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, 2009.





_____
            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 #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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).  YES [X] NO [ ]





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer or a small reporting company. See
definition of “large accelerated filer”, “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act (Check one):




Large
accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer
[   ]  Smaller reporting company [ 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
              April 30,
      2009Common
      Stock, par value $.01 per share
            
            37,467,855shares








AEOLUS
PHARMACEUTICALS, INC.


FORM
10-Q


For the
Quarter Ended March 31, 2009


Table of
Contents





PagePART
      I.                                FINANCIAL
      INFORMATIONItem 1.
                Financial
      StatementsStatement Regarding Financial
      Information
                3Condensed Consolidated Balance
      Sheets as ofMarch
      31, 2009
                  (unaudited)
      and September 30, 2008
                4Condensed Consolidated Statements
      of Operations for the ThreeMonthsand Six Months endedMarch 31, 2009and 2008(unaudited)
                5Condensed Consolidated Statements
      of Cash Flows for theSixMonths endedMarch 31, 2009and 2008(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
                16Item 4T.
                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
                19





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, 2008), 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, 2008, filed
with the SEC on December 12, 2008.














3





AEOLUS
      PHARMACEUTICALS, INC.CONDENSED
      CONSOLIDATED BALANCE SHEETS(In
      thousands, except shares and per share data)March
      31,
                                  
                                  September
      30,2009
                                  
                                  2008(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                  
                                  $
                                  1,433
                                  
                                  
                                  $
                                  399Prepaids
      and other current assets
                                  
                                  
                                  160
                                  
                                  
                                  
                                  156Total
      current assets
                                  
                                  
                                  1,593
                                  
                                  
                                  
                                  555Marketable
      investments (Note D)
                                  
                                  
                                  -
                                  
                                  
                                  
                                  440Other
      investments
                                  
                                  
                                  125
                                  
                                  
                                  
                                  125Total
      assets
                                  
                                  $
                                  1,718
                                  
                                  
                                  $
                                  1,120LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilities:Accounts
      payable
                                  
                                  $
                                  873
                                  
                                  
                                  $
                                  991Margin
      loan (Note E)
                                  
                                  
                                  -
                                  
                                  
                                  
                                  366Current
      maturity of long-term note payable (Note E)
                                  
                                  
                                  -
                                  
                                  
                                  
                                  534Total
      current liabilities
                                  
                                  
                                  873
                                  
                                  
                                  
                                  1,891Senior
      convertible notes to related parties, net (redemption value of
      $1,000,000
                                      and
      $625,000 as of March 31, 2009 and September 30, 2008, respectively (Note
      E))
                                  
                                  
                                  457
                                  
                                  
                                  
                                  266Long-term
      note payable (Note E)
                                  
                                  
                                  562
                                  
                                  
                                  
                                  -Total
      liabilities
                                  
                                  
                                  1,892
                                  
                                  
                                  
                                  2,157Commitments
      and contingences (Note H)Stockholders'
      deficit:Preferred
      stock, $.01 par value per share, 10,000,000 shares
      authorized:Series
      B nonredeemable convertible preferred stock, 600,000
      sharesauthorized;
      475,087 shares issued and outstanding at March 31,2009
      and September 30, 2008
                                  
                                  
                                  5
                                  
                                  
                                  
                                  5Common
      stock, $.01 par value per share, 200,000,000 shares
      authorized;37,467,855 shares issued and outstanding at March 31, 2009
      and31,952,749
      shares issued and outstanding at September 30, 2008
                                  
                                  
                                  375
                                  
                                  
                                  
                                  320Additional
      paid-in capital
                                  
                                  
                                  159,470
                                  
                                  
                                  
                                  157,573Unrealized
      losses on investments, available for sale
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (36
                                  )Accumulated
      deficit
                                  
                                  
                                  (160,024
                                  )
                                  
                                  
                                  (158,899
                                  )Total
      stockholders' deficit
                                  
                                  
                                  (174
                                  )
                                  
                                  
                                  (1,037
                                  )Total
      liabilities and stockholders' deficit
                                  
                                  $
                                  1,718
                                  
                                  
                                  $
                                  1,120The
      accompanying notes are an 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
      31,2009
                                  
                                  
                                  2008
                                  
                                  
                                  2009
                                  
                                  
                                  2008RevenueGrant
      income
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -Costs
      and expenses:Research
      and development
                                  
                                  
                                  214
                                  
                                  
                                  
                                  267
                                  
                                  
                                  
                                  340
                                  
                                  
                                  
                                  522General
      and administrative
                                  
                                  
                                  305
                                  
                                  
                                  
                                  382
                                  
                                  
                                  
                                  587
                                  
                                  
                                  
                                  777Total
      costs and expenses
                                  
                                  
                                  519
                                  
                                  
                                  
                                  649
                                  
                                  
                                  
                                  927
                                  
                                  
                                  
                                  1,299Loss
      from operations
                                  
                                  
                                  (519
                                  )
                                  
                                  
                                  (649
                                  )
                                  
                                  
                                  (927
                                  )
                                  
                                  
                                  (1,299
                                  )Interest
      income (expense), net
                                  
                                  
                                  (108
                                  )
                                  
                                  
                                  1
                                  
                                  
                                  
                                  (208
                                  )
                                  
                                  
                                  10Other
      (expense) income, net
                                  
                                  
                                  (38
                                  )
                                  
                                  
                                  (49
                                  )
                                  
                                  
                                  11
                                  
                                  
                                  
                                  (49
                                  )Net
      loss
                                  
                                  $
                                  (665
                                  )
                                  
                                  $
                                  (697
                                  )
                                  
                                  $
                                  (1,124
                                  )
                                  
                                  $
                                  (1,338
                                  )Net
      loss per weighted share attributable to common
    stockholders:Basic
                                  
                                  $
                                  (0.02
                                  )
                                  
                                  $
                                  (0.02
                                  )
                                  
                                  $
                                  (0.04
                                  )
                                  
                                  $
                                  (0.05
                                  )Diluted
                                  
                                  $
                                  (0.02
                                  )
                                  
                                  $
                                  (0.02
                                  )
                                  
                                  $
                                  (0.04
                                  )
                                  
                                  $
                                  (0.05
                                  )Weighted
      average common shares outstanding:Basic
                                  
                                  
                                  32,143
                                  
                                  
                                  
                                  31,952
                                  
                                  
                                  
                                  32,064
                                  
                                  
                                  
                                  31,952Diluted
                                  
                                  
                                  35,000
                                  
                                  
                                  
                                  31,952
                                  
                                  
                                  
                                  34,733
                                  
                                  
                                  
                                  31,952The
      accompanying notes are an 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
      31,2009
                            
                            
                            2008Cash
      flows from operating activities:Net
      loss
                            
                            $
                            (1,124
                            )
                            
                            $
                            (1,338
                            )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Noncash
      compensation
                            
                            
                            111
                            
                            
                            
                            236Change
      in fair value of trading securities
                            
                            
                            (49
                            )
                            
                            
                            -Noncash
      consulting expense
                            
                            
                            25
                            
                            
                            
                            -Noncash
      interest and financing costs
                            
                            
                            242
                            
                            
                            
                            25Other
      than temporary impairment charge
                            
                            
                            -
                            
                            
                            
                            49Change
      in assets and liabilities:Prepaids
      and other assets
                            
                            
                            (14
                            )
                            
                            
                            (34
                            )Accounts
      payable and accrued expenses
                            
                            
                            (118
                            )
                            
                            
                            36
                            )Net
      cash used in operating activities
                            
                            
                            (927
                            )
                            
                            
                            (1,026
                            )Cash
      flows from investing activities:Sales
      (purchases) of marketable securities
                            
                            
                            525
                            
                            
                            
                            (525
                            )Net
      cash provided by (used in) financing activities
                            
                            
                            525
                            
                            
                            
                            (525
                            )Cash
      flows from financing activities:Repayment
      of short term note payable
                            
                            
                            (368
                            )
                            
                            
                            -Proceeds
      from short term note payable
                            
                            
                            3
                            
                            
                            
                            230Proceeds
      from the issuance of common stock and warrants
                            
                            
                            1,500
                            
                            
                            
                            -Proceeds
      from issuance of Senior Convertible Notes
                            
                            
                            375
                            
                            
                            
                            -Costs
      related to the issuance of common stock and warrants
                            
                            
                            (74
                            )
                            
                            
                            -Net
      cash provided by financing activities
                            
                            
                            1,436
                            
                            
                            
                            230Net
      increase (decrease) in cash and cash equivalents
                            
                            
                            1,034
                            
                            
                            
                            (1,321
                            )Cash
      and cash equivalents at beginning of period
                            
                            
                            399
                            
                            
                            
                            1,727Cash
      and cash equivalents at end of period
                            
                            $
                            1,433
                            
                            
                            $
                            406The
      accompanying notes are integral part of these unaudited condensed
      consolidated financial
statements.


6


AEOLUS
PHARMACEUTICALS, INC.





NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





A.         Organization
and Business and Basis of Presentation





Aeolus
Pharmaceuticals, Inc. is biopharmaceutical company that is developing a new
class of catalytic antioxidant compounds for diseases and disorders of the
central nervous system, respiratory system, autoimmune system and
oncology.  The Company’s initial target indications are for the side
effects of mustard gas exposure, cancer radiation therapy and amyotrophic
lateral sclerosis, also known as “ALS” or “Lou Gehrig’s disease.”  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.  However, further development of AEOL 10150 for the treatment
of ALS and cancer radiation therapy, if any, will be dependent upon future
specific financing for this development or a partnership and the results of
our ongoing studies of AEOL 10150 for the treatment of mustard gas
exposure.





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, 2009, 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, 2008
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,
2008. 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 May 2008, the FASB issued FSP APB
14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash
upon Conversion (Including Partial Cash Settlement).” This FSP applies to
convertible debt instruments that may be settled in cash, or other assets, upon
conversion and are not addressed by APB Opinion No. 14 “Accounting for
Convertible Debt Instruments and Debt Issued with Stock Purchase Warrants.” If
the embedded conversion option is required to be separately accounted for as a
derivative, then such convertible debt instruments should be accounted for under
FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging
Activities” and this FSP does not apply .This FSP is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those fiscal years. Early adoption is prohibited. This
FSP is not expected to have a material impact on the Company’s financial
position, results of operations or liquidity.





In May 2008, the FASB issued Statement
No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” This
Statement identifies the sources of accounting principles and the framework for
selecting the principles used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles in the United States. This Statement is effective
60 days following the Securities and Exchange Commission’s approval of the
Public Company Accounting Oversight Board amendments to AU Section 411, “The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles.” The Board does not expect that this Statement will result in a
change in current practice. The adoption of this Statement is not expected to
have a material impact on the Company’s financial position, results of
operations or liquidity.





In June 2008, the FASB ratified EITF
Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is
Indexed to an Entity’s Own Stock” (“EITF 07-5”). Equity-linked instruments (or
embedded features) that otherwise meet the definition of a derivative as
outlined in SFAS No. 133, “Accounting for Derivative Instruments and Hedging
Activities” (“SFAS 133”), 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. EITF 07-5 provides guidance on how to
determine if equity-linked instruments (or embedded features) such as warrants
to purchase our stock and convertible notes are considered indexed to our stock.
The Company will adopt EITF 07-5, effective October 1, 2009, and apply its
provisions to outstanding instruments as of that date. The Company is evaluating
the effect of adoption of EITF 07-5.





7





B.         Liquidity





The
Company has incurred significant losses from operations of $927,000 and
$2,517,000, and cash outflows from operations of $927,000 and $1,813,000, for
the six months ended March 31, 2009 and for the fiscal year ended September 30,
2008, respectively. The Company expects to incur additional losses and negative
cash flow from operations during the remainder of fiscal year 2009 and for
several more years.





Management
believes the Company has adequate financial resources to conduct operations into
the first 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
first 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.








C.         Net Loss
Per Common Share





The
Company computes basic net 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 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 included
incremental shares issuable upon conversion of the Senior Convertible
Notes.  Diluted weighted average common shares excluded incremental
shares of approximately 34,438,000 as of March 31, 2009 issuable upon the
exercise or conversion of stock options to purchase common stock, convertible
preferred stock, convertible debt and warrants to purchase common stock. These
shares were excluded due to their antidilutive effect as a result of the
Company’s net losses. Diluted weighted average common shares excluded
incremental shares of approximately 18,437,000 as of March 31, 2008 issuable
upon the exercise or conversion of stock options to purchase common stock,
convertible preferred stock, convertible debt and warrants to purchase common
stock. These shares were excluded due to their antidilutive effect as a result
of the Company’s net losses.








D.           Investments





In fiscal
year 2008, the Company invested in auction-rate securities with a par value of
$525,000.  Liquidity for these securities has historically been
provided by an auction process that resets the applicable interest rate at
pre-determined intervals for up to 35 days.  In the past, the auction
process has generally allowed investors to obtain immediate liquidity if so
desired by selling the securities at their face amounts.  However,
disruptions in the credit markets adversely affected the auction market for
these types of securities.  From February 26, 2008 to January 2, 2009,
all auctions scheduled with respect to the Company’s auction-rate securities
failed to close.





In
October 2008, the Company entered into an agreement (the “UBS Agreement”)
with UBS Financial Services, Inc. (“UBS”) for which the Company received the
right (“Put Option”) to sell all four of the auction rate securities back to UBS
at par, at its sole discretion, anytime during the period from January 2, 2009
through January 4, 2011, and gave UBS the right to purchase these auction rate
securities or sell them on the Company’s behalf at par anytime after the
execution of the Agreement through January 4, 2011.  The Put Option is
not transferable, tradable or marginable, and will not be listed or quoted on
any securities exchange or any electronic communications
network.  Since the UBS Agreement is a legally enforceable firm
commitment, the Put Option was recognized as a financial asset at fair value in
the financial statements, and accounted for separately from the associated
securities as a noncurrent asset. Since we intended to and subsequently
exercised the Put Option on January 2, 2009, we did not have the intent to hold
the associated auction rate securities until recovery or maturity. Therefore, we
classified these securities as trading pursuant to Statement of Financial
Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in
Debt and Equity Securities” (“SFAS 115”).  SFAS 115 requires changes in the
fair value of these securities to be recorded in current period
earnings. As a result of this transfer, the Company recognized in the
Statement of Operations a change in market value of $65,000, reflecting a
reversal of the related temporary valuation allowance that was previously
recorded in other comprehensive loss.





8


Prior to
entering into the UBS Agreement, we recorded the auction rate securities as
investments available-for-sale.  We recorded unrealized gains and
losses on the available-for-sale debt securities in accumulated other
comprehensive income in the shareholders’ equity section of the balance
sheets.  Such an unrealized loss did not reduce net income for the
applicable accounting period.





The
Company elected to measure the Put Option under the fair value option of SFAS
No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”,
recorded income of approximately $114,000 and recorded a corresponding long term
investment during the first quarter of fiscal year 2009.




Following the reclassification of the
auction rate securities to trading, we recorded an additional charge to the
Statement of Operations of $16,000 to reduce the value of the auction rate
securities, offset by the gain on the Put Option of $16,000.




On
January 2, 2009, the Company exercised its rights under the Put Option and sold
its four auction rate securities for their par value of $525,000 to
UBS.








E.         Notes
Payable





Senior
Convertible Notes to Related Parties





On August
1, 2008, the Company entered into a Securities Purchase Agreement (the "SCN
Purchase Agreement") with two 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").





The Notes
issued in the Financing and the Subsequent Financings have an initial conversion
price of $0.35 per share, subject to adjustment pursuant to the
Notes.  In addition, the Investors have the option to purchase up to
an additional 4,000 Units, in one or more closings (each, an "Election
Closing"), and at their sole option at any time on or before December 31,
2013.  The additional Units sold at an Election Closing would also be
sold by the Company at a purchase price of $1,000 per Unit, except that the
initial conversion price of the Notes issued in an Election Closing will equal
the volume weighted average closing sale price for the Common Stock for the
sixty consecutive trading day period ending on the trading day immediately
preceding such Election Closing, provided that such initial conversion price may
not be less than $0.20 per share or greater than $0.75 per share, in each case
subject to adjustment pursuant to the Note.





The Notes
will be convertible, at the Investors' sole election, into shares of Common
Stock at any time and from time to time.  As of March 31, 2009, the
Notes would be convertible into 2,857,000 shares of Common Stock with a fair
value of $943,000.  The conversion price of the Notes (including the
$0.20 floor and $0.75 ceiling price with respect to Notes issued at Election
Closings) and the exercise price of the Warrants are subject to adjustment in
the event of a stock dividend or split, reorganization, recapitalization or
similar event.  Additionally, the exercise price of the Warrants may
be reduced in the event the Company issues securities at a price per share lower
than the then current exercise price of the Warrants.  The Notes are
due and payable in cash at the aggregate principal value plus accrued interest
30 months from the date of issuance if not converted earlier by the
Investors.





Interest
on the Notes accrues at the rate of 7.0% per annum from the date of issuance,
and is payable semi-annually, on January 31 and July 31 of each
year.  Interest shall be 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
Warrants are exercisable for a five year period from the date of issuance and
contain a "cashless exercise" feature that allows the Investors to exercise the
Warrants without a cash payment to the Company under certain
circumstances.





9


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 and are included in Prepaid and other current assets in the
Condensed Consolidated Balance Sheet.  The Debt Issuance Costs are
being amortized over the 30-month life of the Notes in the
Financing.





As of
March 31, 2009, the carrying value of the Notes was $457,000 and the redemption
value was $1,000,000.  In connection with the Financing and the
Subsequent Financings, the Company recorded a note discount in the amount of
$365,000 based on the relative fair value of the warrants issued in connection
with the Notes.  In addition, the Company determined that the Notes
contained an embedded beneficial conversion feature with a computed value of
$347,000 which was also recorded as a discount to the Notes.  The note
discounts are being amortized to interest expense over the thirty-month term of
the Notes.  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
maturity of the Notes may be accelerated upon the occurrence of an event of
default, which includes, subject to certain grace periods, exceptions and
qualifications as set forth in the Notes, the failure by the Company to maintain
the listing of the Common Stock, the failure of the Company to deliver shares
Common Stock in a timely manner following a conversion, the failure of the
Company to have reserved a sufficient number shares of Common Stock to issue
upon conversion of the Notes, the failure by the Company to make payments on the
Notes in a timely manner, payment defaults by the Company or any of its
significant subsidiaries on debt or other obligations in excess of $100,000, the
occurrence of certain bankruptcy events with respect to the Company or its
significant subsidiaries, judgments rendered against the Company or its
significant subsidiaries in excess of $100,000 and breaches of material
representations, warranties or covenants by the Company under the Amended
Purchase Agreement or the Notes. Upon the occurrence of an event of default
related to a bankruptcy of the Company, the Notes shall immediately become due
and payable.  Upon the occurrence of any event default other than a
bankruptcy event of default, any holder of the Notes, in its sole discretion,
may declare this Note to be immediately due and payable and the Company shall
pay to the holder in cash the sum of all outstanding principal multiplied by
115%, plus accrued and unpaid interest and late charges, if any,
thereon.  The Notes are unsubordinated obligations of the Company and
all payments due under the Notes rank pari passu with the Elan Note and shall
not be subordinated to any other Indebtedness of the Company.





The Notes
also provide that the Company shall not issue any equity securities other than
certain exempt securities as defined in the Notes, incur any indebtedness other
than certain exempt indebtedness as defined in the Notes, allow the incurrence
of any liens on its assets, repay any indebtedness other than the Notes, pay a
dividend on its common stock or make an investment other than ordinary investing
activities without the consent of the holders of Notes representing a majority
of the then-outstanding principal subject to the Notes.





Affiliates
of Xmark Opportunity Partners, LLC are 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 SCN
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 from
Elan Corporation, plc. (“Elan”) $638,000.  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.





10


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, 2009, the
outstanding balance, including interest, on the note payable to Elan was
$562,000.





Margin
Loan with UBS





During
fiscal year 2008, Aeolus entered into a secured credit agreement (the “Margin
Agreement”) with UBS and subsequently drew $367,000 under the Margin
Agreement.  The Margin Agreement bears interest at the per annum rate
of LIBOR plus 0.25 percent.  The Company repaid the loan in full on
January 2, 2009.








F.           Stockholders’
Deficit





Common
Stock





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.





In
connection with the March 2009 Financing, the Company also entered into a
Registration Rights Agreement (the “Rights Agreement”) with the March 2009
Investors.  Pursuant to the 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 and all shares of common stock issuable upon exercise
of the March 2009 Warrants (together with the Shares, 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 (2) Demand Registrations; provided, however, that the Company
is not obligated to effect more than one (1) Demand Registration within any
period of 12 consecutive months, 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 numbers 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.





Offering
costs of the private placement were $74,000 resulting in net proceeds to the
Company from the March 2009 Financing, after deducting for expenses, 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 are 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.





Warrants





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.





11


In
connection with the SCN Financing (Note E), 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.





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, 2009, warrants to purchase 29,381,525 shares of common stock were
outstanding. Details of the warrants for common stock outstanding at March 31,
2009 were as follows:





Number of Shares
                      
                      Exercise Price
                      
                      Expiration Date2,500,000
                      
                      
                      $    0.28
                      
                      November
      20102,186,668
                      
                      
                      $    0.28
                      
                      May
      201213,392,857
                      
                      
                      $    0.35
                      
                      March
      201450,000
                      
                      
                      $    0.50
                      
                      May
      20111,000,000
                      
                      
                      $    0.50
                      
                      August
      2013250,000
                      
                      
                      $    0.50
                      
                      September
      2013250,000
                      
                      
                      $    0.50
                      
                      October
      2013250,000
                      
                      
                      $    0.50
                      
                      November
      2013250,000
                      
                      
                      $    0.50
                      
                      December
      20137,000,000
                      
                      
                      $    0.75
                      
                      June
      201150,000
                      
                      
                      $    1.00
                      
                      May
      201150,000
                      
                      
                      $    1.50
                      
                      May
      201150,000
                      
                      
                      $    2.00
                      
                      May
      201150,000
                      
                      
                      $    2.50
                      
                      May
      2011410,400
                      
                      
                      $    2.50
                      
                      April
      20091,641,600
                      
                      
                      $    4.00
                      
                      April
      200929,381,525
                      
                      
                      $    0.69








G.         Stock-Based
Compensation





Below is
a summary of Aeolus stock option activity during the six-month period ended
March 31, 2009:





Shares
                  
                  Weighted
      Average Exercise Price
                  
                  Weighted
      Average Remaining Contractual Term
                  
                  Aggregate
      Intrinsic ValueOutstanding
      at September 30, 2008
                  4,235,281
                  
                  $
                  2.50
                  
                  6.7
      years
                  $
                  46Granted
                  284,000
                  
                  $
                  0.38Exercised
                  ---
                  
                  $
                  ---Forfeited
                  ---
                  
                  $
                  ---Outstanding
      at March 31, 2009 (unaudited)
                  4,519,281
                  
                  $
                  2.37
                  
                  6.4
      years
                  $
                  3Exercisable
      at March 31, 2009 (unaudited)
                  4,208,885
                  
                  $
                  2.52
                  
                  6.2
      years
                  $
                  2





For the
six months ended March 31, 2009 and 2008, 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.


12


The
details of stock options outstanding at March 31, 2009 were as
follows:





Options
      Outstanding
                          
                          Options
      ExercisableRange
      of Exercise Prices
                          
                          Number
      Outstanding at March 31, 2009
                          
                          Weighted
      Average Exercise Price
                          
                          Weighted
      Average Remaining Contractual Life
                          
                          Number
      Exercisable at March 31, 2009
                          
                          Weighted
      Average Exercise Price$0.29
      - 0.40
                          
                          659,000
                          
                          $
                          0.35
                          
                          9.4
      years
                          
                          348,604
                          
                          $
                          0.35$0.44
      - $0.60
                          
                          526,050
                          
                          $
                          0.55
                          
                          8.2
      years
                          
                          526,050
                          
                          $
                          0.55$0.68
      - $0.80
                          
                          464,161
                          
                          $
                          0.75
                          
                          7.3
      years
                          
                          464,161
                          
                          $
                          0.75$0.81
      - $0.90
                          
                          780,085
                          
                          $
                          0.88
                          
                          7.1
      years
                          
                          780,085
                          
                          $
                          0.88$0.91
      - $1.45
                          
                          224,500
                          
                          $
                          1.04
                          
                          7.1
      years
                          
                          224,500
                          
                          $
                          1.04$1.50
                          
                          1,256,015
                          
                          $
                          1.50
                          
                          4.3
      years
                          
                          1,256,015
                          
                          $
                          1.50$1.52
      - $12.85
                          
                          461,418
                          
                          $
                          4.24
                          
                          4.8
      years
                          
                          461,418
                          
                          $
                          4.24$14.50
      - $31.88
                          
                          99,253
                          
                          $
                          25.97
                          
                          1.6
      years
                          
                          99,253
                          
                          $
                          25.97$50.9375
                          
                          2,999
                          
                          $
                          50.94
                          
                          1.0
      years
                          
                          2,999
                          
                          $
                          50.94$51.25
                          
                          45,800
                          
                          $
                          51.25
                          
                          1.0
      years
                          
                          45,800
                          
                          $
                          51.25$0.29
      - $51.25
                          
                          4,519,281
                          
                          $
                          2.37
                          
                          6.4
      years
                          
                          4,208,885
                          
                          $
                          2.52





Stock-based
compensation expense recognized in the statement of operations is as follows (in
thousands):





For
      the six months
                  March
      31,2009
                
                
                2008Research
      and development expenses
                
                $
                23
                
                
                $
                36General
      and administrative expenses
                
                
                88
                
                
                
                200Total
      stock-based compensation expense
                
                $
                111
                
                
                $
                236




The total
deferred compensation expense for outstanding and unvested stock options was
$54,000 as of March 31, 2009.  The weighted average remaining
recognition period for the total deferred compensation expense is four months.
The fair value of the options associated with the above compensation expense for
the six months ended March 31, 2009 and 2008, 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 March 31,2009
                  
                  2008Dividend
      yield
                  
                  0%
                  
                  0%Expected
      volatility
                  
                  200%
      - 209%
                  
                  197%Risk-free
      interest rate
                  
                  2.6%
      - 3.8%
                  
                  3.8%
      - 4.6%Expected
      option life after shares are 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.





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.








13


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 trails 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, 2008. 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 series of catalytic antioxidant molecules to protect against the
damaging effects of reactive oxygen derived molecules, commonly referred to as
free radicals. Free radicals cause damage in a broad group of diseases and
conditions. Our initial target applications will be the use of our catalytic
antioxidants for the treatment of mustard gas exposure, cancer radiation therapy
and amyotrophic lateral sclerosis, also known as “ALS” or “Lou Gehrig’s
disease.”    However, further development of AEOL 10150 in
radiation therapy and ALS, if any, will be dependent upon future specific
financing for this development or a partnership and the results of our ongoing
studies of AEOL 10150 for the treatment of mustard gas exposure.  We
have reported positive safety results from two Phase I clinical trials of AEOL
10150 in patients diagnosed with ALS with no serious adverse events
noted.





We do not
have any revenue 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
first quarter of fiscal year 2010, but in order to fund on-going operating cash
requirements beyond the first 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.”





Results of
Operations





Three months ended March 31,
2009 versus three months ended March 31, 2008





We had a
net loss of $665,000 for the three months ended March 31, 2009 versus a net loss
of $697,000 for the three months ended March 31, 2008.





Research
and development (“R&D”) expenses decreased $53,000, or 20%, to $214,000 for
the three months ended March 31, 2009 from $267,000 for the three months ended
March 31, 2008.  The lower level of R&D expenses during the
current quarter is a result of a decline in manufacturing expenses offset by an
increase in outside development expenses.  During the three months
ended March 31, 2008, we were in the process of manufacturing small quantities
of our drug candidates to support our development program whereas during the
current quarter we had no manufacturing underway and were running only stability
studies on existing drug supplies resulting in a decrease of $74,000 in
manufacturing expenses. Offsetting this decline was an increase of $17,000 in
outside research expenses during the current quarter as we expanded our research
of AEOL 10150.





R&D
expenses for our antioxidant program have totaled $34,850,000 from inception
through March 31, 2009.  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.





14


General
and administrative (“G&A”) expenses decreased $77,000, or 20%, to $305,000
for the three months ended March 31, 2009 from $382,000 for the three months
ended March 31, 2008.  G&A expenses were lower during the three
months ended March 31, 2009 versus March 31, 2008 due to a decline in stock
based compensation expense, Board of Directors expense and legal
fees.   Stock compensation expense decreased by $28,000 as a
result of a lower valuation assigned to our stock option grants in the current
quarter when compared to the prior year quarter.  Board of Directors
expense decreased by $34,000 as the Board of Directors adopted a stock based
compensation plan in July 2008 whereas during the quarter ended March 31, 2008,
the Board of Directors received cash and stock based compensation. Legal
fees declined by $33,000 due to management’s continued efforts to reduce costs
by performing regulatory and compliance activities in-house.





We
incurred net interest expense of $108,000 for the three months ended March 31,
2009 compared to net interest income of $1,000 for the three months ended March
31, 2008.  The change reflects higher interest expense as a result of
the issuance of the Senior Convertible Notes which bear interest at a rate of 7%
as well as the related amortization of debt issuance costs and note issuance
discounts related to warrant issuances and beneficial conversion
features.  Interest expense also increased as a result of a higher
average balance of our note payable with Elan.  Interest income on our
investments also decreased due to a lower level of investable assets as well as
a lower level of interest rates during the current quarter.





During
the three months ended March 31, 2009 and as a result of our March 2009
Financing, we were 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 on March 30, 2009.  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 three months ended March 31, 2008, we recorded an “other-than-temporary”
impairment charge of $49,000 based upon reduced market values of our
auction-rate securities as determined based upon investment statements as of
March 31, 2008 received from UBS Financial Services, Inc.





Six months ended March 31,
2009 versus six months ended March 31, 2008





We had a
net loss of $1,124,000 for the six months ended March 31, 2009, versus a net
loss of $1,338,000 for the six months ended March 31, 2008.





R&D
expenses decreased $182,000, or 35%, to $340,000 for the six months ended March
31, 2009 from $522,000 for the six months ended March 31,
2008.   The lower level of R&D expenses during the current
period reflects a lower amount of manufacturing and outside development
expenses.  During the six months ended March 31, 2008, we were in the
process of manufacturing small quantities of our drug candidates to support our
development program whereas during the current year we had no manufacturing
underway and were only running stability studies on existing drug supplies
resulting in a decrease of $77,000 in manufacturing expenses.  Outside
research expenses also declined during the current period as more of the
Company’s research programs were funded by external grants during the current
six month period.  During the six months ended March 31, 2009, outside
research expenses were $98,000 compared to $212,000 during the six months ended
March 31, 2008.





G&A
expenses decreased $190,000, or 24%, to $587,000 for the six months ended March
31, 2009 from $777,000 for the six months ended March 31,
2008.  G&A expenses were lower during the six months ended March
31, 2009 versus the six months ended March 31, 2008 due to a decline in stock
based compensation expense, Board of Directors expense and legal fees offset by
an increase in consulting expenses.   Stock compensation expense
decreased by $112,000 as a result of a lower valuation assigned to our stock
option grants in the current period when compared to the prior year
period.  Board of Directors expense decreased by $68,000 as the Board
of Directors adopted a stock based compensation plan in July 2008 whereas during
the six months ended March 31, 2008, the Board of Directors received cash and
stock based compensation.  Legal fees declined by $54,000 due to
management’s continued efforts to reduce costs by performing regulatory and
compliance activities in-house.  Offsetting these declines was an
increase in consulting fees related to the engagement of a consultant to assist
the Company in strategic activities.





We
incurred net interest expense of $208,000 for the six months ended March 31,
2009 compared to net interest income of $10,000 for the six months ended March
31, 2008.  The change reflects higher interest expense as a result of
the issuance of our Senior Convertible Notes as well as the related amortization
of debt issuance costs and note issuance discounts.  Interest expense
also increased as a result of a higher average balance of our note payable with
Elan and interest on our margin loan with UBS Financial Services, Inc. which was
outstanding during the first quarter of fiscal year 2009.  Interest
income on our investments also decreased due to a lower level of investable
assets as well as a lower level of interest rates during the current year
period.





During
the three months ended March 31, 2009 as a result of our March 2009 Financing,
we were 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 on March 30, 2009.  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.


15


We
recorded a gain of $49,000 related to the net increase in the market value of
our trading securities during the six months ended March 31,
2009.  While during the six months ended March 31, 2008, we recorded
an “other-than-temporary” impairment charge of $49,000 based upon reduced market
values of our auction-rate securities.





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, 2009, we had
$1,433,000 of cash, an increase of $1,034,000 from September 30, 2008. The
increase in cash was primarily due to the March 2009 Financing and the SCN
Financing which generated net proceeds of $1.8 million offset by our $927,000
loss from operations for the six months ended March 31, 2009.  We
believe we have adequate financial resources to conduct operations into the
first 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 $927,000 and $2,517,000, and cash
outflows from operations of $927,000 and $1,813,000, for the six months ended
March 31, 2009 and for the fiscal year ended September 30, 2008, 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 explore other
strategic and financial alternatives, including a merger with another company,
the sale of stock, 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 a 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.





Off-Balance Sheet
Arrangements





We do not
have any off-balance sheet arrangements 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 three and six months ended March 31, 2009. We
do not have any foreign currency or other derivative financial instruments. Our
debt bears interest at a fixed rate.





16


ITEM
4T.                                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, 2009 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, 2009, and based on the
criteria set forth by 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, 2009.





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.





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.





The
following list sets forth information regarding all unregistered securities sold
by the registrant since December 31, 2008:





(1)           On
March 30, 2009, the registrant sold and issued to two accredited investors an
aggregate of 5,357,143 units, comprised of an aggregate of 5,357,143 shares of
Common Stock of the Company and warrants to purchase up to an aggregate of
13,392,857 additional shares of Common Stock, with an initial exercise price of
$0.35 per share, subject to adjustment to the warrant agreement, with each unit
representing one share of Common Stock and a warrant to purchase
two-and-one-half shares of Common Stock, at a purchase price of $0.28 per unit
for aggregate gross proceeds of $1,500,000.  This transaction was
exempt from registration under Section 4(2) of the Securities Act of 1933, as
amended.





(2)           On
January 31, 2009, the registrant issued to two accredited investors an
aggregate of 79,838 shares of its Common Stock for payment of interest in
accordance with the terms of the Senior Convertible Notes.  This
transaction was exempt from registration under Section 4(2) of the Securities
Act of 1933, as amended.





ITEM
3.                      Defaults
Upon Senior Securities.





None.


17


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





The Annual Meeting of Stockholders of
Aeolus Pharmaceuticals was held on March 26, 2009.  The following is a
brief description of each matter voted upon at the meeting and the number of
affirmative votes and the number of negative votes cast with respect to each
matter.





(a)
            The
      stockholders elected the following persons as directors of Aeolus
      Pharmaceuticals:  David C. Cavalier, John M. Farah, Jr., Joseph
      J. Krivulka, Amit Kumar, Michael E. Lewis, Chris A. Rallis and Peter D.
      Suzdak,  The votes for and against (withheld) each nominee were
      as follows:





Nominee
              
              Votes
                For
              
              Votes
                Withheld
              
              Votes
                AbstainedDavid
      C. Cavalier
              
              29,130,357
              
              72,769
              
              0John
      M. Farah, Jr., Ph.D.
              
              29,130,558
              
              72,568
              
              0Joseph
      J. Krivulka
              
              29,181,043
              
              22,083
              
              0Amit
      Kumar, Ph.D.
              
              29,130,093
              
              73,033
              
              0Michael
      E. Lewis, Ph.D.
              
              29,181,043
              
              22.083
              
              0Chris
      A. Rallis
              
              29,130,598
              
              72,528
              
              0Peter
      D. Suzdak, Ph.D.
              
              28,181.043
              
              22.083
              
              0





(b)
            The
      stockholders approved the amendment of the Company’s Amended and Restated
      Certificate of Incorporation to increase the authorized number of shares
      of Common Stock of Aeolus from 150,000,000 shares to 200,000,000 shares,
      with 29,058,765 shares voting for approval, 143,511 shares voting against
      and 850 shares abstained.





(c)
            The
      stockholders approved the appointment by the Audit Committee of the Board
      of Directors of Haskell & White LLP as the Company’s independent
      public accountants to audit the Company’s financial statements for fiscal
      2009, with 29,110,246 shares voting for approval, 91,011 shares voting
      against and 1,868 shares abstained.





ITEM
5.                      Other
Information.




None.





ITEM
6.                      Exhibits





Exhibit
      #
                  
                  Description4.1
                  
                  Registration
      Rights Agreement dated March 30, 2009 by and among the Company and the
      investors whose names appear on the signature pages thereof (incorporated
      by reference to Exhibit 4.1 to the Company's Form 8-K dated March 30,
      2009).10.1
                  
                  Securities
      Purchase Agreement dated March 30, 2009 by and among the Company and the
      investors whose names appear on the signature pages thereof (incorporated
      by reference to Exhibit 10.1 to the Company's Form 8-K dated March 30,
      2009).10.2
                  
                  Form
      of Warrant to Purchase Common Stock (incorporated by reference to Exhibit
      10.2 to the Company's Form 8-K dated March 30,
  2009).10.3
                  
                  Amendment
      No. 2 dated March 30, 2009 to the Securities Purchase Agreement dated
      August 1, 2008, as amended by Amendment No. 1 thereto, dated August 4,
      2008, by and among the Company and the investors whose names appear on the
      signature pages thereof (incorporated by reference to Exhibit 10.3 to the
      Company's Form 8-K dated March 30, 2009).10.4
                  
                  Amendment
      No. 1 To Convertible Promissory Note dated February 7, 2009 by and between
      Aeolus Pharmaceuticals, Inc. and Elan Pharma International Limited
      (incorporated by reference to Exhibit 10.1 to the Company's Form 8-K dated
      February 7, 2009).31.1
                  
                  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.





18


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 1,
2009
              By:
              /s/
      John L. McManusJohn
      L. McManus
                President
      and Chief Executive Officer
                (Principal
      Executive Officer)Date:                         May 1,
2009
              By:
              /s/
      Michael P. McManusMichael
      P. McManus
                Chief
      Financial Officer, Treasurer and Secretary
                (Principal
      Financial and Accounting
Officer)