UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-Q





x QUARTERLY REPORT PURSUANT TO SECTION 13
OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended March
31, 2010.





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


for the
transition period from _____ to _____.





Commission
File Number


0-50481





AEOLUS PHARMACEUTICALS,
INC.


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
              
              56-1953785(State
      or Other Jurisdiction of
                Incorporation
      or Organization)
              
              (I.R.S.
      Employer
                Identification
      No.)26361
      Crown Valley Parkway,
                Suite
      150
                Mission
      Viejo, California
              
              92691(Address
      of Principal Executive Offices)
              
              (Zip Code)(Registrant’s
      Telephone Number, Including Area Code)
                949-481-9825





Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. YES x NO  ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of accelerated
filer and large accelerated filer in Rule 12b-2 of the Exchange Act:




Large
accelerated filer  ̈
Accelerated filer  ̈
Non-accelerated filer x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).YES  ̈ NO x





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.





Class
                Outstanding
      as of
                  May 14, 2010Common
      Stock, par value $.01 per share
                48,224,320shares





AEOLUS
PHARMACEUTICALS, INC.


FORM
10-Q


For the
Quarter Ended March 31, 2010


Table of
Contents





PagePART I.FINANCIAL
      INFORMATIONItem
      1.
                          Financial
      StatementsStatement
      Regarding Financial Information
                          3Condensed
      Consolidated Balance Sheets as of March  31, 2010(unaudited)
      and September 30, 2009
                          4Condensed
      Consolidated Statements of Operations for the Three Months and Six Months
      ended March 31, 2010 and 2009 (unaudited)
                          5Condensed
      Consolidated Statements of Cash Flows for the Six Months ended March 31,
      2010 and 2009 (unaudited)
                          6Notes
      to Condensed Consolidated Financial Statements
                          7Item
      2.
                          Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                          14Item
      3.
                          Quantitative
      and Qualitative Disclosures About Market Risk
                          17Item
      4.
                          Controls
      and Procedures
                          17PART
      II.
                    OTHER
      INFORMATIONItem
      1.
                          Legal
      Proceedings
                          17Item
      1A.
                          Risk
      Factors
                          17Item
      2.
                          Unregistered
      Sales of Equity Securities and Use of Proceeds
                          17Item
      3.
                          Defaults
      Upon Senior Securities
                          17Item
      4.
                          Submission
      of Matters to a Vote of Security Holders
                          18Item
      5.
                          Other
      Information
                          18Item
      6.
                          Exhibits
                          18SIGNATURES
                          18


2





AEOLUS
PHARMACEUTICALS, INC.





PART
I - FINANCIAL INFORMATION





ITEM 1.
            Financial
      Statements.





Statement
Regarding Financial Information





The
condensed consolidated financial statements of Aeolus Pharmaceuticals, Inc. and
its wholly-owned subsidiary, Aeolus Sciences, Inc. (collectively the “Company”),
included herein have been prepared by management, without audit (except for the
Consolidated Balance Sheet as of September 30, 2009), pursuant to the rules and
regulations of the Securities and Exchange Commission (“SEC”). Certain
information normally included in the consolidated financial statements prepared
in accordance with accounting principles generally accepted in the United States
has been condensed or omitted pursuant to such rules and regulations. However,
the Company believes that the disclosures are adequate to make the information
presented not misleading. The Company recommends that you read the consolidated
financial statements included herein in conjunction with the audited
consolidated financial statements and notes thereto included in the Company’s
Annual Report on Form 10-K for the fiscal year ended September 30, 2009, filed
with the SEC on December 28, 2009.


3





AEOLUS PHARMACEUTICALS,
INC.





CONDENSED
CONSOLIDATED BALANCE SHEETS


(In
thousands, except shares and per share data)





March
      31,
                                              
                                              
                                              September
      30,2010
                                              
                                              
                                              2009(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                              
                                              $
                                              1,272
                                              
                                              
                                              $
                                              646Prepaids
      and other current assets
                                              
                                              
                                              71
                                              
                                              
                                              
                                              133Total
      current assets
                                              
                                              
                                              1,343
                                              
                                              
                                              
                                              779Investment
      in CPEC, LLC
                                              
                                              
                                              32
                                              
                                              
                                              
                                              32Total
      assets
                                              
                                              $
                                              1,375
                                              
                                              
                                              $
                                              811LIABILITIES
      AND STOCKHOLDERS’ DEFICITCurrent
      liabilities:Accounts
      payable and accrued expenses
                                              
                                              $
                                              504
                                              
                                              
                                              $
                                              774Total
      current liabilities
                                              
                                              
                                              504
                                              
                                              
                                              
                                              774Non-current
      liabilities:Warrant
      liability
                                              
                                              
                                              10,852
                                              
                                              
                                              
                                              -Senior
      convertible notes payable to related parties, net
                                              
                                              
                                              -
                                              
                                              
                                              
                                              600Long-term
      note payable
                                              
                                              
                                              627
                                              
                                              
                                              
                                              594Total
      liabilities
                                              
                                              
                                              11,983
                                              
                                              
                                              
                                              1,968Commitments
      & ContingenciesStockholders’
      deficit:Preferred
      stock, $.01 par value per share, 10,000,000 shares
    authorized:Series
      B nonredeemable convertible preferred stock, 600,000 shares authorized;
      475,087 shares issued and outstanding at March 31, 2010 and September
      30, 2009
                                              
                                              
                                              5
                                              
                                              
                                              
                                              5Common
      stock, $.01 par value per share, 200,000,000 shares authorized; 48,224,320
      shares issued and outstanding at March 31, 2010 and 37,563,392
      shares issued and outstanding at September 30, 2009
                                              
                                              
                                              482
                                              
                                              
                                              
                                              376Additional
      paid-in capital
                                              
                                              
                                              154,106
                                              
                                              
                                              
                                              159,657Accumulated
      deficit
                                              
                                              
                                              (165,201
                                              )
                                              
                                              
                                              (161,195
                                              )Total
      stockholders’ deficit
                                              
                                              
                                              (10,608
                                              )
                                              
                                              
                                              (1,157
                                              )Total
      liabilities and stockholders’ deficit
                                              
                                              $
                                              1,375
                                              
                                              
                                              $
                                              811





The
accompanying notes are integral part of these unaudited condensed consolidated
financial statements.


4





AEOLUS PHARMACEUTICALS,
INC.





CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)


(In
thousands, except per share data)





Three
      Months Ended
                
                
                Six
      Months EndedMarch 31,
                
                
                March 31,2010
                
                
                2009
                
                
                2010
                
                
                2009RevenueGrant
      income
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Costs
      and expenses:Research
      and development
                
                
                427
                
                
                
                214
                
                
                
                610
                
                
                
                340General
      and administrative
                
                
                455
                
                
                
                305
                
                
                
                862
                
                
                
                587Total
      costs and expenses
                
                
                882
                
                
                
                519
                
                
                
                1,472
                
                
                
                927Loss
      from operations
                
                
                (882
                )
                
                
                (519
                )
                
                
                (1,472
                )
                
                
                (927
                )Interest
      income (expense), net
                
                
                (17
                )
                
                
                (108
                )
                
                
                (843
                )
                
                
                (208
                )Other
      income (expense), net
                
                
                7,817
                
                
                
                (38
                )
                
                
                (6,043
                )
                
                
                11Net
      income (loss)
                
                $
                6,918
                
                
                $
                (665
                )
                
                $
                (8,358
                )
                
                $
                (1,124
                )Net
      income(loss)
      per weighted share attributable to common stockholders:Basic
                
                $
                0.14
                
                
                $
                (0.02
                )
                
                $
                (0.18
                )
                
                $
                (0.04
                )Diluted
                
                $
                0.07
                
                
                $
                (0.02
                )
                
                $
                (0.18
                )
                
                $
                (0.04
                )Weighted
      average common shares outstanding:Basic
                
                
                48,224
                
                
                
                32,143
                
                
                
                47,366
                
                
                
                32,064Diluted
                
                
                94,365
                
                
                
                35,000
                
                
                
                47,366
                
                
                
                34,733





The
accompanying notes are integral part of these unaudited condensed consolidated
financial statements.


5





AEOLUS PHARMACEUTICALS,
INC.





CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


(In
thousands)





Six
      Months EndedMarch 31,2010
                                  
                                  
                                  2009Cash
      flows from operating activities:Net
      loss
                                  
                                  $
                                  (8,358
                                  )
                                  
                                  $
                                  (1,124
                                  )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Noncash
      compensation
                                  
                                  
                                  321
                                  
                                  
                                  
                                  111Change
      in fair value of warrants
                                  
                                  
                                  (170
                                  )
                                  
                                  
                                  -Change
      in fair value of trading securities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (49
                                  )Noncash
      consulting expense
                                  
                                  
                                  14
                                  
                                  
                                  
                                  25Noncash
      interest and warrant charges
                                  
                                  
                                  7,003
                                  
                                  
                                  
                                  242Change
      in assets and liabilities:Prepaids
      and other assets
                                  
                                  
                                  62
                                  
                                  
                                  
                                  (14
                                  )Accounts
      payable and accrued expenses
                                  
                                  
                                  141
                                  
                                  
                                  
                                  (118
                                  )Net
      cash used in operating activities
                                  
                                  
                                  (987
                                  )
                                  
                                  
                                  (927
                                  )Cash
      flows from investing activities:Sales
      of marketable securities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  525Net
      cash provided by investing activities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  525Cash
      flows from financing activities:Repayment
      of short term note payable
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (368
                                  )Proceeds
      from short term note payable
                                  
                                  
                                  -
                                  
                                  
                                  
                                  3Proceeds
      from the issuance of common stock and warrants
                                  
                                  
                                  1,650
                                  
                                  
                                  
                                  1,500Proceeds
      from exercise of warrants
                                  
                                  
                                  17
                                  
                                  
                                  
                                  -Proceeds
      from issuance of Senior Convertible Notes
                                  
                                  
                                  -
                                  
                                  
                                  
                                  375Costs
      related to the issuance of common stock and warrants
                                  
                                  
                                  (54
                                  )
                                  
                                  
                                  (74
                                  )Net
      cash provided by financing activities
                                  
                                  
                                  1,613
                                  
                                  
                                  
                                  1,436Net
      increase in cash and cash equivalents
                                  
                                  
                                  626
                                  
                                  
                                  
                                  1,034Cash
      and cash equivalents at beginning of period
                                  
                                  
                                  646
                                  
                                  
                                  
                                  399Cash
      and cash equivalents, end of period
                                  
                                  $
                                  1,272
                                  
                                  
                                  $
                                  1,433


6


AEOLUS
PHARMACEUTICALS, INC.





NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





A.
            Organization
      and Business and Basis of
Presentation





Aeolus
Pharmaceuticals, Inc. is a biopharmaceutical company that is developing a new
class of catalytic antioxidant compounds as a medical countermeasure against
biological, chemical and radiological weapons as well as for oncology and
diseases and disorders of the central nervous system.  The Company’s
initial target indications are as a protective agent against the effects of
acute radiation syndrome, sulfur mustard gas exposure and chlorine gas
exposure.  The Company has reported positive safety results from two Phase
I clinical trials of AEOL 10150, our lead drug candidate, with no serious
adverse events noted.





The
“Company” or “Aeolus” refers collectively to Aeolus Pharmaceuticals, Inc., a
Delaware corporation (“Aeolus”), and its wholly owned subsidiary, Aeolus
Sciences, Inc., a Delaware corporation. As of March 31, 2010, Aeolus also owned
a 35.0% interest in CPEC LLC, a Delaware limited liability company (“CPEC”). The
Company’s primary operations are located in Mission Viejo,
California.




All
significant intercompany activity has been eliminated in the preparation of the
condensed consolidated financial statements. The unaudited condensed
consolidated financial statements have been prepared in accordance with the
requirements of Form 10-Q and Rule 10-01 of Regulation S-X. Some information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to those rules and regulations. In the opinion of management,
the accompanying unaudited consolidated financial statements include all
adjustments (consisting only of normal recurring adjustments) necessary to
present fairly the consolidated financial position, results of operations and
cash flows of the Company. The consolidated balance sheet at September 30, 2009
was derived from the Company’s audited financial statements included in the
Company’s Annual Report on Form 10-K for the fiscal year ended September 30,
2009. The unaudited condensed consolidated financial statements included herein
should be read in conjunction with the audited consolidated financial statements
and the notes thereto included in that Annual Report on Form 10-K and in the
Company’s other SEC filings. Results for the interim period are not necessarily
indicative of the results for any other period.





New
Accounting Pronouncements





In June 2009, the Financial Accounting
Standards Board ("FASB") issued revised guidance requiring enhanced disclosures
about transfers of financial assets and a company’s continuing involvement in
transferred assets. The new guidance is effective for financial statements
issued for fiscal years beginning after November 15, 2009.  The adoption of
this new guidance is not expected to have a material effect on the Company's
financial statements.





B.
            Liquidity





The
Company has incurred significant losses from operations of approximately
$1,472,000 and $927,000, and cash outflows from operations of $987,000 and
$927,000, for the six months ended March 31, 2010 and for the six months ended
March 31, 2009, respectively. The Company expects to incur additional losses and
negative cash flow from operations during the remainder of fiscal year 2010 and
for several more years.





Management
believes the Company has adequate financial resources to conduct operations into
the fourth quarter of fiscal year 2010. This raises substantial doubt about our
ability to continue as a going concern, which will be dependent on our ability
to generate sufficient cash flows to meet our obligations on a timely basis, to
obtain additional financing and, ultimately, to achieve operating
profits.





The
Company intends to explore strategic and financial alternatives, including a
merger or acquisition with or by another company, the sale of shares of stock
and/or convertible debentures, the establishment of new collaborations for
current research programs that include initial cash payments and on-going
research support and the out-licensing of our compounds for development by a
third party. The Company believes that without additional investment capital it
will not have sufficient cash to fund its activities in the near future, and
will not be able to continue operating. As such, the Company’s continuation as a
going concern is dependent upon its ability to raise additional financing. The
Company is actively pursuing additional equity and/or debt financing to provide
the necessary funds for working capital and other planned
activities.





If the
Company is unable to obtain additional financing to fund operations beyond the
fourth quarter of fiscal year 2010, it will need to eliminate some or all of its
activities, merge with another company, sell some or all of its assets to
another company, or cease operations entirely. There can be no assurance that
the Company will be able to obtain additional financing on favorable terms or at
all, or that the Company will be able to merge with another Company or sell any
or all of its assets.


7





C.
            Net
      Income (Loss)Per
      Common Share





The
Company computes basic net income (loss) per weighted average share attributable
to common stockholders using the weighted average number of shares of common
stock outstanding during the period. The Company computes diluted net income
(loss) per weighted average share attributable to common stockholders using the
weighted average number of shares of common and dilutive potential common shares
outstanding during the period. Potential common shares consist of stock options,
convertible debt, warrants and convertible preferred stock using the treasury
stock method and are excluded if their effect is anti-dilutive.  Diluted
weighted average common shares for the six months ended March 31, 2010 excluded
incremental shares of  60,187,011 issuable upon the exercise or
conversion of convertible debt, stock options to purchase common stock,
convertible preferred stock and warrants to purchase common stock. These shares
were excluded due to their anti-dilutive effect as a result of the Company’s net
loss for the six months ended March 31, 2010. Diluted weighted average
common shares for the six months ended March 31, 2009 included incremental
shares issuable upon conversion of the Senior Convertible Notes but excluded
incremental shares of approximately 34,438,000 due to their anti-dilutive effect
as a result of the Company’s net loss for the six months ended March 31,
2009.





For the
three months ended March 31, 2010, weighted average basic common shares for the
Company were 48,224,320; fully-diluted weighted average shares outstanding for
that period was 94,365,273 shares.  The current fiscal quarter is not
comparable to the three months ended March 31, 2009, due to the fact that the
Company was profitable in the three months ended March 31, 2010, but because the
Company had a net loss in the three months ended March 31, 2009, the incremental
shares were antidilutive in that period, and were therefore excluded from the
calculation of diluted weighted-average common shares.





D.
            Warrant
      Liability





On
October 1, 2009, the Company adopted new accounting guidance originally referred
to as Emerging Issues Task Force 07-5, recently codified by Financial Accounting
Standards Board (FASB) to be Accounting Standards Codification (ASC)
815-40-15.  The new guidance revised existing guidance for determining
whether an Instrument (or Embedded Feature) is indexed to an entity’s own
stock.  Equity-linked instruments (or embedded features) that otherwise
meet the definition of a derivative are not accounted for as derivatives if
certain criteria are met, one of which is that the instrument (or embedded
feature) must be indexed to the entity’s own stock.  The Company applied
the new guidance to outstanding instruments as of October 1, 2009.  The
fair value of the warrants affected by the new guidance at the dates of issuance
totaled $8,282,000 and was initially recorded as a component of additional
paid-in capital. Upon adoption of the new guidance, the Company recorded a
decrease to the opening balance of additional-paid-in capital of $8,142,000 and
recorded a decrease to accumulated deficit totaling $4,353,000, representing the
decrease in the fair value of the warrants from the date of issuance to October
1, 2009.  The fair value of the warrants at October 1, 2009 of $3,789,000
was classified as a liability in the balance sheet as of that date.





Future
increases or decreases in fair value of the warrants will be included as a
component of other income in the accompanying statement of operations for the
respective period.  As of March 31, 2010, the liability for warrants
decreased to approximately$10,852,000, resulting in a benefit to the income
statement for the three months ended March 31, 2010 of approximately
$7,817,000.  The warrant liability and revaluations have not and will not
have any impact on the Company’s working capital, liquidity, or business
operations.





E.
            Note
      Payable





Senior
Convertible Notes to Related Parties





On August
1, 2008, the Company entered into a Securities Purchase Agreement (the "SCN
Purchase Agreement") with three accredited institutional
investors  (the "Investors") pursuant to which the Company agreed to
sell to the Investors units comprised of senior unsecured convertible notes of
the Company (the "Notes"), in an aggregate principal amount of up to $5,000,000,
which shall bear interest at a rate of 7% per year and mature on the 30-month
anniversary of their date of issuance, and warrants to purchase up to an
aggregate of 10,000,000 additional shares of Common Stock (the "Warrant
Shares"), each with an initial exercise price of $0.50 per share, subject to
adjustment pursuant to the warrants (the "Warrants") (collectively the “SCN
Financing”). Each unit (collectively, the "Units") is comprised of $1,000 in
Note principal and Warrants to purchase up to 2,000 shares of the Company's
common stock, par value $0.01 per share (the "Common Stock"), and has a purchase
price of $1,000.





On August
1, 2008, the Company sold and issued to the Investors 500 Units comprised of
Notes in the aggregate principal amount of $500,000 and Warrants to purchase up
to 1,000,000 shares of Common Stock for an aggregate purchase price of $500,000
(the "Financing").





On each
of September 4, 2008, October 1, 2008, November 3, 2008 and December 1, 2008,
the Company sold and issued to the Investors 125 Units comprised of Notes in the
aggregate principal amount of $125,000 and Warrants to purchase up to 250,000
shares of Common Stock for an aggregate purchase price of $125,000 (the
"Subsequent Financings").


8





The Notes
issued in the Financing and the Subsequent Financings had an initial conversion
price of $0.35 per share, subject to adjustment pursuant to the Notes.  In
addition, the Investors had the option to purchase up to an additional 4,000
Units, in one or more closings (each, an "Election Closing") at their sole
option at any time on or before December 31, 2013.





Interest
on the Notes accrued at the rate of 7.0% per annum from the date of issuance,
and was payable semi-annually, on January 31 and July 31 of each year. 
Interest was payable, at the Company's sole election, in cash or shares of
Common Stock, to holders of Notes on the record date for such interest payments,
with the record dates being each January 15 and July 15 immediately preceding an
interest payment date.   The effective interest rate of the Note
including the effect of the amortization of the embedded conversion feature and
the note discount is 39.4 percent.





The net
proceeds to the Company from the sale of 1,000 Units in the Financing and
Subsequent Financing, after deducting for expenses, were approximately
$844,000.  The Company used the net proceeds to fund the development of
AEOL 10150 and to fund ongoing operations of the Company.  Offering costs
of the private placement were $156,000 and were allocated to the Notes and
Warrants based upon their respective fair values.  The offering costs
attributed to the Notes in the amount of $100,000 were capitalized as Debt
Issuance Costs.  The Debt Issuance Costs were amortized over the life of
the Notes in the Financing.





In
connection with a financing that occurred on October 6, 2009 and is more fully
described in Note F – Stockholders’ Equity,  the holders of the Notes
agreed to convert all $1,000,000 of the Company’s Notes  into Common Stock
at a conversion rate of $0.35 per share and to exchange their remaining option
to purchase an additional $4,000,000 in Notes for warrants to purchase up to
14,285,714 shares of Common Stock with an initial exercise price of $0.28 per
share, subject to adjustment pursuant to the warrants (the “Note
Warrants”).





On
December 24, 2009, the “Company entered into an amendment (the “Amendment”) to
the Securities Purchase and Exchange Agreement dated October 6, 2009 (the
“October 2009 Purchase Agreement”) pursuant to which the Company agreed to lower
the conversion price of the Notes from $0.35 per share to $0.28 per share and as
a result, issued an additional 714,286 shares of the Company’s Common
Stock.  The Amendment was executed to resolve a misunderstanding regarding
one of the financing terms in the October 6, 2009 financing between the Company
and the investors in the financing.  The Company did not receive any
proceeds from the issuance.   As a result of the amendment and
issuance of the additional shares, the Company recorded a charge of $343,000 in
the Statement of Operations as interest expense for the value of the shares
issued on the date of issuance.





Affiliates
of Xmark Opportunity Partners, LLC were the sole investors in the SCN Financing.
Together with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 52% of the Company's outstanding common stock prior to the
Financing. Xmark Opportunity Partners, LLC is the sole manager of Goodnow
Capital, L.L.C. and possesses sole power to vote and direct the disposition of
all securities of the Company held by Goodnow. Goodnow has the right to
designate up to two directors for election to the Company's Board of Directors
pursuant to the terms of a purchase agreement between Goodnow and the Company.
David C. Cavalier, a current director of the Company, is President of
Goodnow.  The transaction was evaluated by Management and the Board of
Directors for fairness to ensure the terms were reasonable given the related
party nature of the SCN Financing by providing an option for non-related party
investors to participate in the transaction.





Elan
Note Payable





In August
2002, Aeolus borrowed $638,000 from Elan Corporation, plc. (“Elan”).  The
note payable accrued interest at 10% compounded semi-annually. The note was
convertible at the option of Elan into shares of the Company’s Series B
non-voting convertible preferred stock (“Series B Stock”) at a rate of $43.27
per share. The original note matured on December 21, 2006.  However, in
February 2007, the Company and Elan terminated the note, the Company paid
$300,000 in cash to Elan,  Elan forgave $225,000 of the note payable
and Elan and the Company entered into a new two-year note payable in the amount
of $453,000 under substantially the same terms as the original note.  In
February 2009, the Company and Elan agreed to amend the note payable to extend
the maturity date of the convertible promissory note from February 7, 2009 to
February 7, 2011 and increased the interest rate of the convertible promissory
note from 10% to 11% effective February 7, 2009. As of the date of the
Amendment, an aggregate of $553,000 in principal and interest was outstanding
under the convertible promissory note. In the event of an event of default under
the convertible promissory note, Elan may demand immediate payment of all
amounts outstanding under the note. For purposes of the note, an event of
default includes, among other items, a default in the payment of the note
principal or interest when due and payable, an uncured breach by the Company of
its obligations to Elan pursuant the agreements under which the convertible
promissory note was issued, an inability of the Company to pay its debts in the
normal course of business, the cessation of business activities by the Company
(other than as a result of a merger or consolidation with a third party) without
Elan’s prior written consent and the appointment of a liquidator, receiver,
administrator, examiner, trustee or similar officer of the Company or over all
or substantially all of its assets under the law.





During
the term of the note payable, Elan has the option to convert the note into
shares of Series B Preferred Stock at a rate of $9.00 per share.  Upon the
maturity of the note payable, Aeolus has the option to repay the note either in
cash or in shares of Series B Stock and warrants having a then fair market value
of the amount due; provided that the fair market value used for calculating the
number of shares to be issued will not be less than $13.00 per share. As of
March 31, 2010, the outstanding balance, including interest, on the note payable
to Elan was approximately $627,000.


9


F.
              Stockholders’
      Equity
 
 On
October 6, 2009, the Company entered into the October 2009 Purchase Agreement
with several accredited institutional investors  (the "October 2009
Investors") pursuant to which the Company sold and issued to the October 2009
Investors in a private placement an aggregate of 5,892,857 units (the “Units”),
comprised of an aggregate of 5,892,857 shares of Common Stock (the “Shares”) and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
Common Stock (the “October 2009 Warrants”), with an initial exercise price of
$0.28 per share, subject to adjustment pursuant to the October 2009 Warrants,
with each Unit representing one share of Common Stock and a October 2009 Warrant
to purchase two shares of Common Stock, at a purchase price of $0.28 per Unit
for aggregate gross proceeds of $1,650,000 (collectively, the “October 2009
Financing”).  The October 2009 Warrants are exercisable for a seven
year period from their date of issuance; contain a “cashless exercise” feature
that allows the holder to exercise the October 2009 Warrants without a cash
payment to the Company under certain circumstances; contain a dividend
participation right which allows the holder to receive any cash dividends paid
on the Common Stock without exercising the October 2009 Warrant and contain a
provision that provides for the reduction of the exercise price to $0.01 in the
event of any such payment of cash dividends by the Company or upon a change of
control and contain anti-dilution provisions in the event of a stock dividend or
split, dividend payment or other issuance, reorganization, recapitalization or
similar event.
 
 The
Company also granted to the October 2009 Investors the option to acquire,
collectively, up to an additional 5,892,857 additional Units (the “Additional
Units”), comprised of an aggregate of 5,892,857 shares of Common Stock and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
common stock at the per Additional Unit purchase price of $0.28 (the “Call
Option”). In addition, the October 2009 Investors granted to the Company the
option to require these October 2009 Investors, severally and not jointly, to
acquire up to 5,892,857 Additional Units, less any Additional Units acquired
under the Call Option, at the per Additional Unit purchase price of $0.28 (the
“Put Option”).  The Call Option is exercisable at any time, and from
time to time, on or prior to June 30, 2010.  The Put Option is
exercisable at any time from June 30, 2010 to July 30, 2010.  However,
the Investors shall have the right to terminate the Put Option if they
reasonably determine that a material adverse event, condition or circumstance
has occurred with respect to the prospects of the Company’s AEOL 10150 drug
candidate for acute radiation syndrome; provided that the Company’s failure to
receive a grant or financing shall not, by itself, constitute a material adverse
event, condition or circumstance with respect thereto.
 
 In
addition, the October 2009 Investors agreed to convert all $1,000,000 of the
Company’s Senior Convertible Notes issued in 2008 (the “Notes”) into Common
Stock at a conversion rate of $0.35 per share (the “Conversion Shares”), which
was subsequently lowered to $0.28 as discussed below and to exchange their
remaining option to purchase an additional $4,000,000 in Senior Convertible
Notes for warrants to purchase up to 14,285,714 shares of Common Stock in
substantially the same of form and terms of the October 2009 Warrants issued in
the October 2009 Financing, including an initial exercise price of $0.28 per
share, subject to adjustment pursuant to the warrants (the “Note
Warrants”).  As consideration for the October 2009 Investors to
convert the Notes, the Company agreed to exchange warrants to purchase up to
2,000,000 shares of Common Stock issued to the October 2009 Investors in
connection with the sale of the Notes, warrants to purchase up to 2,150,000
shares of Common Stock issued to the October 2009 Investors and one of their
affiliates in connection with a financing completed in November 2005 and
warrants to purchase up to 13,392,857 shares of Common Stock issued to the
October 2009 Investors in connection with a financing completed in March 2009
(collectively, the “Prior Warrants”) for warrants to purchase up to 17,542,857
shares of Common Stock in substantially the same form and terms of the October
2009 Warrants issued in the October 2009 Financing, including an initial
exercise price of $0.28 per share, subject to adjustment pursuant to the
warrants (the “Exchange Warrants”) (collectively, the
“Conversion”).
 
 In
connection with the October 2009 Financing and the Conversion, the Company also
entered into a Registration Rights Agreement (the “October 2009 Rights
Agreement”) with the Investors.  In addition, the Investors agreed to
terminate the Company’s Registration Rights Agreements dated November 21, 2005
and March 30, 2009.  Pursuant to the October 2009 Rights Agreement,
the Company agreed to file one or more registration statements (collectively,
the “Registration Statements”) with the Securities and Exchange Commission (the
“SEC”) covering the resale of the Shares, the Conversion Shares and all shares
of common stock issuable upon exercise of the Warrants, the Note Warrants and
the Exchange Warrants (collectively, the “Registrable Securities”) upon demand
of the holders of a majority of the Registrable Securities (a “Demand
Registration”).  Such holders have the right to two Demand
Registrations, subject to certain exceptions.  In the event the
holders exercise their right to a Demand Registration, the Company has agreed to
file a Registration Statement to register the resale of the Registrable
Securities within a certain number of days after the request and to use
commercially reasonable efforts to cause the Registration Statement to be
declared effective by the SEC as soon as practicable after the filing
thereof.  The Company also agreed to use its commercially reasonable
efforts to keep the Registration Statements effective for a specified
period.
 
 The net
proceeds to the Company from the October 2009 Financing, after deducting for
expenses, were approximately $1.6 million. The Company intends to use the net
proceeds from the Financing to finance animal efficacy studies in Acute
Radiation Syndrome, the development of AEOL 10150 and ongoing operations of the
Company.
  10
  The fair
value of the October 2009 Warrants, the Note Warrants and the Exchange Warrants
was estimated to be $10,585,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
93%; risk free interest rate of 2.9%; and an expected life of seven
years.   The fair value of the Prior Warrants cancelled on
October 6, 2009 was $3,352,000.   The proceeds from the October
2009 Financing were allocated based upon the relative fair values of the October
2009 Warrants and the Shares.  Due to the anti-dilution provisions of
the October 2009 Warrants, the Note Warrants and the Exchange Warrants, these
warrants were deemed to be a liability under current accounting guidance and as
a result the warrant liability was increased by $7,233,000 of which $6,213,000
was recorded as a charge to the Statement of Operations and $1,020,000 of
proceeds from the October 2009 Financing was allocated to the value of the
October 2009 Warrants.
 
 Affiliates
of Xmark Opportunity Partners, LLC are the sole investors in the Financing and,
together with the Company, are the sole participants in the Conversion. Together
with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 71% of the Company's outstanding common stock prior to the
Financing and the Conversion.  Xmark Opportunity Partners, LLC is the
sole manager of Goodnow Capital, L.L.C. and possesses sole power to vote and
direct the disposition of all securities of the Company held by Goodnow. Goodnow
has the right to designate up to two directors for election to the Company's
Board of Directors pursuant to the terms of a purchase agreement between Goodnow
and the Company. David C. Cavalier, a current director of the Company, is
President of Goodnow.
 
 On
December 24, 2009, the Company entered into an amendment (the “Amendment”) to
the October 2009 Purchase Agreement pursuant to which the Company agreed to
lower the conversion price of the Notes from $0.35 per share to $0.28 per share
and as a result, issued to the investors in the Company’s October 2009 Financing
an additional 714,286 shares of the Company’s Common Stock upon conversion of
the Notes (the “Issuance”).  The Agreement was executed to resolve a
misunderstanding regarding one of the Financing terms between the Company and
the investors in the Financing.  The Company did not receive any
proceeds from the Issuance.  The fair value of the common stock on the
date of issuance was $343,000 and was charged to the Statement of Operations as
interest expense.
 
 On March
30, 2009, Aeolus entered into a Securities Purchase Agreement (the "Purchase
Agreement") with two accredited institutional investors  (the "March
2009 Investors") pursuant to which the Company sold and issued to the March 2009
Investors in a private placement an aggregate of 5,357,143 units (the “March
2009 Units”), comprised of an aggregate of 5,357,143 shares of Common Stock of
the Company (the “Shares”) and warrants to purchase up to an aggregate of
13,392,857 additional shares of Common Stock (the “March 2009 Warrants”), with
an initial exercise price of $0.35 per share, subject to adjustment pursuant to
the March 2009 Warrants, with each March 2009 Unit representing one share of
Common Stock and a March 2009 Warrant to purchase two-and-one-half shares of
Common Stock, at a purchase price of $0.28 per March 2009 Unit for aggregate
gross proceeds of $1,500,000 (collectively, the “March 2009
Financing”).  The March 2009 Warrants are exercisable for a five year
period from their date of issuance; contain a “cashless exercise” feature that
allows the holder to exercise the March 2009 Warrants without a cash payment to
the Company under certain circumstances; contain a dividend participation right
which allows the holder to receive any cash dividends paid on the Common Stock
without exercising the March 2009 Warrant and contain a provision that provides
for the reduction of the exercise price to $0.01 in the event of any such
payment of cash dividends by the Company; and contain standard anti-dilution
provisions that provide for the adjustment of the exercise price and the number
of shares of common stock that can be purchased in the event of a financing at a
price per share below the exercise price, a stock dividend or split, dividend
payment or other issuance, reorganization, recapitalization or similar
event.
 
 The fair
value of the March 2009 Warrants was estimated to be $4,129,000 using the
Black-Scholes option pricing model with the following assumptions: dividend
yield of 0%; risk free interest rate of 1.7%; expected volatility of 164%; and
an expected life of five years.
 
 Offering
costs of the March 2009 Financing were $91,000 resulting in net proceeds to the
Company of approximately $1.4 million. The Company intends to use the net
proceeds from the March 2009 Financing to finance the development of AEOL 10150
and to fund ongoing operations of the Company.
 
 Affiliates
of Xmark Opportunity Partners, LLC were the sole investors in the Financing.
Together with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 57% of the Company's outstanding common stock prior to the March
2009 Financing.
 
 As a
result of the March 2009 Financing, the Company was required to lower the
exercise price of 4,687,000 warrants previously issued in November 2005 and May
2007 to $0.28 per share, the purchase price of the March 2009 Units issued in
the March 2009 Financing.   As a result of the change in the
exercise price, these warrants were revalued resulting in an increase in the
value of $38,000 which was charged to the statement of operations during the
second quarter of fiscal year 2009.
 
 In
connection with the SCN Financing, Aeolus issued warrants to purchase 2,000,000
shares at an exercise price of $0.50 per share with a five year
term.  The fair value of the warrants issued on August 1, 2008 was
estimated to be $282,000 using the Black-Scholes option pricing model with the
following assumptions: dividend yield of 0%; expected volatility of 128% risk
free interest rate of 3.2%; and an expected life of five years.  The
fair value of the warrants issued on September 4, 2008 was estimated to be
$53,000 using the Black-Scholes option pricing model with the following
assumptions: dividend yield of 0%; expected volatility of 130% risk free
interest rate of 3.0%; and an expected life of five
years.    The fair value of the warrants issued on October
1, 2008 was estimated to be $93,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
133% risk free interest rate of 2.9%; and an expected life of five
years.    The fair value of the warrants issued on November
3, 2008 was estimated to be $76,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
139% risk free interest rate of 2.7%; and an expected life of five
years.    The fair value of the warrants issued on December
1, 2008 was estimated to be $75,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
138% risk free interest rate of 1.7%; and an expected life of five
years.
  11
 
 In
addition, as a result of the SCN Financing, the Company was required to lower
the exercise price of 4,687,000 warrants previously issued in the November 2005
Financing and in the 2007 Financing to $0.35 per share, the conversion price of
the Notes issued in the SCN Financing.   As a result of the
change in the exercise price, these warrants were revalued resulting in an
increase in the value of $118,000 which was charged to the statement of
operations during the fourth quarter of fiscal year 2008.
 
 As of
March 31, 2010, warrants to purchase 53,390,953 shares of common stock were
outstanding. Details of the warrants for common stock outstanding at March 31,
2010 were as follows:
 
 NumberofShares
                    
                    ExercisePrice
                    
                    ExpirationDate350,000
                    
                    $
                    0.28
                    
                    November
      20102,126,668
                    
                    $
                    0.28
                    
                    May
      201243,614,285
                    
                    $
                    0.28
                    
                    October
      201650,000
                    
                    $
                    0.35
                    
                    May
      201120,000
                    
                    $
                    0.39
                    
                    September
      201415,000
                    
                    $
                    0.50
                    
                    September
      201415,000
                    
                    $
                    0.60
                    
                    September
      20147,000,000
                    
                    $
                    0.75
                    
                    June
      201150,000
                    
                    $
                    1.00
                    
                    May
      201150,000
                    
                    $
                    1.50
                    
                    May
      201150,000
                    
                    $
                    2.00
                    
                    May
      201150,000
                    
                    $
                    2.50
                    
                    May
      201153,390,953
                    
                    $
                    0.35
 
 Below is
a summary of warrant activity for the six months ended March 31,
2010:
 
 Weighted AverageRemainingContractual Term (in
                    
                    
                    AggregrateNumber of Shares
                    
                    
                    Exercise Price
                    
                    
                    Years)
                    
                    
                    Intrinsic ValueOutstanding
      at September 30, 2009
                    
                    
                    27,379,525
                    
                    
                    $
                    0.46
                    
                    
                    
                    3.25
                    
                    
                    $
                    1,051,247.76Granted
                    
                    
                    43,614,285
                    
                    
                    $
                    0.28
                    
                    
                    
                    6.52
                    
                    
                    $
                    872,285.70Exercised
                    
                    
                    (60,000
                    )
                    
                    $
                    0.28
                    
                    
                    
                    2.14
                    
                    
                    $
                    9,000.00Expired
      or Canceled
                    
                    
                    (17,542,857
                    )
                    
                    $
                    0.36
                    
                    
                    
                    3.52
                    
                    
                    $
                    43,000.00Forfeited
                    
                    
                    -
                    
                    
                    
                    -Vested
                    
                    
                    -
                    
                    
                    
                    -Outstanding
      at March 31, 2010 (Unaudited)
                    
                    
                    53,390,953
                    
                    
                    $
                    0.35
                    
                    
                    
                    5.58
                    
                    
                    $
                    921,819.06Exercisable
      at March 31, 2010 (Unaudited)
                    
                    
                    53,390,953
                    
                    
                    $
                    0.35
                    
                    
                    
                    5.58
                    
                    
                    $
                    921,819.06
 
 As
discussed previously, the Warrants expiring in November 2010, May 2012 and
October 2016 are deemed to be liabilities and as such are carried at their fair
value as a liability on the Balance Sheet.
 
 G.
              Stock-Based
      Compensation
 
 Below is
a summary of stock option activity for the six months ended March 31,
2010:
 
 Weighted AverageRemainingContractual Term (in
                      
                      
                      AggregrateNumber of Shares
                      
                      
                      Exercise Price
                      
                      
                      Years)
                      
                      
                      Intrinsic ValueOutstanding
      at September 30, 2009
                      
                      
                      6,175,015
                      
                      
                      $
                      1.58
                      
                      
                      
                      6.96
                      
                      
                      $
                      137,912.50Granted
                      
                      
                      121,250
                      
                      
                      $
                      0.33
                      
                      
                      
                      9.63
                      
                      
                      $
                      0.00Exercised
                      
                      
                      -
                      
                      
                      
                      -Expired
      or Canceled
                      
                      
                      -
                      
                      
                      
                      -Forfeited
                      
                      
                      (45,000
                      )
                      
                      $
                      0.39
                      
                      
                      
                      
                      
                      
                      $
                      0.00Outstanding
      at March 31, 2010 (Unaudited)
                      
                      
                      6,251,265
                      
                      
                      $
                      1.57
                      
                      
                      
                      6.51
                      
                      
                      $
                      112.50Exercisable
      at March 31, 2010 (Unaudited)
                      
                      
                      5,836,272
                      
                      
                      $
                      1.66
                      
                      
                      
                      6.31
                      
                      
                      $
                      112.50
  12
 
 For the
six months ended March 31, 2010 and 2009, all stock options were issued with an
exercise price at or above the fair market value of the Company’s common stock
on the date of grant.
 
 The
details of stock options for the six months ended March 31, 2010 were as
follows:
 
 Options Outstanding
                            
                            
                            Options ExercisableRange of
                              Exercise Prices
                            
                            
                            Number
                              Outstandingat
                              March31,2010
                            
                            
                            Weighted
                              Average
                              ExercisePrice
                            
                            
                            Weighted
                              Average
                              Remaining
                              Contractual
                              Life
                            
                            
                            Number
                              Exercisableat
                              March31,2010
                            
                            
                            Weighted
                              Average
                              Exercise
                              Price$0.29-$0.32
                            
                            
                            
                            1,526,250
                            
                            
                            $
                            0.30
                            
                            
                            
                            8.97
                            
                            
                            
                            1,297,083
                            
                            
                            $
                            0.30$0.33-$0.44
                            
                            
                            
                            967,750
                            
                            
                            $
                            0.38
                            
                            
                            
                            8.97
                            
                            
                            
                            781,924
                            
                            
                            $
                            0.38$0.45-$0.73
                            
                            
                            
                            558,611
                            
                            
                            $
                            0.58
                            
                            
                            
                            6.92
                            
                            
                            
                            558,611
                            
                            
                            $
                            0.58$0.75-$0.89
                            
                            
                            
                            762,835
                            
                            
                            $
                            0.81
                            
                            
                            
                            5.97
                            
                            
                            
                            762,835
                            
                            
                            $
                            0.81$0.90-$1.25
                            
                            
                            
                            612,750
                            
                            
                            $
                            0.95
                            
                            
                            
                            6.43
                            
                            
                            
                            612,750
                            
                            
                            $
                            0.95$1.45
                            
                            
                            
                            2,500
                            
                            
                            $
                            1.45
                            
                            
                            
                            4.58
                            
                            
                            
                            2,500
                            
                            
                            $
                            1.45$1.50-$1.73
                            
                            
                            
                            1,263,519
                            
                            
                            $
                            1.50
                            
                            
                            
                            3.33
                            
                            
                            
                            1,263,519
                            
                            
                            $
                            1.50$1.85-$6.25
                            
                            
                            
                            375,768
                            
                            
                            $
                            2.92
                            
                            
                            
                            4.13
                            
                            
                            
                            375,768
                            
                            
                            $
                            2.92$8.12-$19.00
                            
                            
                            
                            80,525
                            
                            
                            $
                            13.12
                            
                            
                            
                            1.62
                            
                            
                            
                            80,525
                            
                            
                            $
                            13.12$19.38-$51.25
                            
                            
                            
                            100,757
                            
                            
                            $
                            33.72
                            
                            
                            
                            0.45
                            
                            
                            
                            100,757
                            
                            
                            $
                            33.72$0.29-$51.25
                            
                            
                            
                            6,251,265
                            
                            
                            $
                            1.57
                            
                            
                            
                            6.51
                            
                            
                            
                            5,836,272
                            
                            
                            $
                            1.66
 
 Stock-based
compensation expense recognized in the statement of operations is as follows (in
thousands):
 
 For the three months
                          ended March 31,
                        
                        
                        For the six months
                          ended March 31,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Research
      and Development Expenses
                        
                        
                        10
                        
                        
                        
                        -
                        
                        
                        
                        33
                        
                        
                        
                        23General
      and Administrative Expenses
                        
                        
                        121
                        
                        
                        
                        45
                        
                        
                        
                        288
                        
                        
                        
                        88131
                        
                        
                        
                        45
                        
                        
                        
                        321
                        
                        
                        
                        111
 
 The total
deferred compensation expense for outstanding and unvested stock options for the
six months ended March 31, 2010 was approximately $83,000.  The
weighted average remaining recognition period for the total deferred
compensation expense is approximately three months. The fair value of the
options associated with the above compensation expense was determined at the
date of the grant using the Black-Scholes option pricing model with the
following weighted average assumptions:
 
 For the six months
                      ended March 31,2010
                    
                    
                    2009Dividend
      yield
                    
                    
                    0%
                    
                    
                    
                    0%Expected
      volatility
                    
                    
                    96%
                    
                    
                    
                    200%-209%Risk-free
      interest rate
                    
                    
                    3.36%
                    
                    
                    
                    2.6%-3.8%Expected
      option life after shares have vested
                    
                    10
      years
                    
                    
                    10
      years
 
 H.
              Commitments
 
 The
Company has acquired assets still in development and entered into research and
development arrangements with third parties that may require milestone and
royalty payments to the third party contingent upon the occurrence of certain
future events linked to the success of the asset in development. Milestone
payments may be required, contingent upon the successful achievement of an
important point in the development life-cycle of the pharmaceutical product
(e.g., approval of the product for marketing by a regulatory agency). If
required by the arrangement, the Company may have to make royalty payments based
upon a percentage of the sales of the pharmaceutical product in the event that
regulatory approval for marketing is obtained.
  13
 
 These
arrangements may be material individually, and in the unlikely event that
milestones for multiple products covered by these arrangements were reached in
the same period, the aggregate charge to expense could be material to the
results of operations in any one period. In addition, these arrangements often
give Aeolus the discretion to unilaterally terminate development of the product,
which would allow Aeolus to avoid making the contingent payments; however,
Aeolus is unlikely to cease development if the compound successfully achieves
clinical testing objectives.
 
 I.
              Subsequent
      Events
 
 On May
12, 2010, the Company was notified by Chemical Biological Medical Systems that
it had not been awarded the contract for development of AEOL 10150 as a
countermeasure for GI-Acute Radiation System.  Development of the compound
for GI-ARS continues and continues to be funded by the National Institutes of
Health (NIH) – National Institutes of Allergies and Immunological Disorders
(NIAID).  Review of the Company’s application for a contract award
from the Biologic Advanced Research and Development Authority (BARDA) continues
and a decision is expected before the end of the fiscal year.  The
decision by CBMS does not have a financial impact on the Company as funding from
CBMS was not considered as a component of Aeolus’ programs for budgeting
purposes.  The Company has evaluated for subsequent events through the
date these financial statements were filed and determined that no other
material, subsequent events have occurred.
 
 ITEM 2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
 
 Introduction
 
 Unless
otherwise noted, the terms “we,” “our” or “us” refer collectively to AeolusPharmaceuticals, Inc.
and our wholly owned subsidiary, Aeolus Sciences, Inc.
 
 This
report contains, in addition to historical information, statements by us with
respect to expectations about our business and future results which are
“forward-looking” statements under the Private Securities Litigation Reform Act
of 1995. These statements and other statements made elsewhere by us or by our
representatives, which are identified or qualified by words such as “likely,”
“will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,”
“estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,”
“plans,” or similar expressions, are based on a number of assumptions that are
subject to risks and uncertainties. Such statements include, but are not limited
to, those relating to Aeolus’ product candidates, as well as its proprietary
technologies and uncertainties and other factors that may cause Aeolus’ actual
results to be materially different from historical results or from any results
expressed or implied by such forward-looking statements. Important factors that
could cause results to differ include risks associated with uncertainties of
progress and timing of clinical trials, scientific testing, obtaining regulatory
approval, the need to obtain funding for pre-clinical and clinical trials and
operations, the scope and validity of intellectual property protection for
Aeolus’ product candidates, proprietary technologies and their uses, new
accounting and SEC requirements and competition from other biopharmaceutical
companies. Certain of these factors and others are more fully described in
Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual
Report on Form 10-K for the fiscal year ended September 30, 2009.  All
forward-looking statements are based on information available as of the date
hereof, and we do not assume any obligation to update such forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof.
 
 Operations
Summary
 
 We are
developing a new class of catalytic antioxidant compounds as a medical
countermeasure against biological, chemical and radiological weapons as well as
for oncology and diseases and disorders of the central nervous
system.  Our initial target indications are as a protective agent
against the effects of acute radiation syndrome, sulfur mustard gas exposure and
chlorine gas exposure.  We have reported positive safety results from
two Phase I clinical trials of AEOL 10150, our lead drug candidate, with no
serious adverse events noted.
 
 We do not
have any revenue, other than grant income, and therefore we must rely on public
or private equity offerings, debt financings, collaboration arrangements or
grants to finance our operations.
 
 Need for Additional
Funds
 
 We
believe we have adequate financial resources to fund our operations into the
fourth quarter of fiscal year 2010, but in order to fund on-going operating cash
requirements beyond the fourth quarter of fiscal year 2010, or to accelerate or
expand our programs; we will need to raise significant additional funds. Our
need for additional financing is discussed under “Liquidity and Capital
Resources.”
  14
 
 Results of
Operations
 
 Three months ended March 31,
2010 versus three months ended March 31, 2009
 
 We had a
net profit of approximately $6,918,000 for the three months ended March 31,
2010, versus a net loss of approximately $665,000 for the three months ended
March 31, 2009.
 
 Research
and development (“R&D”) expenses increased about $213,000, or 99%, to
$427,000 for the three months ended March 31, 2010 from approximately $214,000
for the three months ended March 31, 2009.  R&D expenses were
higher during the three months ended March 31, 2010 versus March 31, 2009 due to
an increase in research activities.  During the three months ended
March 31, 2010 consulting expenses increased by about $186,000, due principally
to the cost of hiring a consultant to assist the Company in filing detailed
proposals with: 1) the Biological Advanced Development Authority (BARDA) for a
government funded contract to develop AEOL 10150 for Lung Acute Radiation
Syndrome (ARS), and 2) with the Chemical, Biological Medical Systems (CBMS) for
a government funded contract to develop AEOL 10150 for GI
ARS.     Preclinical fees increased about $40,000 over
the comparable period in 2009 due to increased animal study activity to support
the Company’s ARS development program.  The Company currently has
seven studies in progress: the study of its drug candidates as a potential
countermeasure against the effects of sulfur mustard gas on the lung and skin,
as a protectant against the effects of radiation on the lungs and on the
gastro-intestinal tract, as a countermeasure against the effects of chlorine
gas, as a potential treatment for epilepsy and for the potential treatment for
Parkinson’s disease.
 
 R&D
expenses for our antioxidant program have totaled approximately $36,132,000 from
inception through March 31, 2010. Because of the uncertainty of our research and
development and clinical studies, we are unable to predict the level of spending
and the anticipated program completion date, if any.
 
 General
and administrative (“G&A”) expenses increased about $150,000, or 49%, to
approximately $455,000 for the three months ended March 31, 2010 from
approximately $305,000 for the three months ended March 31,
2009.  Salaries and wages increased by about $38,000 due to the hiring
of a new employee during the first quarter of fiscal 2010.  Stock
compensation expense increased by about $76,000 as a result of a higher level of
grant activity to employees, consultants, and directors.  Legal fees
increased by about $47,000 as a result of the retention of a law firm to assist
with legal matters related to the October 2009 financing, and also to assist
with legal matters relating to the conversion of a note payable to equity,
discussed previously. Investor relations expenses increased by $9,000, due to
increased IR-related activities performed by outside consultants.
 
 We
incurred interest expense of approximately $17,000 for the three months ended
March 31, 2010 compared to interest expense of about $108,000 for the three
months ended March 31, 2009.  The decrease in interest expense is
primarily the result of the conversion of a note payable to equity.
 
 During
the three months ended March 31, 2010, we incurred a benefit to the income
statement of approximately $7,817,000 related to non-cash financing charges and
the change in fair value of warrants.  As disclosed previously,
certain of the Company’s warrants to purchase common stock were deemed to be a
liability upon adoption of a new accounting pronouncement on October 1,
2009.  Subsequent changes to the fair value of these warrants have
been charged to the Statement of Operations and resulted in a net charge of
approximately $13,860,000 during the three months ended December 31,
2009.  Subsequent changes to the fair market value resulted in an
offsetting benefit on the income statement of about $7,817,000 for the three
month period ended March 31, 2010.  The warrant liability and
revaluations have not and will not have any impact on the Company’s working
capital, liquidity, or business operations.
 
 Six months ended March 31,
2010 versus six months ended March 31, 2009
 
 We had a
net loss of approximately $8,358,000 for the six months ended March 31, 2010,
versus a net loss of approximately $1,124,000 for the six months ended March 31,
2009.
 
 Research
and development (“R&D”) expenses increased by about $270,000, or 79%, to
approximately $610,000 for the six months ended March 31, 2010 from about
$340,000 for the six months ended March 31, 2009.  R&D expenses
were higher during the six months ended March 31, 2010 versus March 31, 2009 due
to an increase in research activities to support the Company’s ARS development
program and the retention of a consultant to assist in the writing of proposals
for government funding described in the discussion of three months
results.  For the six months ended March 31, 2010 consultant expenses
increased by about $195,000 due to costs associated with the
consultant.  Preclinical fees increased about $135,000 over the
comparable period in 2009 due to increased animal studies to support the
Company’s ARS development program.  The Company currently has seven
studies in progress: the study of its drug candidates as a potential
countermeasure against the effects of sulfur mustard gas on the lung and skin,
as a protestant against the effects of radiation on the lungs and on the
gastro-intestinal tract, as a countermeasure against the effects of chlorine
gas, as a potential treatment for epilepsy and for the potential treatment for
Parkinson’s disease.
  15
 
 General
and administrative (“G&A”) expenses increased approximately $275,000, or
47%, to approximately $862,000 for the six months ended March 31, 2010 from
about $587,000 for the six months ended March 31, 2009.  Salaries and
wages increased by about $63,000 due to the hiring of a new employee during the
first quarter of fiscal 2010.  Stock compensation expense increased by
about $199,000 as a result of a higher level of grant activity to employees,
consultants, and directors.  Legal fees increased by about $44,000 as
a result of the retention of a law firm to assist with legal matters related to
the October 2009 financing discussed previously, and also to assist with legal
matters related to the conversion of a note payable to equity, also discussed
previously. Investor relations expenses increased by approximately $32,000,
resulting from increased IR-related activities performed by outside
consultants.
 
 We
incurred interest expense of approximately $843,000 for the six months ended
March 31, 2010 compared to interest expense of about $208,000 for the six months
ended March 31, 2009.  The expense in the six month period ended March
31, 2010 reflects about $826,000 incurred in the first quarter of fiscal year
2010, mostly due to charges due to the conversion of the Senior Convertible
Notes on October 6, 2009.  In the second quarter of 2010, interest
expense dropped significantly principally due to the conversion of the
aforementioned note payable to equity (and the recognition of the related
non-legal fees in the first quarter).
 
 During
the six months ended March 31, 2010, we incurred a charge to the income
statement of approximately $6,043,000 related to non-cash financing charges and
the change in fair value of warrants.  As previously disclosed,
certain of the Company’s warrants to purchase common stock were deemed to be a
liability upon adoption of a new accounting pronouncement on October 1,
2009.  Subsequent changes to the fair value of these warrants have
been charged to the Statement of Operations and resulted in a net charge of
approximately $13,860,000 during the three months ended December 31,
2009.  Subsequent changes to the fair market value resulted in an
offsetting benefit on the income statement of approximately $7,817,000 for the
three-month period ended March 31, 2010.  The warrant liability and
revaluations have not and will not have any impact on the Company’s working
capital, liquidity, or business operations.
 
 Liquidity and Capital
Resources
 
 We do not
have any revenue and therefore we rely on investors, grants, collaborations and
licensing of our compounds to finance our operations. At March 31, 2010, we had
$1,272,000 of cash and cash equivalents, an increase of $626,000 from September
30, 2009. The increase in cash was primarily due to the October 2009 financing
which generated net proceeds of $1.6 million, which was offset by our loss from
operations of approximately $1,472,000 for the six months ended March 31,
2010.  We believe we have adequate financial resources to conduct
operations into the fourth quarter of fiscal year 2010, but in order to fund
on-going operating cash requirements beyond that point, or to further accelerate
or expand our programs, we need to raise significant additional
funds.
 
 We
incurred significant losses from operations of approximately $1,472,000 and
$2,003,000, and cash outflows from operations of $987,000 and $1,923,000, for
the six months ended March 31, 2010 and for the fiscal year ended September 30,
2009, respectively. Our ongoing future cash requirements will depend on numerous
factors, particularly the progress of our catalytic antioxidant program and
clinical trials and our ability to negotiate and complete collaborative
agreements or out-licensing arrangements. In order to help fund our on-going
operating cash requirements, we intend to seek new collaborations for our
antioxidant research program that include initial cash payments and on-going
research support. In addition, we might sell additional shares of our stock
and/or convertible debentures and explore other strategic and financial
alternatives, including a merger with another company, the sale of stock and/or
debt, the establishment of new collaborations for current research programs,
that include initial cash payments and ongoing research support and the
out-licensing of our compounds for development by a third party.
 
 There are
significant uncertainties as to our ability to access potential sources of
capital. We may not be able to enter into any collaboration on terms acceptable
to us, or at all, due to conditions in the pharmaceutical industry or in the
economy in general or based on the prospects of our catalytic antioxidant
program. Even if we are successful in obtaining collaboration for our
antioxidant program, we may have to relinquish rights to technologies, product
candidates or markets that we might otherwise develop ourselves. These same
risks apply to any attempt to out-license our compounds.
 
 Similarly,
due to market conditions, the illiquid nature of our stock and other possible
limitations on equity offerings, we may not be able to sell additional
securities or raise other funds on terms acceptable to us, if at all. Any
additional equity financing, if available, would likely result in substantial
dilution to existing stockholders.
 
 Our
forecast of the period of time through which our financial resources will be
adequate to support our operations is forward-looking information, and actual
results could vary.
  16
 
 Off-Balance Sheet
Arrangements
 
 We do not
have any off-balance sheet arrangements or other commitments or contracts that
have or are reasonably likely to have a current or future effect on our
financial condition, changes in financial condition, revenues or expenses,
results of operations, liquidity, capital expenditures or capital
resources.
 
 ITEM 3.
              Quantitative
      and Qualitative Disclosures About Market
  Risk.
 
 Our
exposure to market risk is presently limited to the interest rate sensitivity of
our cash and cash equivalents, which is affected by changes in the general level
of U.S. interest rates. However, we believe that we are not subject to any
material market risk exposure and do not expect that changes in interest rates
would have a material effect upon our financial position. A hypothetical 10%
change in interest rates would not have a material effect on our Statement of
Operations or Cash Flows for the six months ended March 31, 2010. We do not have
any foreign currency or other derivative financial instruments. Our debt bears
interest at a fixed rate.
 
 ITEM 4.
              Controls
      and Procedures.
 
 (a) 
As of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company’s
management, including the Company’s President and Chief Executive Officer (the
Company’s Principal Executive Officer) and Chief Financial Officer (the
Company’s Principal Financial and Accounting Officer), of the effectiveness of
the Company’s disclosure controls and procedures required by Exchange Act Rule
13a-15.  Based upon that evaluation, the Company’s Principal Executive
Officer and Principal Financial and Accounting Officer have concluded that the
Company’s disclosure controls and procedures were not effective as of March
31, 2010 to provide reasonable assurance that information required to be
disclosed by us in reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in SEC rules and forms because of the material weakness discussed
below.
 
 As a
result of the lack of segregation of duties, management has determined that a
material weakness in internal control over financial reporting related to the
segregation of duties existed as of March 31, 2010, and based on the
criteria set forth by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), concluded that the Company’s internal control over financial
reporting was not effective as of March 31, 2010.
 
 A
“material weakness,” as defined by the Public Company Accounting Oversight Board
(PCAOB) is a deficiency, or a combination of deficiencies, in internal control
over financial reporting, such that there is a reasonable possibility that a
material misstatement of the Company’s annual or interim financial statements
will not be prevented or detected on a timely basis.  This material
weakness has not resulted in an adjustment or misstatements to the financial
statements.
 
 To
address the material weakness, management has established mitigating controls to
minimize the potential for material misstatements in the financial
statements.  Management has determined that given the Company’s size,
level of operations and financial resources, it is not practicable for the
Company to eliminate the segregation of controls weakness and therefore
management has established mitigating controls to minimize the impact of the
lack of segregation of duties.
 
 (b) 
During the most recent fiscal quarter, there were no significant changes in the
Company’s internal control over financial reporting or in other factors that
materially affected or are reasonably likely to materially affect the Company’s
internal control over financial reporting, except that on January 15, 2010,
Michael P. McManus resigned as Chief Financial Officer of the
Company.  The Company has commenced a search for a new Chief Financial
Officer and, in the interim, John L. McManus serves as the principal financial
officer of Aeolus Pharmaceuticals, Inc.
 
 PART
II. - OTHER INFORMATION
 
 ITEM 1.
              Legal
      Proceedings.
 
 None.
 
 ITEM
      1A.
              Risk
      Factors.
 
 None.
 
 ITEM 2.
              Unregistered
      Sales of Equity Securities and Use of
  Proceeds.
 
 None.
 
 ITEM 3.
              Defaults
      Upon Senior Securities.
 
 None.
  17
 
 ITEM 4.
              Submission
      of Matters to a Vote of Security
Holders.
 
 None.
 
 ITEM 5.
              Other
      Information.
  None.
 
 ITEM 6.
              Exhibits
 
 Exhibit #
              
              Description31.1
              
              Certification
      of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).31.2
              
              Certification
      of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).32.1
              
              Certification
      by the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002.
 
 SIGNATURES
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
 
 AEOLUS
      PHARMACEUTICALS, INC.Date:     May
      14, 2010
                      By:
                      /s/ John L. McManusJohn
      L. McManusPresident
      and Chief Executive Officer(Principal
      Executive Officer)Chief
      Financial Officer, Treasurer and Secretary(Principal
      Financial and Accounting
Officer)
  18