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
December 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, Suite 150
              Mission
      Viejo, California
            
            92691(Address
      of Principal Executive Offices)
            
            (Zip Code)(Registrant’s
      Telephone Number, Including Area Code)
              949-481-9825







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





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




Large
accelerated filer  ̈
Accelerated filer  ̈
Non-accelerated filer x




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





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





Class
            Outstanding
      as of
              February
      19,
      2010Common
      Stock, par value $.01 per share
            48,224,320shares











AEOLUS
PHARMACEUTICALS, INC.


FORM
10-Q


For the
Quarter Ended December 31, 2009


Table of
Contents





PagePART
      I.                 FINANCIAL
      INFORMATIONItem 1.
                      Financial
      Statements
                      3Statement Regarding Financial
      Information
                      3Condensed Consolidated Balance
      Sheets as ofDecember 31, 2009
                        (unaudited)
      and September 30, 2009
                      4Condensed Consolidated Statements
      of Operations for the ThreeMonthsendedDecember 31, 2009and 2008(unaudited)
                      5Condensed Consolidated Statements
      of Cash Flows for theThreeMonths endedDecember 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 4.
                      Controls and
      Procedures
                      16PART
      II.                 OTHER
      INFORMATIONItem 1.
                      Legal
      Proceedings
                      16Item 1A.
                      Risk
    Factors
                      16Item 2.
                      Unregistered Sales of Equity
      Securities and Use of Proceeds
                      16Item 3.
                      Defaults
      Upon Senior Securities
                      16Item 4.
                      Submission of Matters to a Vote
      of Security Holders
                      17Item
    5.
                      Other
      Information
                      17Item 6.
                      Exhibits
                      17SIGNATURES
                      17




2





AEOLUS
PHARMACEUTICALS, INC.





PART
I - FINANCIAL INFORMATION





ITEM
1.                Financial
Statements.





Statement
Regarding Financial Information





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


3




AEOLUS
PHARMACEUTICALS, INC.
 
 CONDENSED
CONSOLIDATED BALANCE SHEETS
 (In
thousands, except shares and per share data)




December
      31,
                                        
                                        
                                        September 30,2009
                                        
                                        
                                        2009(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                        
                                        $
                                        1,870
                                        
                                        
                                        $
                                        646Prepaid
      and other current assets
                                        
                                        
                                        28
                                        
                                        
                                        
                                        133Total
      current assets
                                        
                                        
                                        1,898
                                        
                                        
                                        
                                        779Investment
      in CPEC LLC
                                        
                                        
                                        32
                                        
                                        
                                        
                                        32Total
      assets
                                        
                                        $
                                        1,930
                                        
                                        
                                        $
                                        811LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilities:Accounts
      payable
                                        
                                        $
                                        307
                                        
                                        
                                        $
                                        774Total
      current liabilities
                                        
                                        
                                        307
                                        
                                        
                                        
                                        774Warrant
      liability (Note D)
                                        
                                        
                                        18,669
                                        
                                        
                                        
                                        —Senior
      convertible notes to related parties, net (redemption value of zero
      and $1,000,000 as of December 31, 2009 and September 30, 2009,
      respectively (Note E))
                                        
                                        
                                        —
                                        
                                        
                                        
                                        600Long-term
      note payable
                                        
                                        
                                        610
                                        
                                        
                                        
                                        594Total
      liabilities
                                        
                                        
                                        19,586
                                        
                                        
                                        
                                        1,968Commitments
      and contingences (Note B and H)Stockholders'
      equity (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 December
31,2009
      and September 30, 2009
                                        
                                        
                                        5
                                        
                                        
                                        
                                        5Common
      stock, $.01 par value per share, 200,000,000 shares
      authorized;48,224,320
      shares issued and outstanding at December 31, 2009
    and37,563,392
      shares issued and outstanding at September 30, 2009
                                        
                                        
                                        482
                                        
                                        
                                        
                                        376Additional
      paid-in capital
                                        
                                        
                                        153,975
                                        
                                        
                                        
                                        159,657Accumulated
      deficit
                                        
                                        
                                        (172,118
                                        )
                                        
                                        
                                        (161,195
                                        )Total
      stockholders' deficit
                                        
                                        
                                        (17,656
                                        )
                                        
                                        
                                        (1,157
                                        )Total
      liabilities and stockholders' deficit
                                        
                                        $
                                        1,930
                                        
                                        
                                        $
                                        811




The
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 EndedDecember 31,2009
                
                
                2008RevenueGrant
      income
                
                $
                -
                
                
                $
                -Costs
      and expenses:Research
      and development
                
                
                184
                
                
                
                125General
      and administrative
                
                
                406
                
                
                
                283Total
      costs and expenses
                
                
                590
                
                
                
                408Loss
      from operations
                
                
                (590
                )
                
                
                (408
                )Change
      in fair value of trading securities, net
                
                
                -
                
                
                
                49Non-cash
      financing charges and change in fair value of warrants  (Notes
      D, E and F)
                
                
                (13,860
                )
                
                
                -Interest
      expense, net
                
                
                (826
                )
                
                
                (100
                )Net
      loss
                
                $
                (15,276
                )
                
                $
                (459
                )Net
      loss per weighted share attributable to common
    stockholders:Basic
                
                $
                (0.33
                )
                
                $
                (0.01
                )Diluted
                
                $
                (0.33
                )
                
                $
                (0.02
                )Weighted
      average common shares outstanding:Basic
                
                
                46,527
                
                
                
                31,988Diluted
                
                
                46,527
                
                
                
                34,472





The
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)Three
      Months EndedDecember 31,2009
                                          
                                          
                                          2008Cash
      flows from operating activities:Net
      loss
                                          
                                          $
                                          (15,276
                                          )
                                          
                                          $
                                          (459
                                          )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Noncash
      compensation
                                          
                                          
                                          190
                                          
                                          
                                          
                                          65Change
      in fair value of trading securities
                                          
                                          
                                          —
                                          
                                          
                                          
                                          (49
                                          )Change
      in fair value of warrants
                                          
                                          
                                          7,646
                                          
                                          
                                          
                                          —Noncash
      consulting expense
                                          
                                          
                                          14
                                          
                                          
                                          
                                          25Noncash
      interest and warrant costs
                                          
                                          
                                          6,986
                                          
                                          
                                          
                                          100Change
      in assets and liabilities:Prepaid
      and other assets
                                          
                                          
                                          105
                                          
                                          
                                          
                                          34Accounts
      payable and accrued expenses
                                          
                                          
                                          (54
                                          )
                                          
                                          
                                          (322
                                          )Net
      cash used in operating activities
                                          
                                          
                                          (389
                                          )
                                          
                                          
                                          (606
                                          )Cash
      flows from financing activities:Draws
      on UBS margin loan
                                          
                                          
                                          —
                                          
                                          
                                          
                                          3Payments
      on UBS margin loan
                                          
                                          
                                          —
                                          
                                          
                                          
                                          (2
                                          )Proceeds
      from issuance of common stock and warrants
                                          
                                          
                                          1,650
                                          
                                          
                                          
                                          —Costs
      related to the issuance of common stock and warrants
                                          
                                          
                                          (54
                                          )
                                          
                                          
                                          —Proceeds
      from exercise of warrants
                                          
                                          
                                          17
                                          
                                          
                                          
                                          —Proceeds
      from issuance of Senior Convertible Notes
                                          
                                          
                                          —
                                          
                                          
                                          
                                          375Net
      cash provided by financing activities
                                          
                                          
                                          1,613
                                          
                                          
                                          
                                          376Net
      increase (decrease) in cash and cash equivalents
                                          
                                          
                                          1,224
                                          
                                          
                                          
                                          (230
                                          )Cash
      and cash equivalents at beginning of period
                                          
                                          
                                          646
                                          
                                          
                                          
                                          399Cash
      and cash equivalents at end of period
                                          
                                          $
                                          1,870
                                          
                                          
                                          $
                                          169Supplemental
      disclosure of cash flow information:Cash
      payments of interest
                                          
                                          $
                                          —
                                          
                                          
                                          $
                                          2Supplemental
      disclosure of non-cash investing and financing
      activities:Common
      stock issued for payment of accounts payable
                                          
                                          $
                                          413
                                          
                                          
                                          $
                                          —Common
      stock issued upon conversion of Senior Convertible
    Notes
                                          
                                          $
                                          1,000,000
                                          
                                          
                                          $
                                          —Common
      stock issued for payment of interest on Senior Convertible
      Notes
                                          
                                          $
                                          13
                                          
                                          
                                          $
                                          2





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





The
“Company” or “Aeolus” refers collectively to Aeolus Pharmaceuticals, Inc., a
Delaware corporation (“Aeolus”), and its wholly owned subsidiary, Aeolus
Sciences, Inc., a Delaware corporation. As of December 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, 2009
was derived from the Company’s audited financial statements included in the
Company’s Annual Report on Form 10-K for the fiscal year ended September 30,
2009. The unaudited condensed consolidated financial statements included herein
should be read in conjunction with the audited consolidated financial statements
and the notes thereto included in that Annual Report on Form 10-K and in the
Company’s other SEC filings. Results for the interim period are not necessarily
indicative of the results for any other period.





New
Accounting Pronouncements





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





B.         Liquidity





The
Company has incurred significant losses from operations of $590,000 and
$2,003,000, and cash outflows from operations of $389,000 and $1,923,000, for
the three months ended December 31, 2009 and for the fiscal year ended September
30, 2009, respectively. The Company expects to incur additional losses and
negative cash flow from operations during the remainder of fiscal year 2010 and
for several more years.





Management
believes the Company has adequate financial resources to conduct operations into
the third 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
third quarter of fiscal year 2010, it will need to eliminate some or all of its
activities, merge with another company, sell some or all of its assets to
another company, or cease operations entirely. There can be no assurance that
the Company will be able to obtain additional financing on favorable terms or at
all, or that the Company will be able to merge with another Company or sell any
or all of its assets.


7





C.         Net 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 excluded
incremental shares of approximately 60,223,000 as of December 31, 2009 issuable
upon the exercise or conversion of convertible debt, stock options to purchase
common stock, convertible preferred stock and warrants to purchase common stock.
These shares were excluded due to their antidilutive effect as a result of the
Company’s net losses. Diluted weighted average common shares included
incremental shares issuable upon conversion of the Senior Convertible Notes but
excluded incremental shares of approximately 20,954,000 as of December 31, 2008
issuable upon the exercise or conversion of convertible debt, stock options to
purchase common stock, convertible preferred stock and warrants to purchase
common stock. These shares were excluded due to their antidilutive effect as a
result of the Company’s net losses.





D.           Warrant
Liability





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





Future
increases or decreases in fair value of the warrants will be included as a
component of other income in the accompanying statement of operations for the
respective period.  As of December 31, 2009, the liability for
warrants increased to $18,669,000 resulting in an additional charge to the
statement of operations of $7,646,000.  The warrant liability and
revaluations have not and will not have any impact on the Company’s working
capital, liquidity, or business operations.





E.         Note
Payable





Senior
Convertible Notes to Related Parties





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





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





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





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





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


8





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





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





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





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





Elan
Note Payable





In August
2002, Aeolus borrowed 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.





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 December 31, 2009, the outstanding balance, including interest, on
the note payable to Elan was $610,000.


9





F.           Stockholders’
Equity





On
October 6, 2009, the Company entered into the October 2009 Purchase Agreement
with several accredited institutional investors  (the "October 2009
Investors") pursuant to which the Company sold and issued to the October 2009
Investors in a private placement an aggregate of 5,892,857 units (the “Units”),
comprised of an aggregate of 5,892,857 shares of Common Stock (the “Shares”) and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
Common Stock (the “October 2009 Warrants”), with an initial exercise price of
$0.28 per share, subject to adjustment pursuant to the October 2009 Warrants,
with each Unit representing one share of Common Stock and a October 2009 Warrant
to purchase two shares of Common Stock, at a purchase price of $0.28 per Unit
for aggregate gross proceeds of $1,650,000 (collectively, the “October 2009
Financing”).  The October 2009 Warrants are exercisable for a seven
year period from their date of issuance; contain a “cashless exercise” feature
that allows the holder to exercise the October 2009 Warrants without a cash
payment to the Company under certain circumstances; contain a dividend
participation right which allows the holder to receive any cash dividends paid
on the Common Stock without exercising the October 2009 Warrant and contain a
provision that provides for the reduction of the exercise price to $0.01 in the
event of any such payment of cash dividends by the Company or upon a change of
control and contain anti-dilution provisions in the event of a stock dividend or
split, dividend payment or other issuance, reorganization, recapitalization or
similar event.





The
Company also granted to the October 2009 Investors the option to acquire,
collectively, up to an additional 5,892,857 additional Units (the “Additional
Units”), comprised of an aggregate of 5,892,857 shares of Common Stock and
warrants to purchase up to an aggregate of 11,785,714 additional shares of
common stock at the per Additional Unit purchase price of $0.28 (the “Call
Option”). In addition, the October 2009 Investors granted to the Company the
option to require these October 2009 Investors, severally and not jointly, to
acquire up to 5,892,857 Additional Units, less any Additional Units acquired
under the Call Option, at the per Additional Unit purchase price of $0.28 (the
“Put Option”).  The Call Option is exercisable at any time, and from
time to time, on or prior to June 30, 2010.  The Put Option is
exercisable at any time from June 30, 2010 to July 30, 2010.  However,
the Investors shall have the right to terminate the Put Option if they
reasonably determine that a material adverse event, condition or circumstance
has occurred with respect to the prospects of the Company’s AEOL 10150 drug
candidate for acute radiation syndrome; provided that the Company’s failure to
receive a grant or financing shall not, by itself, constitute a material adverse
event, condition or circumstance with respect thereto.





In
addition, the October 2009 Investors agreed to convert all $1,000,000 of the
Company’s Senior Convertible Notes issued in 2008 (the “Notes”) into Common
Stock at a conversion rate of $0.35 per share (the “Conversion Shares”), which
was subsequently lowered to $0.28 as discussed below and to exchange their
remaining option to purchase an additional $4,000,000 in Senior Convertible
Notes for warrants to purchase up to 14,285,714 shares of Common Stock in
substantially the same of form and terms of the October 2009 Warrants issued in
the October 2009 Financing, including an initial exercise price of $0.28 per
share, subject to adjustment pursuant to the warrants (the “Note
Warrants”).  As consideration for the October 2009 Investors to
convert the Notes, the Company agreed to exchange warrants to purchase up to
2,000,000 shares of Common Stock issued to the October 2009 Investors in
connection with the sale of the Notes, warrants to purchase up to 2,150,000
shares of Common Stock issued to the October 2009 Investors and one of their
affiliates in connection with a financing completed in November 2005 and
warrants to purchase up to 13,392,857 shares of Common Stock issued to the
October 2009 Investors in connection with a financing completed in March 2009
(collectively, the “Prior Warrants”) for warrants to purchase up to 17,542,857
shares of Common Stock in substantially the same form and terms of the October
2009 Warrants issued in the October 2009 Financing, including an initial
exercise price of $0.28 per share, subject to adjustment pursuant to the
warrants (the “Exchange Warrants”) (collectively, the
“Conversion”).





In
connection with the October 2009 Financing and the Conversion, the Company also
entered into a Registration Rights Agreement (the “October 2009 Rights
Agreement”) with the Investors.  In addition, the Investors agreed to
terminate the Company’s Registration Rights Agreements dated November 21, 2005
and March 30, 2009.  Pursuant to the October 2009 Rights Agreement,
the Company agreed to file one or more registration statements (collectively,
the “Registration Statements”) with the Securities and Exchange Commission (the
“SEC”) covering the resale of the Shares, the Conversion Shares and all shares
of common stock issuable upon exercise of the Warrants, the Note Warrants and
the Exchange Warrants (collectively, the “Registrable Securities”) upon demand
of the holders of a majority of the Registrable Securities (a “Demand
Registration”).  Such holders have the right to two Demand
Registrations, subject to certain exceptions.  In the event the
holders exercise their right to a Demand Registration, the Company has agreed to
file a Registration Statement to register the resale of the Registrable
Securities within a certain number of days after the request and to use
commercially reasonable efforts to cause the Registration Statement to be
declared effective by the SEC as soon as practicable after the filing
thereof.  The Company also agreed to use its commercially reasonable
efforts to keep the Registration Statements effective for a specified
period.





The net
proceeds to the Company from the October 2009 Financing, after deducting for
expenses, were approximately $1.6 million. The Company intends to use the net
proceeds from the Financing to finance animal efficacy studies in Acute
Radiation Syndrome, the development of AEOL 10150 and ongoing operations of the
Company.





The fair
value of the October 2009 Warrants, the Note Warrants and the Exchange Warrants
was estimated to be $10,585,000 using the Black-Scholes option pricing model
with the following assumptions: dividend yield of 0%; expected volatility of
93%; risk free interest rate of 2.9%; and an expected life of seven
years.   The fair value of the Prior Warrants cancelled on
October 6, 2009 was $3,352,000.   The proceeds from the October
2009 Financing were allocated based upon the relative fair values of the October
2009 Warrants and the Shares.  Due to the anti-dilution provisions of
the October 2009 Warrants, the Note Warrants and the Exchange Warrants, these
warrants were deemed to be a liability under current accounting guidance and as
a result the warrant liability was increased by $7,233,000 of which $6,213,000
was recorded as a charge to the Statement of Operations and $1,020,000 of
proceeds from the October 2009 Financing was allocated to the value of the
October 2009 Warrants.


10




Affiliates
of Xmark Opportunity Partners, LLC are the sole investors in the Financing and,
together with the Company, are the sole participants in the Conversion. Together
with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 71% of the Company's outstanding common stock prior to the
Financing and the Conversion.  Xmark Opportunity Partners, LLC is the
sole manager of Goodnow Capital, L.L.C. and possesses sole power to vote and
direct the disposition of all securities of the Company held by Goodnow. Goodnow
has the right to designate up to two directors for election to the Company's
Board of Directors pursuant to the terms of a purchase agreement between Goodnow
and the Company. David C. Cavalier, a current director of the Company, is
President of Goodnow.





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





On March
30, 2009, Aeolus entered into a Securities Purchase Agreement (the "Purchase
Agreement") with two accredited institutional investors  (the "March
2009 Investors") pursuant to which the Company sold and issued to the March 2009
Investors in a private placement an aggregate of 5,357,143 units (the “March
2009 Units”), comprised of an aggregate of 5,357,143 shares of Common Stock of
the Company (the “Shares”) and warrants to purchase up to an aggregate of
13,392,857 additional shares of Common Stock (the “March 2009 Warrants”), with
an initial exercise price of $0.35 per share, subject to adjustment pursuant to
the March 2009 Warrants, with each March 2009 Unit representing one share of
Common Stock and a March 2009 Warrant to purchase two-and-one-half shares of
Common Stock, at a purchase price of $0.28 per March 2009 Unit for aggregate
gross proceeds of $1,500,000 (collectively, the “March 2009
Financing”).  The March 2009 Warrants are exercisable for a five year
period from their date of issuance; contain a “cashless exercise” feature that
allows the holder to exercise the March 2009 Warrants without a cash payment to
the Company under certain circumstances; contain a dividend participation right
which allows the holder to receive any cash dividends paid on the Common Stock
without exercising the March 2009 Warrant and contain a provision that provides
for the reduction of the exercise price to $0.01 in the event of any such
payment of cash dividends by the Company; and contain standard anti-dilution
provisions that provide for the adjustment of the exercise price and the number
of shares of common stock that can be purchased in the event of a financing at a
price per share below the exercise price, a stock dividend or split, dividend
payment or other issuance, reorganization, recapitalization or similar
event.





The fair
value of the March 2009 Warrants was estimated to be $4,129,000 using the
Black-Scholes option pricing model with the following assumptions: dividend
yield of 0%; risk free interest rate of 1.7%; expected volatility of 164%; and
an expected life of five years.





Offering
costs of the March 2009 Financing were $91,000 resulting in net proceeds to the
Company of approximately $1.4 million. The Company intends to use the net
proceeds from the March 2009 Financing to finance the development of AEOL 10150
and to fund ongoing operations of the Company.





Affiliates
of Xmark Opportunity Partners, LLC were the sole investors in the Financing.
Together with its affiliates, Xmark Opportunity Partners, LLC beneficially owned
approximately 57% of the Company's outstanding common stock prior to the March
2009 Financing.





As a
result of the March 2009 Financing, the Company was required to lower the
exercise price of 4,687,000 warrants previously issued in November 2005 and May
2007 to $0.28 per share, the purchase price of the March 2009 Units issued in
the March 2009 Financing.   As a result of the change in the
exercise price, these warrants were revalued resulting in an increase in the
value of $38,000 which was charged to the statement of operations during the
second quarter of fiscal year 2009.





In
connection with the SCN Financing (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.


11





In
addition, as a result of the SCN Financing, the Company was required to lower
the exercise price of 4,687,000 warrants previously issued in the November 2005
Financing and in the 2007 Financing to $0.35 per share, the conversion price of
the Notes issued in the SCN Financing.   As a result of the
change in the exercise price, these warrants were revalued resulting in an
increase in the value of $118,000 which was charged to the statement of
operations during the fourth quarter of fiscal year 2008.





As of
December 31, 2009, warrants to purchase 53,390,953 shares of common stock were
outstanding. Details of the warrants for common stock outstanding at December
31, 2009 were as follows:





Number of Shares
                          
                          Exercise Price
                          
                          Expiration Date350,000
                          
                          $
                          0.28
                          
                          November
      20102,126,668
                          
                          $
                          0.28
                          
                          May
      201243,614,285
                          
                          $
                          0.28
                          
                          October
      201650,000
                          
                          $
                          0.35
                          
                          May
      201120,000
                          
                          $
                          0.39
                          
                          September
      201415,000
                          
                          $
                          0.50
                          
                          September
      201415,000
                          
                          $
                          0.60
                          
                          September
      20147,000,000
                          
                          $
                          0.75
                          
                          June
      201150,000
                          
                          $
                          1.00
                          
                          May
      201150,000
                          
                          $
                          1.50
                          
                          May
      201150,000
                          
                          $
                          2.00
                          
                          May
      201150,000
                          
                          $
                          2.50
                          
                          May
      201153,390,953
                          
                          $
                          0.35





As
discussed in Note D, the Warrants expiring in November 2010, May 2012 and
October 2016 are deemed to be liabilities and as such are carried at their fair
value as a liability on the Balance Sheet.





G.         Stock-Based
Compensation





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





Shares
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
      Price
                                      
                                      Weighted
      Average
                                        Remaining
                                        Contractual
      Term
                                      
                                      Aggregate
                                        Intrinsic
                                        ValueOutstanding
      at September 30, 2009
                                      
                                      
                                      6,175,015
                                      
                                      
                                      $
                                      1.58
                                      
                                      7.0
      years
                                      
                                      $
                                      138Granted
                                      
                                      
                                      113,750
                                      
                                      
                                      $
                                      0.33
                                      
                                      
                                      
                                      
                                      17Exercised
                                      
                                      
                                      —
                                      
                                      
                                      $
                                      —Forfeited
                                      
                                      
                                      —
                                      
                                      
                                      $
                                      —Outstanding
      at December 31, 2009 (unaudited)
                                      
                                      
                                      6,288,765
                                      
                                      
                                      $
                                      1.56
                                      
                                      6.8
      years
                                      
                                      $
                                      370Exercisable
      at December 31, 2009 (unaudited)
                                      
                                      
                                      5,373,458
                                      
                                      
                                      $
                                      1.77
                                      
                                      6.3
      years
                                      
                                      $
                                      233





For the
three months ended December 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 December 31, 2009 were as
follows:





Options
      Outstanding
                                        
                                        Options
      ExercisableRange
      of
                                          Exercise
      Prices
                                        
                                        Number
                                          Outstanding
                                          at
      December
                                          31,
      2009
                                        
                                        
                                        Weighted
                                          Average
                                          Exercise
      Price
                                        
                                        Weighted
                                          Average
                                          Remaining
                                          Contractual
                                          Life
                                        
                                        Number
                                          Exercisable
      at
                                          December
      31,
                                          2009
                                        
                                        
                                        Weighted
                                          Average
                                          Exercise
      Price$0.29
      - 0.32
                                        
                                        
                                        1,526,250
                                        
                                        
                                        $
                                        0.30
                                        
                                        9.2
      years
                                        
                                        
                                        982,708
                                        
                                        
                                        $
                                        0.31$0.33
      - $0.45
                                        
                                        
                                        1,057,250
                                        
                                        
                                        $
                                        0.39
                                        
                                        9.2
      years
                                        
                                        
                                        685,485
                                        
                                        
                                        $
                                        0.39$0.55
      - $0.75
                                        
                                        
                                        771,861
                                        
                                        
                                        $
                                        0.65
                                        
                                        6.9
      years
                                        
                                        
                                        771,861
                                        
                                        
                                        $
                                        0.65$0.78
      - $0.90
                                        
                                        
                                        889,335
                                        
                                        
                                        $
                                        0.87
                                        
                                        6.4
      years
                                        
                                        
                                        889,335
                                        
                                        
                                        $
                                        0.87$0.91
      - $1.45
                                        
                                        
                                        223,500
                                        
                                        
                                        $
                                        1.04
                                        
                                        6.3
      years
                                        
                                        
                                        223,500
                                        
                                        
                                        $
                                        1.04$1.50
                                        
                                        
                                        1,256,019
                                        
                                        
                                        $
                                        1.50
                                        
                                        3.6
      years
                                        
                                        
                                        1,256,019
                                        
                                        
                                        $
                                        1.50$1.52
      - $1.85
                                        
                                        
                                        211,250
                                        
                                        
                                        $
                                        1.84
                                        
                                        4.7
      years
                                        
                                        
                                        211,250
                                        
                                        
                                        $
                                        1.84$2.10
      - $8.125
                                        
                                        
                                        173,018
                                        
                                        
                                        $
                                        4.20
                                        
                                        4.0
      years
                                        
                                        
                                        173,018
                                        
                                        
                                        $
                                        4.20$11.50
      - $19.375
                                        
                                        
                                        90,860
                                        
                                        
                                        $
                                        13.95
                                        
                                        1.8
      years
                                        
                                        
                                        90,860
                                        
                                        
                                        $
                                        13.95$20.00
      - $51.25
                                        
                                        
                                        89,422
                                        
                                        
                                        $
                                        35.54
                                        
                                        0.6
      years
                                        
                                        
                                        89,422
                                        
                                        
                                        $
                                        35.54$0.29
      - $51.25
                                        
                                        
                                        6,288,765
                                        
                                        
                                        $
                                        1.56
                                        
                                        6.8
      years
                                        
                                        
                                        5,373,458
                                        
                                        
                                        $
                                        1.77





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





For
      the three months
                  December
      31,2009
                
                
                2008Research
      and development expenses
                
                $
                24
                
                
                $
                22General
      and administrative expenses
                
                
                166
                
                
                
                43Total
      stock-based compensation expense
                
                $
                190
                
                
                $
                65





The total
deferred compensation expense for outstanding and unvested stock options was
$226,000 as of December 31, 2009.  The weighted average remaining
recognition period for the total deferred compensation expense is six months.
The fair value of the options associated with the above compensation expense was
determined at the date of the grant using the Black-Scholes option pricing model
with the following weighted average assumptions:





For
      the three months December 31,2009
                                
                                
                                2008Dividend
      yield
                                
                                0%
                                
                                
                                0%Expected
      volatility
                                
                                96%
                                
                                
                                200%–
      201%Risk-free
      interest rate
                                
                                3.3%
                                
                                
                                2.6%
      - 3.8%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.





I.           Subsequent
Events





We have
evaluated subsequent events through the issuance of the financial statements,
which occurred on February 19, 2010.


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, 2009. All
forward-looking statements are based on information available as of the date
hereof, and we do not assume any obligation to update such forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof.





Operations
Summary





We are
developing a new class of catalytic antioxidant compounds as a medical
countermeasure against biological, chemical and radiological weapons as well as
for diseases and disorders of the central nervous system, respiratory system,
autoimmune system and oncology.  Our initial target indications are as
a protective agent against the effects of acute radiation syndrome, sulfur
mustard gas exposure and chlorine gas exposure.  We have reported
positive safety results from two Phase I clinical trials of AEOL 10150, our lead
drug candidate, with no serious adverse events
noted.





We do not
have any revenue, other than grant income, and therefore we must rely on public
or private equity offerings, debt financings, collaboration arrangements or
grants to finance our operations.





Need for Additional
Funds





We
believe we have adequate financial resources to fund our operations into the
third quarter of fiscal year 2010, but in order to fund on-going operating cash
requirements beyond the third 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 December
31, 2009 versus three months ended December 31, 2008





We had
net losses of $15,276,000 for the three months ended December 31, 2009, versus
net losses of $459,000 for the three months ended December 31,
2008.





Research
and development (“R&D”) expenses increased $59,000, or 47%, to $184,000 for
the three months ended December 31, 2009 from $125,000 for the three months
ended December 31, 2008.  R&D expenses were higher during the
three months ended December 31, 2009 versus December 31, 2008 due to an increase
in research activities.  During the quarter, the Company initiated an
additional study of AEOL 10150 as a protectant against the effects of radiation
on the lungs.  During the three months ended December 31, 2009 outside
research expenses increased by $98,000.  Offsetting the increase was a
decline in patent fees in the amount of $34,000.  The Company
currently has seven studies in progress: the study of its drug candidates as a
potential countermeasure against the effects of sulfur mustard gas on the lung
and skin, as a protectant against the effects of radiation on the lungs and on
the gastro-intestinal tract, as a countermeasure against the effects of chlorine
gas, as a potential treatment for epilepsy and for the potential treatment for
Parkinson’s disease.


14


R&D
expenses for our antioxidant program have totaled $35,706,000 from inception
through December 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.





General
and administrative (“G&A”) expenses increased $123,000, or 43%, to $406,000
for the three months ended December 31, 2009 from $283,000 for the three months
ended December 31, 2008.  G&A expenses were higher during the
three months ended December 31, 2009 versus December 31, 2008 due to an increase
in stock based compensation expense.   Stock compensation expense
increased by $123,000 as a result of a higher level of grant activity and an
increase in the valuation assigned to such grants in the current quarter when
compared to the prior year quarter.





We
incurred net interest expense of $826,000 for the three months ended December
31, 2009 compared to net interest expense of $100,000 for the three months ended
December 31, 2008.  The current quarter expense reflects $808,000 in
charges as a result of the conversion of the Senior Convertible Notes on October
6, 2009.  The expense in the prior year quarter is a result of
interest expense related to the Senior Convertible Notes which had a stated
interest rate of 7%, the related amortization of debt issuance costs and a note
issuance discounts on the Senior Convertible Notes, the Elan Note and a margin
loan with UBS Financial Services which was paid off in the second quarter of
fiscal year 2009.





During
the three months ended December 31, 2009, we incurred a charge to the Statement
of Operations of $13,860,000 related to non-cash financing charges and the
change in fair value of warrants.  As more fully disclosed in Note D,
certain of the Company’s warrants to purchase common stock were deemed to be a
liability upon adoption of a new accounting pronouncement on October 1,
2009.  Subsequent changes to the fair value of these warrants have
been charged to the Statement of Operations and resulted in a net charge of
$7,646,000 during the three months ended December 31, 2009.  In
addition, as a result of the completion of the October 2009 Financing, a net
charge of $6,213,000 was recorded to the Statement of Operations.  The
warrant liability and revaluations have not and will not have any impact on the
Company’s working capital, liquidity, or business operations.





We
recorded a gain of $49,000 related to the net increase in the market value of
our trading securities during the three months ended December 31,
2008.





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 December 31, 2009, we
had $1,870,000 of cash, an increase of $1,224,000 from September 30, 2009. The
increase in cash was primarily due to the October 2009 Financing which generated
net proceeds of $1.6 million offset by our loss from operations of $590,000 for
the three months ended December 31, 2009.  We believe we have adequate
financial resources to conduct operations into the third 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 $590,000 and $2,003,000, and cash
outflows from operations of $389,000 and $1,923,000, for the three months ended
December 31, 2009 and for the fiscal year ended September 30, 2009,
respectively. Our ongoing future cash requirements will depend on numerous
factors, particularly the progress of our catalytic antioxidant program and
clinical trials and our ability to negotiate and complete collaborative
agreements or out-licensing arrangements. In order to help fund our on-going
operating cash requirements, we intend to seek new collaborations for our
antioxidant research program that include initial cash payments and on-going
research support. In addition, we might sell additional shares of our stock
and/or convertible debentures and explore other strategic and financial
alternatives, including a merger with another company, the sale of stock and/or
debt, the establishment of new collaborations for current research programs,
that include initial cash payments and ongoing research support and the
out-licensing of our compounds for development by a third party.





There are
significant uncertainties as to our ability to access potential sources of
capital. We may not be able to enter into any collaboration on terms acceptable
to us, or at all, due to conditions in the pharmaceutical industry or in the
economy in general or based on the prospects of our catalytic antioxidant
program. Even if we are successful in obtaining 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.


15


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 months ended December 31, 2008. We do not
have any foreign currency or other derivative financial instruments. Our debt
bears interest at a fixed rate.





ITEM
4.                Controls
and Procedures.





(a)    As
of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company’s
management, including the Company’s President and Chief Executive Officer (the
Company’s Principal Executive Officer) and Chief Financial Officer (the
Company’s Principal Financial and Accounting Officer), of the effectiveness of
the Company’s disclosure controls and procedures required by Exchange Act Rule
13a-15.  Based upon that evaluation, the Company’s Principal Executive
Officer and Principal Financial and Accounting Officer have concluded that the
Company’s disclosure controls and procedures were not effective as of
December 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 December 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 December 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. However, subsequent to quarter end,
on January 15, 2010, Michael P. McManus resigned as Chief Financial Officer of
the Company.  The Company will actively search for a new Chief
Financial Officer and, in the interim, John L. McManus will serve as the
principal financial officer of Aeolus Pharmaceuticals, Inc.





PART
II. - OTHER INFORMATION





ITEM
1.         
     Legal
Proceedings.





None.





ITEM
1A.            Risk
Factors.





None.





ITEM
2.          
     Unregistered
Sales of Equity Securities and Use of Proceeds.





None.





ITEM
3.               Defaults Upon Senior
Securities.





None.


16


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





None.





ITEM
5.               Other
Information.





None.





ITEM
6.               Exhibits





Exhibit
      #
              
              Description31.1
              
              Certification
      of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).31.2
              
              Certification
      of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a)
      and 15d-14(a).32.1
              
              Certification
      by the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002.





SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





AEOLUS
      PHARMACEUTICALS, INC.Date:               February 19,
      2010
                  By:
                  /s/
      John L. McManusJohn
      L. McManus
                    President
      and Chief Executive Officer
                    (Principal
      Executive Officer)
                    Chief
      Financial Officer, Treasurer and Secretary
                    (Principal
      Financial and Accounting
Officer)


17