of a new generation of our product depends upon the success of theDEKA Agreement. The ultimate success of the development efforts under the DEKAAgreement is subject to a number of cost, timing and other risks anduncertainties, many of which are outside of our control. We cannot be certainthat the DEKA Agreement will be successful or that any product will ultimatelybe developed under this agreement.

***Uncertainty andamount of third-party reimbursement 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 andtechnological advances could cause us to lose current and future businessopportunities and materially harm our results of operations and ability togrow.***

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, BaxterInternational, Inc., and Gambro AB. These competitors have more financial,scientific, and technical resources than do we, as well as more experience withrespect to manufacturing, product development, and marketing in the dialysismarket. We also compete with NxStage Medical, Inc.  If our competitors succeed in developingproducts that are more effective and/or less costly than the PHD System forperforming more frequent home hemodialysis, both our sales and our prospectsfor achieving profitability may be adversely impacted. We also expect that thenumber of our competitors will increase, and there can be no assurance that wewill be able to compete successfully against any 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 with diabetesand hypertension), technological developments by others, development of newmedications designed to reduce the incidence of kidney transplant rejection andprogress in using kidneys harvested from genetically-engineered animalsas 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 salescould be adversely affected due to our limited marketing experience.***

We currently marketour products and services primarily through our own sales force. There can beno assurance that we will be able to staff an adequate marketing staff or salesforce or that the cost of such 

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willnot be prohibitive, or that our direct sales and marketing efforts will besuccessful. The choice of dialysis therapy involves the successful marketing todialysis clinic operators and nurses, nephrologists and patients, each of whichmay have different factors that they consider in making their decision.Ineffective marketing to any one of these decision makers may adversely affectacceptance of the PHD System. We may have difficulty in gaining acceptance ofthe 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 toextensive government regulation, which can be costly, time consuming andsubject us to unanticipated interruptions or delays in our commercialoperations.***

The PHD System, our sole product, is subject tostringent government regulation in the United States and other countries. Inthe United States, the PHD System is regulated as a medical device by the FDA. InMarch 2002, we announced receipt of clearance from the FDA to market thePHD System in the United States. The FDA clearance had no restrictions andincluded authorization to use the product in the home; however, FDA clearanceunder 510(k) is subject to continual review and later discovery ofpreviously unknown problems may result in restrictions on product marketing orwithdrawal of the product from 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 applicable requirementscan result in fines, recalls or seizures of products, total or partialsuspension of production, withdrawal of existing product approvals orclearances, refusal to approve or clear new applications or notices andcriminal prosecution.

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 onindependent contract manufacturers for the manufacture of our PHD System. Ourinability to manufacture the PHD System, and our dependence on independentcontractors, may delay or impair our ability to generate revenues, or adverselyaffect 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 to conducttheir business at their own discretion. Although certain of our contractmanufacturers have entered into contracts with us to manufacture components ofthe PHD System, such contracts can be terminated at any time under certaincircumstances by us or by the contractors, and can be breached at any time. Further,work stoppages and the slowing of production at a single independentcontractor would have a material adverse effect on our results of operations.

There are also other risksinherent in using a single source of supply. We have not made alternativearrangements for the manufacture of the major components of the PHD System andwe may not be able to implement acceptable alternative arrangements on a timelybasis, or at all.  It is likely that asignificant interruption in supply would result if we utilize or were requiredto utilize a different manufacturing contractor for any of the major componentsof PHD Systems. The loss of the services of any of our contract manufacturerswould have a materially adverse effect on our results of operations.  See “Risk Factors—*If ourcurrent manufacturing agreement with Delphi is terminated and we are requiredto establish new manufacturing relationships, we may experience increasedcosts, disruptions in the manufacture and shipment of the PHD System and a lossof revenue.”*  In addition, weor our manufacturers may not be able to obtain, on a timely basis, componentsor other supplies necessary to manufacture or use the PHD System.

***We may not be ableto protect our intellectual property rights and, as a result, we could losecompetitive advantages that could adversely affect our operating results.***

Our successdepends, in part, on our ability and the ability of our licensors to obtain,assert and defend patent rights, protect trade secrets and operate withoutinfringing the proprietary rights of others. We currently own or have rights inrelevant fields to 47 U.S. patents and 26 foreign patents. There can be noassurance, however, that:

·       wewill be able to obtain additional licenses to patents of others or that we willbe able to develop additional 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;

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·       otherswill not independently develop similar products;

·       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 proprietaryknow-how and confidential information and employ various methods, such asentering into confidentiality and noncompete agreements with our currentemployees and with certain third parties to whom we have divulged proprietaryinformation, to protect the processes, concepts, ideas and documentationassociated with our technologies. Such methods may not afford significantprotection to us, and we may not be able to protect adequately our tradesecrets or our competitors or other companies may acquire information that weconsider proprietary.

***Productliability claims may reduce demand for the PHD System or result in damages thatexceed our insurance coverage.***

Our business exposes us topotential product liability risks that are inherent in the production,marketing and sale of dialysis products. We currently maintain productliability 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.

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***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 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 cannotdevelop adequate distribution, customer service and technical support networks,we may not be able to market and distribute 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**

***Our common stock has been delisted from the NasdaqNational Market and could be delisted 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 (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 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 

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Nasdaq denying our requestfor continued listing on the Nasdaq National Market. In response to thisletter, on December 30, 2005, we requested a hearing before the NasdaqListing Qualifications Panel to review the Nasdaq staff’s determination. Wesubsequently received notification from the Nasdaq Listing Qualifications Panelthat our common stock would be delisted from the Nasdaq National Market andwould begin trading on the Nasdaq Capital Market on February 14, 2006.

The Nasdaq Capital Markethas its own standards for continued listing, including Marketplace 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 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 assurancethat we will sustain compliance with these standards. In particular, we do notcurrently have a minimum of $2,500,000 in stockholders’ equity and we did nothave $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. Inthe event we cannot sustain compliance with the Nasdaq Capital Market’s listingstandards, our common stock will be delisted from the Nasdaq Capital Market andwe may be unable to list our common stock on another stock exchange orquotation service. Such a delisting may make it difficult or impossible forstockholders to sell their shares, for us to issue additional securities andfor us to obtain additional financing in the future. A delisting may alsoresult in a more limited amount of news and analyst coverage for our Companyand could have a material adverse effect on the market price of our commonstock.

***If our common stockbecomes a “penny stock” you may find it difficult to resell shares.***

Generally, a “penny stock”is a common stock that is not listed on a securities exchange and trades forless than $5.00 a share. Prices often are not available to buyers and sellersand the market may be very limited. Penny stocks in start-up companies areamong the riskiest equity investments. Broker-dealers who sell penny stocksmust provide purchasers of these stocks with a standardized risk-disclosuredocument prepared by the Securities and Exchange Commission. The documentprovides information about penny stocks and the nature and level of risksinvolved in investing in the penny stock market. A broker must also give apurchaser, orally or in writing, bid and offer quotations and informationregarding broker and salesperson compensation, make a written determinationthat the penny stock is a suitable investment for the purchaser, and obtain thepurchaser’s written agreement to the purchase. Many brokers choose not toparticipate in penny stock transactions. If our common stock is delisted from the Nasdaq Capital Market****and we are unable to satisfy certain other financial testswe will be classified as a “penny stock” as that term is defined under Rule 3a51-1of the Securities Exchange Act of 1934. Because of the penny stock rules, thereis less trading activity in penny stock, and consequently you may havedifficulty selling your shares.

***Our common stock isthinly traded, so you may be unable to sell at or near ask price or at all ifyou need to liquidate your shares.***

Our common shares havehistorically been sporadically or “thinly-traded” on the Nasdaq Capital Marketand the Nasdaq National Market (priorto our delisting from  the NasdaqNational Market), meaning that the number of persons interested inpurchasing our common shares at or near ask prices at any given time may berelatively small or non-existent. As of December 31,2005, our average trading volume per day for the past three months wasapproximately 57,932 shares aday with a high of 425,322shares traded and a low of 1,775 shares traded. This situation is attributableto a number of factors, including the fact that we are a small company which isrelatively unknown to stock analysts, stock brokers, institutional investorsand others in the investment community that generate or influence sales volume,and 

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thateven if we came to the attention of such persons, they tend to be risk-averseand would be reluctant to follow an unproven company such as ours or purchaseor recommend the purchase of our shares until such time as we became moreseasoned and viable. As a consequence, there may be periods of several days ormore when trading activity in our shares is low, as compared to a seasonedissuer which has a large and steady volume of trading activity that willgenerally support continuous sales without an adverse effect on share price. Wecannot give you any assurance that a broader or more active public tradingmarket for our common shares will develop or be sustained, or that currenttrading levels will be sustained.

***The market price ofour common stock may be subject to significant 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 ofsubstantial amounts of our common stock in the public market could adverselyaffect the market price of the common stock, and also could impair our abilityto raise additional capital through the sale of our equity securities.

***The resale by theDurus fund of a substantial number of shares of our common stock couldadversely impact the market price of our common 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.

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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 contribute to a decline in the market price of ourstock. In addition, these factors may have a material adverse effect on ourability to raise capital through the issuance of our equity securities.

***We do not intend topay cash dividends on our common stock 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 needto issue additional shares of our common stock and/or preferred stock in thefuture, which would dilute your voting 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 our commonstock and will not be able to exercise voting control over most matters put toa vote of stockholders.”

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***Our charterdocuments and Section 203 of the DGCL could make it more difficult for athird party to acquire us.***

Our RestatedCertificate of Incorporation (“Charter”) and Amended and Restated Bylaws (“Bylaws”)contain certain provisions that are intended to enhance the likelihood ofcontinuity and stability in the composition of our board of directors and whichmay have the effect of delaying, deferring or preventing a future takeover orchange in control of the Company unless the takeover or change of control isapproved by our board of directors. Such provisions may also render the removalof the current board of directors and of management more difficult. Theseprovisions provide for, among other things:

·       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 are subject tothe “business combination” statute of the General Corporation Law of the Stateof Delaware (the “DGCL”). In general, Section 203 of the DGCL prohibits apublicly-held Delaware corporation from engaging in a “business combination”with an “interested stockholder,” for a period of three years after the date ofthe transaction in which a person became an “interested stockholder,” 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 orasset sales and other transactions resulting in a financial benefit to the “interestedstockholders.”  An “interestedstockholder” is a person who, together with affiliates and associates, owns (orwithin three years, did own) 15% or more of the voting stock of the subjectcorporation. Although Section 203 permits us to elect not to be governedby its provisions, we have not made this election. As a result of theapplication of Section 203, potential acquirers of our company may bediscouraged from attempting to effect an acquisition transaction with us,thereby possibly depriving holders of our securities of certain opportunitiesto sell or otherwise dispose of such securities at above-market pricespursuant to such transactions.

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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  Bylawsare filed as exhibits to this report and deemed to be incorporated herein intheir 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.***

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.”

**Item 2.**                        Properties.

We lease approximately 41,500 square feet of office spacein Lincolnshire, Illinois to conduct our research, development, marketing andadministrative functions. This lease was initiated September 1, 1996, withan expiration date of August 31, 2006. In November 2004, we amendedthe lease with an extension in the term of the lease to December 31, 2011.In December 2005, we abandoned approximately 10,000 square feet of theoffice space which we lease in Lincolnshire, Illinois in conjunction with thereduction of our work force. On December 29, 2005, we entered into anagreement with a third party to market this vacant office space. In addition,we lease approximately 1,305 square feet of space in Stone, United Kingdom tostore component parts and perform maintenance and repairs 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 matters submitted for a vote of ourstockholders 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

TheCompany’s common stock was listed on the Nasdaq National Market****under the symbol “AKSY” until February 14,2006, when the Company’s stock began trading on the Nasdaq Capital Market underthe same symbol. The following table lists the quarterly high and low closingprices of the common stock for the period 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. Inaddition, we estimate that there were approximately 5,500 holders of our commonstock at March 20, 2006, who held shares in “street name.”  We have not paid cash dividends to date, andmanagement anticipates that all future earnings will be retained fordevelopment of our business.

**Equity CompensationPlan Information**

Thefollowing table sets forth information about the Company’s common stock thatmay be issued under all of the Company’s existing equity compensation plans asof December 31, 2005, including the 1993 Stock Option Plan, the 1996 StockAwards Plan and the 2001 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 thefollowing discussion together with the consolidated financials statements andrelated notes appearing elsewhere in this annual report. This discussioncontains forward-looking statements that involve risks and uncertainties.Actual results may differ materially from those included in suchforward-looking statements. See “Notes on Forward-Looking Information*”.*

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**Item 7.        Management’s Discussion and Analysis ofFinancial 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 to improvingmachine performance, with the goal of reducing the frequency of service callsand 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 Medicarereimbursement should improve the economics of the PHD System for clinics andcould influence their decision to use the PHD System. Further changes inreimbursement are also under consideration by the government, including thepossible bundling of reimbursement for dialysis treatment, drugs and lab testsinto 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 ofLincoln and Berkshire Medical Center accounted for 24%, 10% and 9%,respectively, of our revenues (by dollar volume).

**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 thefollowing conditions exist: (1) there is persuasive evidence of anarrangement, (2) the product has been delivered and accepted or servicesand supplies have been provided to the customer, (3) the sales price isfixed 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 indicate thatthe 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.

**ContractualObligations**

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$1,432,000 as of December 31, 2005. In the fourth quarter of 2005, werecorded a reserve to this deposit to reflect the uncertainty associated withthis vendor’s voluntary petition for business reorganization under Chapter 11of the U.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 Partnership Agreements****  *We added 10 clinic partnership agreements inthe year ended December 31, 2005, bringing the total number of signedpartnership agreements to 54. The activity level under our agreements variesfrom 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 $396,000 and$120,000, respectively. Revenue from units sold in 2004 in the United Statesand United Kingdom was $797,000 and $275,000, respectively. While there havebeen no material changes to our sales price per unit, the number of units soldvaries greatly from quarter to quarter as we are still in the earlycommercialization stages of the PHD System. While we have continued to increaseour customer base, increased competition in the home hemodialysis marketcontributed to the increase in rentals and decrease in sales of our machine. Inan effort to gain market acceptance of our relatively new product, we allowcustomers to rent the PHD System. Rentals are made pursuant to short-term andlong-term operating leases. We maintain ownership of the units and classifythem as leased assets. Depreciation expense is recorded monthly. Theexpectation is that over time some of these rentals may convert to sales.Rental revenue for the year ended December 31, 2005 was $706,000, an increaseof $320,000 or 83% from $386,000 for the year ended December 31, 2004. In2005, we recognized revenue from operating leases of  $698,000 in the United States and $8,000 inthe United Kingdom. In 2004, we recognized rental revenue from operating leasesof $379,000 in the United States 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.

Whilethere has been no material change to our monthly rental price over the past twoyears, rental revenue and service and supplies revenue have increased as ourpatient base has continued to grow. Service and supply revenue is generatedfrom patient utilization 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 the levelrequired by our current near-term revenue opportunities.  The cost structure for production of the PHDSystem exceeded and continues to exceed its market price. Additionally, thecontinued uncertainty related to adequate third-party reimbursements for dialysistreatment, especially from Medicare and Medicaid, caused us to re-evaluate ournear-term growth opportunity and align our cost structure accordingly. As aresult, on December 6, 2005 we announced a plan to realign our servicenetwork by designating geographic operating districts which have shown thehighest adoption rates for the PHD System. The plan includes severaloperational changes designed to significantly reduce our cash burn rate andprovide 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.

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 related suppliesand 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 the U.S.Bankruptcy Code. The ultimate effect of the bankruptcy on our relationship withDelphi is unclear. We have a Uniform Commercial Code financing statement onfile with the Colorado Secretary of State with respect to certain parts inventorythat is located at Delphi’s warehouses. We have had ongoing discussions withDelphi regarding our accounts payable balance to them, our cash deposit andcertain parts inventory located at Delphi’s warehouses. In the first quarter of2006, we received correspondence from Delphi advising us of their decision tostop further shipments of PHD Systems and parts until these items have beenresolved. We plan to continue our discussions with Delphi and believe that wehave a sufficient inventory of parts and machines on hand to enable us tocontinue operations pending resolution of this matter. If Delphi rejects ourmanufacturing agreement in connection with its bankruptcy proceeding or we areunable to resolve our open issues with Delphi on a timely basis, we would beforced to establish new manufacturing and/or parts sourcing relationships whichcould 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 performance of our machine does not improve, wemay not be able to reduce the per-unit cost of 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 ended December 31,2004. Fluctuations in each specific area are discussed below.

*Researchand development expenses*   For the year ended December 31,2005, research and development expenses were $8,069,000, an increase of$1,385,000 or 21% from $6,684,000 for the year ended December 31, 2004. Theincrease was primarily due to costs associated with advancing PHD performanceand new product development.

*Salesand marketing expenses*   For the year ended December 31,2005, sales and marketing expenses were $4,532,000, a decrease of $260,000 or5% from $4,792,000 for the year ended December 31, 2004. The decrease wasdue primarily to a reduction in spending for marketing promotions and adecrease in personnel expenses. These decreases were offset partially byincreases in marketing-related consulting, travel, convention and other projectexpenses.

*Generaland administrative expenses*   For the year ended 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 to increases in contract labor for informationtechnology, recruiting and professional fees, and facilities expenses.   Facilities expenses increased compared to2004 because in 2004 we re-negotiated the lease for our office space. We hadpreviously recorded a liability to straight-line the future rent payments. Whenwe signed the new lease we recognized the remaining balance of the deferredrent, $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. Revenue generatedfrom 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. The numberof units sold varies greatly from quarter to quarter as we are still in theearly commercialization stages of the PHD System. In an effort to gain marketacceptance of our relatively new product, we allow customers to rent the PHDSystem. 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 PHD Systemssold in the United Kingdom. In fiscal 2003, revenue from product sales in theUnited States and United Kingdom was $993,000 and $83,000, respectively. Thesales recorded were made directly with the dialysis provider or pursuant to anagreement with a third party leasing provider who leases directly to thedialysis 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 UnitedKingdom in 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. Includedin product sales cost of sales for 2004 is an inventory adjustment in theamount of $568,000, in order to value the PHD machines in inventory at thelower of cost or market. The 2003 inventory cost adjustment was $1,431,000. Thenumber of units manufactured decreased from 127 in 2003 to 83 in 2004. During2004, we determined that we had sufficient inventory on hand to meet demand andreduced 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 increase of$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*   Forthe year ended December 31, 2004, general and administrative expensesincreased $712,000 to $7,389,000, an 11% increase from $6,677,000 for the yearended December 31, 2003. The increase is primarily a result of the costsincurred to comply with the Sarbanes-Oxley Act of 2002. We also experienced anincrease in insurance expenses in 2004 as compared 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; 

·       continued progress inresearch and development; and

·       thecosts involved with protecting our proprietary rights.

During 2006, we expect to use approximately $16million and $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 Systems platform technology to develop our next generationproduct. We believe cash and liquid investments of $7,756,000 (including thereceivable for the settlement on the sale of long-term investment securities)at December 31, 2005, combined with the expected proceeds from the Durusfund financing, are only sufficient to finance our operations into 2007.

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In 2006, we will seek to raise the additional capitalrequired to fund commercial activities in 2007. There can be no assurance that we will be able to raise the capital wewill need on terms acceptable to us, or at all. Also, due to the recent tradingprices of our common stock, completion of a financing could be more difficultand could result in significant dilution to the ownership interests of theDurus 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 throughJanuary 1, 2007. However, this letter does not represent a legally bindingcommitment of the Durus fund to provide the Company with any financing, and theletter further provides that there are no third party beneficiaries to theletter.

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 substantialdoubt regarding our ability to continue as a going concern beyond 2006. Wehave already taken certain steps to restructure our business and conserve cash,including the reduction in force during the fourth quarter of 2005. In theevent we are not able to raise capital for our operations in 2007, we may needto take additional steps to reduce our operations.

***Cash Flows***

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 parts purchased onour behalf to be used in production. During 2005, we reduced the deposit by$1,977,000 for parts purchased and parts used in production. In 2005, accountspayable and accrued liability balances increased by $2,253,000 while thosebalance had decreased by $2,658,000 during 2004, a change of $4,911,000. In2004, accounts payable balances decreased due to payments related to increasedPHD production in the last quarter of 2003. Payment for these machines was notmade until 2004. In 2005, accounts payable and accrued liability balancesincreased because of additional product warranty reserves in 2005 and becauseof manufacturing activity in the quarter ended December 31, 2005.   Decreases in cash used for operationsrelating to deposits with vendors and accounts payable and accrued liabilitieswere partially offset by an increase to the net loss in 2005 compared to 2004. Thenet loss, excluding non-cash expenses of $5,541,000 and $1,916,000 for 2005 and2004, respectively, increased by $2,889,000. In addition, beginning in thefourth quarter of 2005, cash used in operating activities decreased as part ofour overall initiative to reduce costs and decrease our monthly cash burn rate.

Net cash provided by investing activities was$21,399,000 in fiscal 2005 compared to cash used in investing activities of$24,948,000 in fiscal 2004. In 2005, we used cash from investments to fundoperations. In 2004, we invested the proceeds from the settlement with theDurus fund in investment grade securities. Net cash used in financingactivities was $3,215,000 in fiscal 2005 compared to cash provided by financingactivities of $52,362,000 in fiscal year 2004. In 2005, we repaid a $3,400,000line of credit balance. Cash provided by financing activities in 2004 resultedfrom the settlement from the Durus fund and obtaining the $3,400,000 line ofcredit.

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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 2003. Also, accounts payableand accrued liabilities decreased by $2,658,000 in 2004 while those balancesincreased 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$2,862,000 in 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 areserve established in the quarter ended December 31, 2004 for replacementof major components of machines already produced. In 2004, we spent $1,731,000on inventory compared to $4,593,000 in 2003. The decrease in spending oninventory is attributable to a decrease in the market value of finished unitson hand at December 31, 2004 compared to 2003 and a decrease in spareparts inventory. Other sources and uses of cash were consistent in 2004compared 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 the proceeds from thesettlement with the Durus fund in investment grade securities. In 2003, we usedcash from investments to fund operations.  Net cash provided by financing activities was$52,362,000 and $31,597,000 in fiscal years 2004 and 2003, respectively.  Cash provided by financing activities in 2004resulted from the settlement with the Durus fund and obtaining a $3,400,000line of credit. Cash provided from financing activities in 2003 resulted fromthe issuance of common stock.

***Recent Financing Activities***

***Transaction with 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 ourSettlement Agreement and second amendment to our rights agreement filed asexhibits to this Annual Report on Form 10-K and (iv) the form ofinvestor rights agreement, form of warrant agreement, form of loan agreementand form certificate of designation of rights, preferences, privileges andrestrictions of Series B Convertible Preferred Stock filed as exhibits tothe Durus Fund’s Schedule 13D/A on April 5, 2006, each of which is deemedto be incorporated 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 $48.7million. We had filed a lawsuit in August 2003 after learning thatthe Durus fund, Scott Sacane, Durus Capital Management, LLC (“Durus Capital”),Durus Capital Management (N.A.), LLC (“Durus Capital (N.A.)”) and the Artalfund had acquired over 70% of our outstanding common stock. We refer to theDurus fund, 

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Mr. Sacane, DurusCapital, Durus Capital (N.A.) and the Artal fund collectively 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 2003Agreement”). We entered into the April 2003 Agreement after we learned thatcertain of the defendants had accumulated a position in our common stock inexcess of the 15% ownership level that would potentially trigger ourshareholder rights agreement, referenced on Exhibit 4.2 hereto (the “ShareholderRights Agreement”).

Pursuant to the terms of the April 2003Agreement, Mr. Sacane and Durus Capital represented that they:  (1) then owned 5,238,248 shares(approximately 19.5%) of our outstanding common stock, (2) crossed the 15%ownership level inadvertently, and (3) held this investment in the Companyin the ordinary course of business and not for the purpose or with the effectof changing or influencing the control of the Company. In addition, they agreedto reduce their holdings to below 15% ownership over a two-year period and notto purchase any additional shares of our common stock until such time as theirownership was less than 15% of the shares then-outstanding (and thereafter notin 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 settled allother claims against the defendants, and received as part of that settlement anadditional $34.1 million in cash, of which $16.1 million was in exchange forunsecured subordinated promissory notes. In May 2004, we received a finalpayment of $10.0 million in connection with the effectiveness of a registrationstatement we filed with the Securities and Exchange Commission covering thesecurities 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 of the Section 16(b) claim)to settle the remaining claims in our lawsuit and release any other potentialclaims against the defendants. In addition, we filed a registration statementwith the Securities and Exchange Commission which was declared effective on May 17,2004 and the defendants agreed that they would not seek to exercise controlover the Company and that they would not hold the shares of our common stockwith the purpose or intent of changing or influencing the control or managementof the Company. As noted below, as part of our transaction with the Durus fund,we have released the Durus fund from this and other restrictive covenants inthe 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 Settlement Agreementthe Notes became due and payable after the later of 

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(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 the SettlementAgreement we were entitled to use shares of our common stock to repay theprincipal amount owing under the Notes in certain circumstances. As notedbelow, upon closing of the Securities Purchase Agreement, the Outstanding Noteswill be cancelled and exchanged for new Loan Notes, Series B PreferredStock, and Warrants, each as defined below.

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 operating losscarryforwards will be used to cover a portion of any tax triggered under thealternative 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 to generatetaxable income, there is a full valuation allowance for our deferred tax assetsat 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 of OutstandingNotes, will acquire newly issued shares of our Series B Preferred Stock,$0.01 par value (the “Series B Preferred Stock’’ convertible into 5million shares of our common stock at a conversion price of $1.00 per share andwarrants (the “Warrants’’) to purchase 5 million shares of our common stock atan exercise price of $1.10 per share. The Series B Preferred Stock hasvoting rights, and the Durus fund will be entitled to vote, on an as convertedbasis, together with the holders of our common stock as a single class withrespect to any matter upon which holders of our common stock have the right tovote (provided, however, that for voting purposes, the conversion price of theSeries B Preferred Stock is equal to the closing price of the common stock onthe Nasdaq Capital Market on the date of the Securities Purchase Agreement). Inaddition, holders of the Series B Preferred Stock shall be entitled toelect one director to our 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 our Board of Directorsunder the terms of the Investor Rights Agreement described below. The Durusfund’s shares of Series B Preferred Stock will have an aggregateliquidation preference of $5 million, accrue dividends at the rate of 10% perannum and become redeemable after seven years at the option of the holders of amajority of the voting power of the shares of Series B Preferred Stockthen outstanding or at the option of the Durus fund at an earlier date upon theoccurrence of specified trigger events. We are required to obtain the consentof the holders of at least two-thirds of the outstanding shares of Series BPreferred 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 B PreferredStock 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 Preferred Stockand Warrants, such additional shares of Series B Preferred Stock will beconvertible into 15 million shares of common stock at a conversion price of$1.00 per share and the additional Warrants will be exercisable to purchase 15million shares of common stock at an exercise price of $1.10 per share.

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*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 of oursenior secured notes (the “Bridge Notes”). The Bridge Notes bear interest atthe rate of 7% per annum, and the entire principal 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 ourproperty, 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 $15.8million in aggregate principal amount of our senior secured notes bearinginterest at 7% per annum and payable in full on December 31, 2007 (the “LoanNotes”). Under the Loan Agreement, the Durus fund will also make available tous 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 ongoing operations if we areunable to obtain financing from other sources and various funding conditionsare satisfied. The Loan Agreement contains a number of affirmative and negativecovenants and grants certain operational controls over expenditures to theDurus fund. Our obligations under the Loan Agreement and the Loan Notes willalso be secured by a security interest in all of our property, including ourintellectual 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 restrictivecovenants, including to eliminate the requirement that the Durus fundsignificantly reduce its ownership of shares of our common stock by May 2006and to terminate the proxy granted to the Company by the Durus fund under theterms of the Settlement Agreement, which proxy granted the Company the power tovote the Durus fund’s shares of our common stock in proportion to the votescast by other holders of shares of our common stock in matters requiring astockholder vote. By releasing the Durus fund from the standstill restrictionsin the Settlement 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 to eliminatethe 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 of Directorsalso replaced William Dow with Laurence Birch as interim President and ChiefExecutive Officer.

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*InvestorRights Agreement.*   As a condition to the closingof the Securities Purchase Agreement, we have agreed to enter into an investorrights agreement with the Durus fund and the Artal fund (the “Investor RightsAgreement”) which requires that our Board of Directors consist of seven membersand grants the Durus fund the right to designate four of the seven Boardmembers (inclusive of the Board member designated by the Durus fund as holderof the Series B Preferred Stock) and to approve the 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.  TheInvestor Rights Agreement also grants the Durus fund and the Artal fund certainregistration rights with respect to the sale of shares of our common stock intothe open market, as well as providing that the Durus fund shall have a right offirst refusal in the event that the Company proposes to sell itself, or greaterthan 30% of its fully diluted capital stock, to a third party, or the Companyotherwise accepts a bona fide offer from a third party to acquire the Companyor such number of shares of the Company’s capital stock, on the same terms andconditions, including price, as the terms and conditions applying to the thirdparty. The Investor Rights Agreement will require us to use our 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 underRule 144 of the Securities Act of 1933, as amended, and (ii) the dateon which the Durus fund and the Artal fund shall have sold all of theirsecurities covered by the registration statement. The Investor Rights Agreementwill amend and supersede the registration rights agreement which we previouslyentered with the 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.Under the Agreement, as long as the market price of our common stock remainsabove $0.10 and certain other conditions are satisfied, we are permitted tosell to Fusion Capital up to $40,000 of common stock on each market tradingday, up to an 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’snotice. In addition, we have the right to increase the daily purchase amount ifthe market price of our common stock increases. For every $0.10 increase in the“threshold price” (defined as the lowest sale price of our common stock duringthe five trading days immediately preceding the notice to increase the dailypurchase amount) above $0.95, we have the right to increase the daily purchaseamount by an 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.

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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 upon onetrading 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/orSection 4(2) of the Securities Act of 1933, as amended.

***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 consecutive businessdays the bid price of our common stock closed below the minimum $1.00 per sharerequired by Marketplace Rule 4450(a)(5). On December 27, 2005, wereceived a letter from the Nasdaq denying our request for continued listing onthe 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.

**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 assurancethat we will sustain compliance with these standards.** In particular, we do not currently have a minimumof $2,500,000 in stockholders’ equity and we did not have $500,000 of netincome from continuing operations for the most recently completed fiscal yearor two of the three most recently completed fiscal years, but the currentmarket value of our listed securities 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 

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proposed standard inaccordance with the original provisions of SFAS No. 123; that is, anentity would recognize employee compensation cost in the amounts reported inthe pro forma disclosures currently required by SFAS No. 123. A companywould not be permitted to make any changes to those amounts upon adoption ofthe proposed standard unless those changes represent a correction of an error(and are disclosed accordingly). For periods after the date of adoption of theproposed standards the modified prospective transition method described abovewould 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 anticipate that the effect of adopting SFAS No. 123Rwill increase total stock-based compensation expense in 2006 by approximately$1.5 million to $1.8 million.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs*. SFAS No.151 isan amendment of Accounting Research Bulletin No. 43, Chapter 4. SFAS No. 151clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs and wasted material. SFAS No. 151 is effective forinventory 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 FASBissued FASB Statement No. 154,*Accounting Changes and Error**Corrections.*Statement 154 establishes, unless impracticable, retrospective application asthe 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.

**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.government and federal agency bonds and high-grade commercial paper andcorporate bonds.  Interest rate risk withrespect to our investments is not significant as substantially all of suchinvestments are in short-term U.S. dollar cash equivalents, which are by theirnature less sensitive to interest rate movements. At December 31, 2005,all investments have been converted to cash and liquid investments.  Imputed interest on the long-term notespayable was calculated using an estimated interest rate for a similarinstrument, since no objective market exists for this particular obligation. A1% change in interest rates would not have a material effect on our results ofoperations.

**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 pound wouldnot have a material effect on our financial condition or results of operations.We do not use any hedges or other derivative financial instruments to manage orreduce exchange rate risk.

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**Item8.**                        FinancialStatements and Supplementary Data.

| 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 ofIndependent Registered Public Accounting Firm***

The Board of Directors and StockholdersAksys, Ltd.:

We have audited the accompanying consolidated balancesheets of Aksys, Ltd. and subsidiaries as of December 31, 2005 and 2004,and the related consolidated statements of operations, stockholders’ equity(deficit) and comprehensive income (loss), and cash flows for each of the yearsin the three-year period ended December 31, 2005. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements 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 our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Aksys, Ltd. and subsidiaries as ofDecember 31, 2005 and 2004, and the results of their operations and theircash flows for each of the years in the three-year period ended December 31,2005, in conformity with U.S. generally accepted accounting principles.

| KPMG LLP                               |
|----------------------------------------|
| Chicago, Illinois  April 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 OperationsYears 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 originally incorporatedin Illinois on January 18, 1991. In March 1993, the Company mergedinto a Delaware corporation. During the quarter ended September 30, 2002,the Company commenced commercial activities and was no longer considered to bein the development stage. The Company is involved in the sale and marketing of itssole product, the PHD System. In addition, the Company continues devoting someof its efforts to product development. The Company operates in one industrysegment and substantially all of its long-lived assets are located in theUnited 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) Principles of 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) Use of 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) Cash and 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) Investment Securities***

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-Lived Assets***

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). Leased assets includePHD Systems currently under operating leases and machines held for futureleases. 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) Product Warranty***

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) Revenue Recognition***

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 these operatingsystem contracts on a straight-line basis over the lease term. The Company hasno contracts with distributors and sells its product directly to its customersthrough its own sales force.

***(i) Research and Development Costs***

Research and development costs are charged to expensewhen incurred.

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***(j) Income Taxes***

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 not more likely than not to berealized.

***(k) Computation of 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-Based Compensation***

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. SFASNo. 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 SFASNo. 123, as amended. The following table illustrates the effect on netlosses if the fair value based method had been applied to all outstanding andunvested awards in 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) Recently Issued Accounting Pronouncements***

In December 2004, the FASB issued SFASNo. 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 subsequent modifications of awards after the grant date must berecognized. The Company will adopt this 

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Statement onJanuary 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 million to$1.8 million in 2006.

In November 2004, the FASB issued SFASNo. 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) Translation of 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 atthe balance sheet date. Income and expenses are translated at the averageexchange rate prevailing throughout the year. Resulting cumulative translationadjustments have been recorded as a separate component of stockholders’ equity(deficit).

***(o) Comprehensive Income (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) Advertising Costs***

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) Fair Value of Financial Instruments andConcentration 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 theseinstruments approximates their carrying value due to the short period of timeto their maturities. The fair 

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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 and BerkshireMedical Center accounted for 24%, 10% and 9%, respectively, of its totalrevenue.

Since the Company’s inception, substantially all efforthas been devoted to the development of the PHD System. The Company expectsto be entirely dependent for the foreseeable future on sales of, and servicesrelating to, the PHD System for revenues. The Company’s dependence on a singleproduct creates significant risk for the Company and its stockholders.

The Company currently relies on single contractmanufacturers to manufacture each of the major components of the PHD System. Suchcontractors are not employed or otherwise controlled by the Company and aregenerally free to conduct their business at their own discretion. Although certainof the Company’s contract manufacturers have entered into contracts tomanufacture components of the PHD System, such contracts can be terminated atany time under certain circumstances by the Company or by the contractors, andcan be breached 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 our 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)   Liquidity and 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 our proprietary rights.

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 directed 

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toward using the PHDSystem’s platform technology to develop the Company’s next generation product. TheCompany believes that cash and liquid investments of approximately $7.8 million(including the receivable for the settlement of the sale of long-terminvestment securities) at December 31, 2005 as well as proceeds from itstransaction with the Durus Life Sciences Master Fund, Ltd (“the Durus fund”) (seeNote 20) are only sufficient to finance its operations into 2007.

In 2006, the Company will seek to raise the additionalcapital required to fund commercial activities in 2007. There can be noassurance that we will be able to raise the capital it will need on termsacceptable to the Company, or at all. Also, due to the recent trading prices ofthe Company’s common stock, completion of a financing could be more difficultand could result in significant dilution to the ownership interests of theDurus fund and the other existing stockholders.

The Company has received a letter dated as ofMarch 31, 2006, in which the Durus fund stated its intention, andconfirmed its ability, to provide financing necessary to fund the Company’soperations at least through January 1, 2007. However, this letter does notrepresent a legally binding commitment of the Durus fund to provide the Companywith any financing, and the letter further provides that there are no thirdparty beneficiaries to the 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 certainsteps to restructure its business to conserve cash, including a reduction inforce during the fourth quarter of 2005. In the event the Company is not ableto raise capital for operations in 2007, it may need to take additional stepsto 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 Valu** | ** ** |
| 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, atDecember 31, 2005 and 2004, the Company was required to hold a letter ofcredit secured by cash equivalents in the amount of $750,000 and $600,000,respectively, as a security deposit on the building lease. The restricted cashbalance is classified 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 endedSeptember 30, 2005, applied their cost against the deposit andreclassified $851,000 of the liability to the excess and obsolete inventoryreserve to properly value inventory on hand. The reserve is reduced in theperiod in which certain parts and consumable supplies are utilized ordiscarded.

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 is aninternationally recognized quality systems standard for the medical deviceindustry. Delphi is also FDA registered and quality system regulations (“QSR”)compliant.**The contractautomatically renews each February on an annual basis unless six-monthadvance notice is provided by either party to terminate the contract or a partyexercises its right to terminate for breach or under certain 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.There can be no assurance that Delphi or any other manufacturer of theCompany’s products will continue to comply with applicable regulatoryrequirements or that Delphi or any other manufacturer will be able to supplythe Company with products 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 atDecember 31, 2005 were $4,901,000 with related accumulated depreciation of$938,000. At December 31, 2004, leased assets were $2,848,000 withaccumulated 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) then owned 5,238,248 shares (approximately 19.5%) of the Company’soutstanding common stock, (2) crossed the 15% ownership levelinadvertently, and (3) held this investment in the Company in the ordinarycourse of business and not for the purpose or with the effect of changing orinfluencing the 

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control of the Company. Inaddition, they agreed to reduce their holdings to below 15% ownership over atwo-year period and not to purchase any additional shares of the Company’scommon stock until such time as their ownership was less than 15% of the sharesthen-outstanding (and thereafter not in excess of 15% without the consent ofthe 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 defendants disclosedthat they owned 21,333,118 of these shares and the Artal fund owned 498,100.

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 ofshort-swing trading profits under Section 16(b) of the SecuritiesExchange Act of 1934.

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 the Durusfund. 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 thefirst quarter of 2004, and the $10.0 million received during the secondquarter of 2004 from the Durus settlement were considered to be capitalcontributions and were recorded as an increase to additional paid-in capital.The Company also received $16.1 million in cash in exchange forzero-interest, long-term notes payable. As discussed in Note 20, $15.8 millionof the outstanding Notes will be exchanged in connection with the Company’stransaction with the Durus fund.

The Company imputed an interest rate of 10%, anddiscounted the Notes to $12.6 million. The $3.5 million discount onthe 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 

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becomedue and payable in cash upon a change of control. In the event of a change ofcontrol repayment, in addition to repayment of the then-outstanding principalamount of the Notes, the Company is required to pay to the holders of the Notesan amount equal to (1) 5% of the consideration received by (a) theCompany in the case of an asset sale transaction constituting a change ofcontrol (net of corporate taxes, transaction expenses and indebtedness of theCompany) or (b) the Company’s stockholders and the holders of the Notes ina merger or other type of transaction constituting a change 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 onOctober 15, 2002. Pursuant to the terms of the Amended and Restated CommonStock Purchase Agreement between the Company and Kingsbridge, the Company couldsell common stock at its sole discretion over a 24-month period on a“when and if needed” basis, and Kingsbridge was required under the terms of theagreement to purchase this stock, subject to the satisfaction of certainconditions contained in the agreement. During the year ended December 31,2003, the Company issued 2,489,408 shares of common stock to Kingsbridge underthe equity 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 1,363,637shares of 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 of stockat an exercise price of $13.75 per share. This warrant had a fair value of$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 for servicesperformed through December 31, 2005. The Company is required to makepayments 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, 

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Development and LicenseAgreement (the “Product”) with the applicable percentage based upon the numberof patients using such Product.

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.

TheResearch, Development and License Agreement provided for the issuance to DEKAof warrants to purchase 350,000 shares of the Company’s common stock (the “Warrants”).The Warrants 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 stock may beforfeited by DEKA. If the milestones are not achieved, no warrants will vest. Theexercise price of the Warrants is $1.62 per share, the average of the high andlow trading price of the Company’s common stock on the Nasdaq National MarketSystem 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)   Stock Option 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, the1993 Stock Option Plan was terminated, except with respect to options thenoutstanding. At December 31, 2005, 2,930,768 shares of common stock havebeen 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 stockoptions granted during 2005, 2004 and 2003 was $1.50, $5.17 and $4.63,respectively, on the dates of grant using the Black Scholes option-pricingmodel with the following weighted-average assumptions: 2005—expected dividendyield of 0%, expected volatility of 94.55%, risk-free interest rate averaging3.90% and an expected life of 5 years; 2004—expected dividend yield of 0%,expected volatility of 97.41%, risk-free interest rate averaging 2.28% and anexpected life of 5 years; 2003—expected dividend yield of 0%, expectedvolatility of 65.05%, risk-free interest rate averaging 2.07% and an expectedlife of 5 years. The number of options exercisable at December 31, 2005,2004 and 2003 were 1,539,499, 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 atDecember 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)   Employee Benefit 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 allows employeesto purchase Company common stock at a 15% discount to market, based on eligiblepayroll deductions. There are four plan periods in each calendar year, witheach such plan period corresponding with a calendar quarter. Market price iscalculated as the fair market value of the common stock as of the last tradingday of such plan period less the discount to the market. A total of 250,000shares of common stock were reserved for issuance under the 2001 Stock PurchasePlan. Total shares issued based on payroll withholdings for the years ended 

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December 31,2005, 2004 and 2003 were 104,951 (34,120 issued January 2006), 37,738(9,738 issued January 2005) and 16,394 (4,071 issued January 2004),respectively. As of December 31, 2005, there were 26,118 shares remainingunder the 2001 Stock Purchase Plan, after considering the shares issued inJanuary 2006.

**(9)   Stockholder Rights 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 its shareholderrights agreement so that it will not be applicable to the Durus fund or thetransactions with the Durus fund and to eliminate its rights agreement.

**(10) Income Taxes**

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 the Company’s ownership would causeadditional limitations on the amount of loss and credit carryforwards that canbe 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                  |       | $           | —     |        | $          | — |   |

 

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

**(11) Contractual Obligations**

***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, Delphipurchased approximately $3,895,000 of parts on the Company’s behalf to be usedin future production. In 2004, the Company paid a deposit of $3,409,000 toDelphi in consideration of purchase obligations. In addition, the Company had areserve 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 of the corresponding reserve on thedeposit, $851,000, was transferred from short-term liabilities to the excessand obsolete inventory reserve to properly value 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’s Equityand Notes Payable), the Company may terminate the agreement on 90 days advancenotice. During the 90 day notice period, the Company will continue to reimburseDEKA, but the monthly reimbursement 

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amountwill not exceed the average rate of the prior three months. As of December 31,2005, the contractual obligation to DEKA was $600,000.

***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 |      |
|                  |   | $       | 3,672,266 |   |

 

***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 |      |
| All subsequent years  |   | $       | 1,525,588 |   |

 

Totalroyalty expense for the years ended December 31, 2005, 2004 and 2003 was$251,667, $255,000, and $215,000, respectively.

**(12) Impairment Charge**

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 is 

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being amortized over theremaining life. The impaired rental machines, which will be taken out of serviceand replaced with a new model of the machine, will be disposed of, as they haveno resale or residual value.

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 Company has revised the useful life of similar machines classified withinproperty and equipment, which are utilized for internal training and testingpurposes, and depreciation has been accelerated on these machines.

**(13) Product Warranty**

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** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Establishmentof  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) Accrued Liabilities**

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) Commitments and 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. et al.,District of Connecticut, Civil Action No. 3:04-CV-01232). Thelawsuit is a purported class action filed on behalf of all short-sellers of theCompany’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 to indemnify certain of itscontract manufacturers against certain liabilities resulting from the sale ofthe PHD System. It is not possible to predict the maximum amount of futurepayments under the indemnification agreements due to the conditional nature ofthe Company’s obligations. Historically, the Company has not made any paymentsunder these agreements. As of December 31, 2005, management was not awareof any obligations arising under indemnification agreements.

**(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 agreed to take atemporary 20% deferral of base pay beginning February 1, 2006. Additionally,the Company cancelled the 2005 bonus plan for all employees and executiveofficers. The Company put a bonus plan in place for employees whose employmentcontinues through each quarter of 2006, with the quarterly payment based on apercentage of each employee’s base compensation. The total amount of paymentsfor 2006 is expected to be approximately $761,000. Neither the salary deferralnor the bonus plan is reflected in the accompanying consolidated financial statementsas of December 31, 2005.

**(17) Line of 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 $6.0million revolving line of credit, which originally matured on December 31,2005. The Line of Credit bore interest at the bank’s prime rate or at LIBORplus a margin of 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 on theCompany’s behalf to be used in future production, pursuant to the agreementwith that vendor. At December 31, 2004, there was $3.4 million outstandingunder the Line of Credit. The Company was required to maintain a minimumbalance in its investment account as collateral for the Line of Credit. Theamount of collateral required was dependant on the type of investments in theaccount. As of December 31, 2004, 90% of the value of restricted securitieswas required to cover the maximum available credit of $6.0 million. As of December 31,2004, the Company had restricted short-term investments of $6.7 million inorder to satisfy the line of credit collateral requirement.

On September 27, 2005, the Company repaid itsline of credit obligations of $3.4 million. Repayment of the line of creditremoved 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) Quarterly Results 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 future performance.

| ** **                           | ** ** | **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 | ) |
| Earnings per share                   |       | $                                | (0.25      | ) | $ | (0.23 | ) | $ | (0.36 | ) | $ | (0.30 | ) | $ | (0.27 | ) | $ | (0.21 | ) | $ | (0.22 | ) | $ | (0.23 | ) |

 

**(19) Geographic Concentration**

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 |   |
|                |            |              |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

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The Company’s largestcustomers, DaVita, the Dialysis Centers of Lincoln and Northwest Kidney Centeraccounted 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 largest customers, Northwest Kidney Center, the DialysisCenters of Lincoln 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) Subsequent Events**

***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 newly issuedshares of the Company’s Series B Preferred Stock, $0.01 par value,convertible into 5 million shares of the Company’s common stock at a conversionprice of $1.00 per share and warrants to purchase 5 million shares of theCompany’s 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 the Company’s commonstock as a single class with respect to any matter upon which holders of theCompany’s common stock have the right to vote (provided, however, that forvoting purposes, the conversion price of the Series B Preferred Stock isequal to the closing price of the common stock on the Nasdaq Capital Market onthe date of the Securities Purchase Agreement). In addition, holders of the Series BPreferred Stock shall be entitled to elect one (1) director to the Company’sBoard of Directors. As the only holder of the Series B Preferred Stockimmediately following the closing of the Securities Purchase Agreement, theDurus fund alone shall exercise this right, along with the Durus fund’s rightto designate a majority of the members of the Company’s Board of Directorsunder the terms of the Investor Rights Agreement described below. The Company’sshares of Series B Preferred Stock will have an aggregate liquidationpreference of $5 million, accrue dividends at the rate of 10% per annum andbecome redeemable after seven years at the option of the holders of a majorityof the voting power of the shares of Series B Preferred Stock then outstandingor at the option of the Durus fund at an earlier date upon the occurrence ofspecified trigger events. The Company is required to obtain the consent of theholders of at least two-thirds of the outstanding shares of Series BPreferred 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 B PreferredStock 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 Preferred Stockand warrants, such additional shares of Series B Preferred Stock will beconvertible into 15 million shares of common stock at a conversion price of$1.00 per Share and the additional warrants will be exercisable to purchase 15million shares of common stock at an exercise price of $1.10 per share.

***Loan Agreements***

At the time ofentering into the Securities Purchase Agreement, the Company also entered intoand closed a bridge loan agreement (“Bridge Loan Agreement”) with the Durusfund, pursuant to which the Durus fund lent $5 million in cash to the Companyin exchange for $5 million in principal amount of its senior secured notes (the“Bridge Notes”). The Bridge Notes bear interest at the rate of 7% per annum,and the entire principal amount of the Bridge Notes is due and payable on January 1,2007, unless prepaid 

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or rolled over into longerterm senior secured notes of the Company as contemplated by the SecuritiesPurchase Agreement. The Bridge Loan Agreement contains a number of reportingand other affirmative and negative covenants, including operational controlsover expenditures which may be exercised by the Durus fund. To secure itsobligations under the terms of the Bridge Loan Agreement and the Bridge Notes, theCompany has granted the Durus fund a security interest in all of its property,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.

***Other Actions***

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 the warrantsat the closing of the Securities Purchase Agreement and to exercise the optionto acquire additional shares of Series B Preferred Stock and warrants, asprovided in the Securities Purchase Agreement, and the Durus fund is no longerprohibited from acquiring more shares of common stock or other securities ofthe Company or making any solicitation of proxies regarding the voting of sharesof common stock. In addition, in connection with the entering into of theSecurities Purchase Agreement, the Issuer took action to amend its RightsAgreement to exempt from the application thereof the transactions contemplatedby the Securities Purchase Agreement, and to eliminate the Rights Agreement.

*Appointmentof Durus fund Designee to the Company’s Board of Directors and Appointment ofNew CEO.**  *At thetime of the execution and delivery of the Securities Purchase Agreement, theBoard of Directors of the Company increased the size of the Board to seven andappointed Shodhan Trivedi, a member of the board of directors of the Durusfund, to the Company’s Board of Directors. The Company’s Board of Directorsalso replaced William Dow with Laurence Birch as interim President and ChiefExecutive Officer of the Company.

*Investor Rights Agreement.**  *As a condition to the closing of the SecuritiesPurchase Agreement, the Company has agreed to enter into an investor rightsagreement (“Investor Rights Agreement”) with the Durus fund and the Artal fund whichrequires that the Company’s Board of Directors consist of seven 

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members and grantsthe Durus fund the right to designate four of the seven Board members(inclusive of the Board member designated by the Durus fund as holder of the Series BPreferred Stock) and to approve the selection of the Company’s Chairman of theBoard, Chief Executive Officer and Chief Financial Officer. Under the terms ofthe Investor Rights Agreement, the Durus fund’s designees to the Board ofDirectors shall be entitled to serve on the executive committee of the Board,and the Company may not take certain actions without the approval of the Boardof Directors, including the affirmative vote of the Board members designated bythe 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 us to use our best efforts to registerthe shares held by 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 the Company previouslyentered into with the Durus fund in February 2004.

***Common StockPurchase Agreement with Fusion Capital Fund II. LLC***

On January 13, 2006,the Company entered into a common stock purchase agreement (“Fusion CapitalAgreement”) with Fusion Capital Fund II, LLC (“Fusion Capital”). Funding underthe Fusion Capital Agreement commences once the Securities and ExchangeCommission declares effective a registration statement relating to thetransaction and will continue over a 25-month period. The Company has notfiled a registration statement with respect to this transaction at this time. Underthe Fusion Capital Agreement, as long as the market price of the Company’scommon stock remains above $0.10 and certain other conditions are satisfied,the Company is permitted to sell to Fusion Capital up to $40,000 of commonstock on each market trading day, up to an aggregate of $20,000,000 of commonstock.

Under an amendment to theFusion Capital Agreement dated January 27, 2006, the Company and FusionCapital agreed that the Company shall not effect any sale under the FusionCapital Agreement and Fusion Capital shall not have the right or obligation topurchase any shares of common stock under the Fusion Capital Agreement to theextent that after giving effect to such purchase, the “Exchange Cap” has beenreached. The “Exchange Cap” will be deemed to have been reached if, at any timeprior to the shareholders of the Company approving the transaction contemplatedby the Fusion Capital Agreement, the shares purchased would, together with allshares previously purchased under this Fusion Capital Agreement, exceed5,998,405 shares of common stock (19.99% of the 30,007,031 outstanding sharesof common stock as of the date of this Fusion Capital Agreement). The Companymay, but shall be under no obligation to, request its shareholders to approvethe transaction contemplated by this Fusion Capital Agreement.

The Company has the rightto decrease the daily amount to be purchased by Fusion Capital at any time effectiveupon one trading day’s notice. In addition, the Company has the right toincrease the daily purchase amount if the market price of the Company’s commonstock increases. For every $0.10 increase in the “threshold price” (defined asthe lowest sale price of the Company’s common stock during the five tradingdays immediately preceding the notice to increase the daily purchase amount)above $0.95, the Company has the right to increase the daily purchase amount byan additional $4,000.

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In addition to the dailypurchase amount, the Company may elect to require Fusion Capital to purchase upto $250,000 of the Company’s common stock on any single trading day, providedthat the share price is above $1.00 during the ten trading days prior thereto. Thisamount may be increased to up to $1,000,000 if specified increases in theCompany’s share price occur.

Fusion Capital mayterminate the Fusion Capital Agreement upon the occurrence of an event ofdefault, which includes a material adverse change in the Company’s business orthe failure of the common stock to be listed on the Nasdaq National Market, theNasdaq Capital Market or the Nasdaq OTC Bulletin Board. In addition, FusionCapital has the right to terminate the Fusion Capital Agreement if sales underthe Agreement have not commenced by September 30, 2006. The Company hasthe right to terminate the Fusion Capital Agreement at any time effective uponone trading day’s notice.

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’sCommon Stock on the Nasdaq Capital Market***

**On November 14, 2005, the Company received a letterfrom the Nasdaq noting that it had failed to comply with the minimum $10million 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, the Company was notified by the Nasdaq that for the last 30 consecutivebusiness days the bid price of its common stock closed below the minimum $1.00per share required by Marketplace Rule 4450(a)(5). On December 27,2005, the Company received a letter from the Nasdaq denying our request forcontinued listing on the Nasdaq National Market. In response to this letter on,December 30, 2005, we requested a hearing before the Nasdaq ListingQualifications Panel to review the Nasdaq staff’s determination. The Companysubsequently received notification from the Nasdaq Listing Qualification Panelthat the Company’s common stock would be delisted from the Nasdaq NationalMarket and would 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 compliance with thesestandards. In particular, the Company does not currently have a minimumof $2,500,000 in stockholders’ equity and it did not have $500,000 of netincome from continuing operations for the most recently completed fiscal yearor two of the three most recently completed fiscal years, but the currentmarket value of its listed securities does exceed $35,000,000. In the event the Company cannot sustain compliancewith the Nasdaq Capital Market’s listing standards, its common stock will bedelisted from the Nasdaq Capital Market and the Company may be unable to list itscommon stock on another stock exchange or quotation service. Such a delistingmay make it difficult or impossible for stockholders to sell their shares, for theCompany to issue additional securities and to obtain additional financing inthe future. A delisting may also result in a more limited amount of news andanalyst coverage for the Company and could have a material adverseeffect on the market price of its common stock.

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

None.

**Item 9A.**                Controlsand Procedures

*DisclosureControls and Procedures.**  *Asrequired by Rule 13a-15 under the Securities Exchange Act, as of theend of the period covered by this report, we carried out an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures. This evaluation was carried out under the supervision and with theparticipation of our management, including the Chief Financial Officer andinterim President and Chief Executive Officer. Based on this evaluation, the ChiefFinancial Officer and interim President and Chief Executive Officer concludedthat our disclosure controls and 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.**  *Therehave been no changes in our internal control over financial reporting thatoccurred during the fourth quarter of 2005 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting. In accordance with Item 308 of Regulation S-K and based upon theaggregate market value of our voting stock held by non-affiliates as of June 30,2005, this Annual Report on Form 10-K does not contain an annualreport of management on internal control over financial reporting or anattestation report of our independent registered public accounting firmregarding management’s assessment of internal control of financial reporting.

**Item 9B.**               OtherInformation

Not applicable.

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**PART III**

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

Information with respectto Directors of the Company shall be set forth in our Proxy Statement under theheading “Election of Directors,” which is incorporated herein by reference.Information regarding the executive officers of the Company is set forth abovein Part I under “Business—Executive Officers.”  Information required by Item 405 ofRegulation S-K shall be set forth in our Proxy Statement under the heading “Section 16(A) BeneficialOwnership Reporting Compliance,” which is incorporated herein by reference.

**Item 11.**                 ExecutiveCompensation.

Information with respect to the SecurityOwnership of Certain Beneficial Owners and Management shall be set forth in ourProxy Statement under the heading “Beneficial Ownership Of Common Stock,” whichinformation is incorporated herein by reference. Information required by Item201(d) of Regulation S-K shall be set forth in our Proxy Statementunder the sub-heading “Equity Compensation Plan Information,” which informationis incorporated herein by reference. Additional information required by thisItem 11 shall be set forth in our Proxy Statement under the heading “Compensationof Executive Officers,” which information is incorporated herein by reference.

**Item12.      Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

Information with respect to the Security Ownership ofCertain Beneficial Owners and Management shall be set forth in the ProxyStatement under the heading “Beneficial Ownership of Common Stock” whichinformation is incorporated herein by reference.  Information required by Item 201(d) ofRegulation S-K shall be set forth in the Proxy Statement under the sub-heading“Equity Compensation Plan Information,” which information is incorporatedherein by reference.

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

Information with respectto Certain Relationships and Related Transactions shall be set forth in ourProxy Statement under the sub-heading “Certain Relationships and RelatedTransactions,” which information is incorporated herein by reference.

**Item 14.**                 PrincipalAccountant Fees and Services

Information with respect to Principal Accountant Feesand Services shall be set forth in our Proxy Statement under the heading “IndependentRegistered Public Accountants,” which information is incorporated herein byreference.

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**PART IV**

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

(a)           Consolidated FinancialStatements:

1.                *Consolidated Financial 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 Consolidated Financial Statements

2.                *Financial Statement Schedules.*

None.

(b)          Exhibits.

See “Exhibit Index” below.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized on the 13th 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 13 day of April, 2006.

|                              | **Signature** | ** **                                      | ** ** | ** ** | **Capacity** | ** ** |
|------------------------------|---------------|-------------------------------------------------|------------|------------|--------------|------------|
| /s/ LAURENCE  P. BIRCH       |          | Chief Financial  Officer and interim            |
| Laurence  P. Birch           |          | President 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                                        |
| Shodan 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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    *       Filedherewith.

 (1)       Incorporatedby reference to the Company’s Registration Statement on Form S-1(Registration No. 333-2492).

 (2)       Incorporatedby reference to the Company’s Registration Statement on Form 8A12G, filedon November 5, 1996.

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

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

 (5)       Incorporatedby reference to the Company’s Annual Report on Form 10-K for theyear ended December 31, 1997.

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 (6)       Incorporatedby reference to the Company’s Annual Report on Form 10-K for theyear ended December 31, 1999.

 (7)       Incorporatedby reference to the Company’s Annual Report on Form 10-K for theyear ended December 31, 2002.

 (8)       Incorporatedby reference to the Company’s Proxy Statement for its 2004 Annual Meeting ofStockholders.

 (9)       Incorporatedby reference to the Company’s Registration Statement on Form S-3(Registration No. 102651).

 (10)   Incorporatedby reference to the Company’s Annual Report on Form 10-K for theyear ended December 31, 2003.

 (11)   Incorporatedby reference to the Company’s Annual Report on Form 10-K for theyear ended December 31, 2004

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

 (13)   Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for thequarter ended June 30, 2005.

 (14)   Incorporatedby reference to the Company’s Quarterly Report on Form 10-Q for thequarter ended September 30, 2005.

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

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

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

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

(19) Incorporatedby reference to Durus Life Sciences Master Fund Ltd.’s Schedule 13D/A,filed on April 5, 2006.

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