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 June
30, 2008.





_____
            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.)23811
      Inverness Place
              Laguna Niguel,California
            
            92677(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, a non-accelerated filer, or a smaller 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 [X] Smaller
reporting company [ ]




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
              July 31,
      2008Common
      Stock, par value $.01 per share
            31,952,749shares











AEOLUS
PHARMACEUTICALS, INC.


FORM
10-Q


For the
Quarter Ended June 30, 2008


Table of
Contents





PagePART
      I.                                FINANCIAL
      INFORMATIONItem
      1.
            Financial
      StatementsStatement
      Regarding Financial Information
            3Condensed
      Consolidated Balance Sheets as ofJune
      30, 2008
              (unaudited)
      and September 30, 2007
            4Condensed
      Consolidated Statements of Operations for the ThreeMonthsand
      Nine Months endedJune
      30,
      2008and
      2007(unaudited)
            5Condensed
      Consolidated Statements of Cash Flows for theNineMonths
      endedJune
      30,
      2008and
      2007(unaudited)
            6Notes
      to Condensed Consolidated Financial Statements
            7Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            12Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            15Item
      4.
            Controls
      and Procedures
            15PART
      II.OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            15Item
      1A.
            Risk
      Factors
            15Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            15Item
      3.
            Defaults
      Upon Senior Securities
            15Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            15Item
      5.
            Other
      Information
            15Item
      6.
            Exhibits
            16SIGNATURES
            16





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, 2007), 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, 2007, filed
with the SEC on December 13, 2007.














3





AEOLUS
      PHARMACEUTICALS, INC.CONDENSED
      CONSOLIDATED BALANCE SHEETS(In
      thousands, except shares and per share data)June
      30,
            
            
            September
      30,2008
            
            
            2007(Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
            
            $
            181
            
            
            $
            1,727Prepaids
      and other current assets
            
            
            74
            
            
            
            79Total
      current assets
            
            
            255
            
            
            
            1,806Investments,
      available-for-sale
            
            
            459
            
            
            
            -Other
      investments
            
            
            125
            
            
            
            125Total
      assets
            
            $
            839
            
            
            $
            1,931LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            432
            
            
            $
            266Accrued
      expenses
            
            
            5
            
            
            
            2Current
      maturity of long-term note payable
            
            
            520
            
            
            
            -Short-term
      debt
            
            
            365
            
            
            
            -Total
      current liabilities
            
            
            1,322
            
            
            
            268Long-term
      note payable
            
            
            -
            
            
            
            483Total
      liabilities
            
            
            1,322
            
            
            
            751Commitments
      and contingences (Note H)Stockholders'
      equity: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 June 30,2008
      and September 30, 2007
            
            
            5
            
            
            
            5Common
      stock, $.01 par value per share, 150,000,000 shares
      authorized;31,952,749 shares issued and outstanding at June 30, 2008
      andSeptember
      30, 2007
            
            
            320
            
            
            
            320Additional
      paid-in capital
            
            
            157,054
            
            
            
            156,781Unrealized
      gains (losses) on investments, available for sale
            
            
            (17
            )
            
            
            -Accumulated
      deficit
            
            
            (157,845
            )
            
            
            (155,926
            
            )Total
      stockholders' equity
            
            
            (483
            )
            
            
            1,180Total
      liabilities and stockholders' equity
            
            $
            839
            
            
            $
            1,931The
      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
            
            
            Nine
      Months EndedJune
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007RevenueGrant
      income
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Costs
      and expenses:Research
      and development
            
            
            210
            
            
            
            192
            
            
            
            732
            
            
            
            869General
      and administrative
            
            
            360
            
            
            
            320
            
            
            
            1,138
            
            
            
            1,396Total
      costs and expenses
            
            
            570
            
            
            
            512
            
            
            
            1,870
            
            
            
            2,265Loss
      from operations
            
            
            (570
            )
            
            
            (512
            )
            
            
            (1,870
            )
            
            
            (2,265
            )Interest
      income (expense), net
            
            
            (10
            )
            
            
            3
            
            
            
            1
            
            
            
            38Other
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            225Other
      than temporary impairment on marketable investments
            
            
            -
            
            
            
            -
            
            
            
            (49
            )
            
            
            -Net
      loss
            
            $
            (580
            )
            
            $
            (509
            )
            
            $
            (1,918
            )
            
            $
            (2,002
            )Net
      loss per weighted share attributable to common
    stockholders:(basic
      and diluted)
            
            $
            (0.02
            )
            
            $
            (0.02
            )
            
            $
            (0.06
            )
            
            $
            (0.07
            )Weighted
      average common shares outstanding:Basic
      and diluted
            
            
            31,952
            
            
            
            30,429
            
            
            
            31,952
            
            
            
            29,661The
      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)Nine
      Months EndedJune
      30,2008
            
            
            2007Cash
      flows from operating activities:Net
      loss
            
            $
            (1,918
            )
            
            $
            (2,002
            )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Noncash
      compensation
            
            
            272
            
            
            
            471Noncash
      interest and financing costs
            
            
            40
            
            
            
            40Forgiveness
      of note payable
            
            
            -
            
            
            
            (225
            )Other
      than temporary impairment charge
            
            
            49
            
            
            
            -Change
      in assets and liabilities:Prepaids
      and other assets
            
            
            5
            
            
            
            (194
            )Accounts
      payable and accrued expenses
            
            
            169
            
            
            
            (723
            )Net
      cash used in operating activities
            
            
            (1,383
            )
            
            
            (2,633
            )Cash
      flows from investing activities:Purchases
      of marketable securities
            
            
            (525
            )
            
            
            -Net
      cash used in financing activities
            
            
            (525
            )
            
            
            -Cash
      flows from financing activities:Repayment
      of note payable
            
            
            -
            
            
            
            (300
            )Proceeds
      from short term note payable
            
            
            368
            
            
            
            -Repayments
      of short term note payable
            
            
            (6
            )
            
            
            -Net
      proceeds from issuance of common stock
            
            
            -
            
            
            
            1,761Proceeds
      from exercise of stock options
            
            
            -
            
            
            
            21Net
      cash provided by (used in) financing activities
            
            
            362
            
            
            
            (1,482
            )Net
      decrease in cash and cash equivalents
            
            
            (1,546
            )
            
            
            (1,151
            )Cash
      and cash equivalents at beginning of period
            
            
            1,727
            
            
            
            3,324Cash
      and cash equivalents at end of period
            
            $
            181
            
            
            $
            2,173The
      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, as a protective agent against radiation
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 is also conducting an
additional pre-clinical study of AEOL 11207 for the treatment of patients with
Parkinson’s Disease.





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 June 30, 2008, Aeolus also owned a
35.0% interest in CPEC LLC, a Delaware limited liability company (“CPEC”). The
Company’s primary operations are located in Laguna Niguel,
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, 2007
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,
2007. 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
February 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement No. 159, The Fair Value Option for Financial Assets and Financial
Liabilities, Including an Amendment of SFAS 115 (“FAS 159”).  FAS 159
permits companies to choose to measure many financial instruments and certain
other items at fair value. It also establishes presentation and disclosure
requirements designed to facilitate comparisons between companies that choose
different measurement attributes for similar types of assets and liabilities.
FAS 159 requires companies to provide additional information that will help
investors and other users of financial statements to more easily understand the
effect of a company’s choice to use fair value on its earnings. It also requires
entities to display the fair value of those assets and liabilities for which a
company has chosen to use fair value on the face of the balance sheet.  FAS
159 is effective for fiscal years beginning after November 15, 2007 and interim
periods within those fiscal years. The Company does not expect the adoption of
FAS 159 to significantly affect its financial condition or results of
operations.





In
September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“FAS
157”). FAS 157 defines fair value, establishes a framework for measuring fair
value in generally accepted accounting principles and expands disclosures about
fair value measurements.  FAS 157 codifies the definition of fair value as
the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date. The standard clarifies the principle that fair value should be
based on the assumptions market participants would use when pricing the asset or
liability and establishes a fair value hierarchy that prioritizes the
information used to develop those assumptions.  FAS 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2008.
The Company does not expect the adoption of FAS 157 to significantly affect its
financial condition or results of operations.





In December 2007, the FASB issued SFAS
No. 160, Noncontrolling Interests in Consolidated Financial Statements (“FAS
160”). FAS 160 is an amendment of Accounting Research Bulletin (“ARB”) No. 51
and was issued to improve the relevance, comparability, and transparency of the
financial information that a reporting entity provides in its consolidated
financial statements. This Statement applies to all entities that prepare
consolidated financial statements, except not-for-profit organizations, but will
affect only those entities that have an outstanding noncontrolling interest in
one or more subsidiaries. FAS 160 clarifies that a noncontrolling interest in a
subsidiary is an ownership interest in the consolidated entity that should be
reported as equity in the consolidated financial statements and that a parent
company must recognize a gain or loss in net income when a subsidiary is
deconsolidated.  FAS 160 is effective for fiscal years beginning after
December 15, 2008 and early adoption is


7


prohibited.
The Company is currently evaluating the potential impact on its statement of
financial position and results of operations.








B.         Liquidity





The
Company has incurred significant losses from operations of $1,870,000 and
$3,300,000, and cash outflows from operations of $1,383,000 and $3,079,000, for
the nine months ended June 30, 2008 and for the fiscal year ended September 30,
2007, respectively. On August 1, 2008, the Company completed a $500,000
convertible note financing with an additional $500,000 expected to be invested
over the next four months (See Note I).  The investors also have an
option to invest an additional $4.0 million over the next eighteen
months.  The Company expects to incur additional losses and negative
cash flow from operations during the remainder of fiscal year 2008 and for
several more years.





Management
believes the Company has adequate financial resources to conduct operations
through the second quarter of fiscal year 2009. 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
profit.





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,
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 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
second quarter of fiscal year 2009, 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. Diluted weighted average common shares excluded
incremental shares of approximately 18,439,000 as of June 30, 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 anti-dilutive effect as a result
of the Company’s net losses.








D.           Investments





The
Company has invested in auction-rate securities with a par value of $525,000.
 The auction-rate securities are debt obligations secured by student loans,
which loans are generally guaranteed by the U.S. Government under the Federal
Family Education Loan Program (FFELP). In addition to the U.S. Government
guarantee on such student loans, many of the securities also have separate
insurance policies guaranteeing both the principal and accrued interest.
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, as has been recently reported in the financial press, the
current disruptions in the credit markets have adversely affected the auction
market for these types of securities. From February 26, 2008 to June 30, 2008,
all auctions scheduled with respect to the Company’s auction-rate securities
failed to close. This is the first time the Company has experienced this type of
event for its holdings of auction-rate securities and the Company believes that
prior to February 13, 2008, the Company’s investment advisor, UBS Financial
Services, Inc. (“UBS”), had not had a failed auction.  The Company
understands that the failure of auctions is broad based and not limited to those
securities held by the Company. The auction-rate securities continue to pay
interest.





As a
result of the failed auctions, these auction-rate securities held by the Company
are currently not liquid. Furthermore, the Company cannot predict how long they
will remain illiquid. As such, at least in the near term, the Company believes
it may not be able to liquidate some or all of its remaining auction-rate
securities prior to their maturities at prices approximating their face amounts.
The final maturity dates of the auction-rate securities which the Company owns
is between 2029 and 2038.


8





The
Company has taken an “other-than-temporary” impairment charge during the quarter
ended March 31, 2008 of $49,000 based upon reduced market values as determined
based upon investment statements as of March 31, 2008 received from
UBS.  The Company also holds these investments as available for sale
and accordingly records its value on the balance at market value as determined
by investments statements provided by UBS.  Our auction-rate
securities had an estimated fair value of approximately $459,000 as of June 30,
2008.  The estimated fair value of the auction-rate securities could
decrease or increase significantly in the future based on market conditions.
Management will continue to assess the fair value of the auction-rate securities
based on analysis of account statements and other correspondence from
UBS.





In June
2008, the Company filed arbitration and mediation claims against UBS seeking
recession of the purchase transactions of its four auction-rate securities,
reimbursement for lost interest income and lost revenue due to delays in the
development of its drug candidates and punitive
damages.  However there can be no assurance as to the ultimate
outcome of these claims.





The
current market for the auction-rate securities held by the Company is uncertain
and management will continue to monitor and evaluate the market for these
securities to determine if further impairment of the carrying value of the
securities has occurred due to the loss of liquidity or for other reasons. If
the credit ratings of the security issuers deteriorate or if normal market
conditions do not return in the near future, the Company may be required to
further reduce the value of these securities through an impairment charge
against net income.








E.         Notes
Payable





Aeolus
has entered into a secured credit agreement (the “Margin Agreement”) with UBS
Financial Services, Inc and subsequently drew $368,000 under the Margin
Agreement.  The Margin Agreement bears interest at the per annum rate
of LIBOR plus 0.25 percent.  Availability of the line of credit is
subject to the Company’s compliance with certain financial and other
covenants.   Borrowings under the Margin Agreement are secured by
the Company’s investments held by UBS.  In June 2008, UBS notified the
Company that it is in violation of the Margin Agreement and has requested
repayment of $20,000.  The Company has not made such payment and
informed UBS that no such payment will be made pending the outcome of the
arbitration claim as more fully discussed in Note D.





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.





The remaining principal plus accrued
interest will be due and payable in February 2009.  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 June 30,
2008, the outstanding balance, including interest, on the note payable to Elan
was $520,000.








F.           Stockholders’
Equity





Common
Stock





On May
22, 2007, Aeolus Pharmaceuticals, Inc. entered into a Securities Purchase
Agreement with certain accredited investors (the “Investors”) pursuant to which
the Company sold to the Investors an aggregate of 2,666,667 shares of the
Company’s common stock (the “Shares”) at a purchase price of $0.75 per share for
aggregate gross proceeds of $2,000,000 and issued to the Investors warrants (the
“Investor Warrants”) to purchase up to an aggregate of 2,000,001 shares of
common stock of the Company with an exercise price of $0.75 per share
(collectively, the “May 2007 Private Placement”). The Investor Warrants are
exercisable until May 22, 2012.  In addition, we issued to a placement
agent a warrant to purchase up to an aggregate of 186,667 shares of common stock
with an exercise price of $0.75 per share.





The
aggregate net proceeds to the Company from the May 2007 Private Placement, after
deducting for expenses related to finders fees, legal and accounting fees, were
approximately $1,761,000. The Company intends to use the net proceeds from the
May 2007 private placement to finance the clinical development of AEOL 10150 and
AEOL 11207 and to fund ongoing operations of the Company.


9


The fair
value of the Investor Warrants on May 22, 2007 was estimated to be $1,428,000
using the Black-Scholes option pricing model with the following assumptions:
dividend yield of 0%; risk free interest rate of 4.8%; expected volatility of
132%; and an expected life of five years.





Pursuant
to the terms of the Subscription Agreement, the Company filed a registration
statement which was declared effective on July 19, 2007.  The
subscription agreement further provides that if a registration statement is not
filed, declared effective within specified time periods or its effectiveness
maintained, the Company is required to pay each holder an amount in cash, as
liquidated damages, equal to 1.5% per month of the aggregate purchase price paid
by such holder in the private placement for the common stock and warrants then
held.





Warrants





As of
June 30, 2008, warrants to purchase 14,025,427 shares of common stock were
outstanding. Details of the warrants for common stock outstanding at June 30,
2008 were as follows:





Number of Shares
            Exercise Price
            
            Expiration Date50,000
            
            $    0.50
            
            May
      20112,500,000
            
            $    0.50
            
            November
      20102,186,668
            
            $    0.75
            
            May
      20127,000,000
            
            $    0.75
            
            June
      201150,000
            
            $    1.00
            
            May
      201135,000
            
            $    1.00
            
            July
      200850,000
            
            $    1.50
            
            May
      201150,000
            
            $    2.00
            
            May
      201150,000
            
            $    2.50
            
            May
      2011410,400
            
            $    2.50
            
            April
      20091,641,600
            
            $    4.00
            
            April
      20091,759
            
            $  19.90
            
            October
      200814,025,427
            
            $    1.15








G.         Stock-Based
Compensation





Below is
a summary of Aeolus stock option activity during the nine-month period ended
June 30, 2008:





Shares
            
            Weighted
      Average Exercise Price
            
            Weighted
      Average Remaining Contractual Term
            
            Aggregate
      Intrinsic ValueOutstanding
      at September 30, 2007
            
            
            3,873,617
            
            $
            2.72
            
            7.3
      years
            $
            2Granted
            
            
            120,000
            
            $
            0.42Exercised
            
            
            ---
            
            $
            ---Forfeited
            
            
            (113,336
            )
            $
            0.87Outstanding
      at June 30, 2008 (unaudited)
            
            
            3,880,281
            
            $
            2.70
            
            6.6
      years
            $
            1Exercisable
      at June 30, 2008 (unaudited)
            
            
            3,776,948
            
            $
            2.76
            
            6.6
      years
            $
            ---





For the
nine months ended June 30, 2008 and 2007, 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.





10


The
details of stock options outstanding at June 30, 2008 were as
follows:





Options
      Outstanding
            
            Options
      ExercisableRange
      of Exercise Prices
            
            Number
      Outstanding at June 30, 2008
            
            Weighted
      Average Exercise Price
            
            Weighted
      Average Remaining Contractual Life
            
            Number
      Exercisable at June 30, 2008
            
            Weighted
      Average Exercise Price$0.40
      - 0.60
            
            546,050
            
            $
            0.54
            
            8.9
      years
            
            471,050
            
            $
            0.55$0.68
      - $0.80
            
            464,161
            
            $
            0.75
            
            8.0
      years
            
            464,161
            
            $
            0.75$0.81
      - $0.89
            
            388,035
            
            $
            0.85
            
            7.4
      years
            
            388,035
            
            $
            0.85$0.90
            
            392,050
            
            $
            0.90
            
            8.4
      years
            
            371,217
            
            $
            0.90$0.91
      - $1.45
            
            224,500
            
            $
            1.04
            
            7.8
      years
            
            217,000
            
            $
            1.04$1.50
            
            1,256,015
            
            $
            1.50
            
            5.1
      years
            
            1,256,015
            
            $
            1.50$1.52
      - $5.10
            
            394,391
            
            $
            2.86
            
            5.9
      years
            
            394,391
            
            $
            2.86$6.25
      - $31.88
            
            166,280
            
            $
            20.48
            
            2.9
      years
            
            166,280
            
            $
            20.48$50.9375
            
            2,999
            
            $
            50.94
            
            1.8
      years
            
            2,999
            
            $
            50.94$51.25
            
            45,800
            
            $
            51.25
            
            1.8
      years
            
            45,800
            
            $
            51.25$0.40
      - $51.25
            
            3,880,281
            
            $
            2.70
            
            6.6
      years
            
            3,776,948
            
            $
            2.76





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





For
      the nine months
              June
      30,2008
            
            
            2007Research
      and development expenses
            
            $
            43
            
            
            $
            161General
      and administrative expenses
            
            
            229
            
            
            
            283Total
      stock-based compensation expense
            
            $
            272
            
            
            $
            444




The total
deferred compensation expense for outstanding and unvested stock options was
$8,000 as of June 30, 2008.  The weighted average remaining
recognition period for the total deferred compensation expense is two months.
The fair value of the options associated with the above compensation expense for
the nine months ended June 30, 2008 and 2007, was determined at the date of the
grant using the Black-Scholes option pricing model with the following weighted
average assumptions:





For
      the nine months June 30,2008
            
            2007Dividend
      yield
            
            0%
            
            0%Expected
      volatility
            
            197%
            
            191%
      – 195%Risk-free
      interest rate
            
            3.8%
      - 4.6%
            
            4.5%
      - 5.1%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.





11


I.           Subsequent
Events





On August
1, 2008, the Company entered into a Securities Purchase Agreement (the “Purchase
Agreement”) with three accredited institutional investors  (the
“Investors”) pursuant to which the Company agreed to sell to the
Investors  (and one or more additional accredited
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”). 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.





The Notes
will be convertible, at the Investors' sole election, into shares of Common
Stock at any time and from time to time.  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 conversion price
of the Notes and 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
conversion price of the Notes.





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").  The Notes and Warrants were issued pursuant to the
Purchase Agreement. The Investors have also agreed, upon the satisfaction of
certain conditions by the Company pursuant to the Purchase Agreement, to
purchase an additional 125 Units on each of September 2, 2008, October 1, 2008,
November 3, 2008 and December 1, 2008 (the "Subsequent Closings"), in each case
for an aggregate purchase price of $125,000.  The Notes issued in the
Financing and at the Subsequent Closings have, or will have, an initial
conversion price of $0.35 per share, subject to adjustment pursuant to the
Notes.  In addition, the Investors (and one or more additional
accredited 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 February 1, 2010. 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.





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, 2007. 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.





12


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, protective agent against
radiation 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.   The Company is also conducting an additional
pre-clinical study of AEOL 11207 for the treatment of patients with Parkinson’s
Disease





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 through the
second quarter of fiscal year 2009, but in order to fund on-going operating cash
requirements beyond the second quarter of fiscal year 2009, 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 June 30,
2008 versus three months ended June 30, 2007





We had a
net loss of $580,000 for the three months ended June 30, 2008 versus a net loss
of $509,000 for the three months ended June 30, 2007.





Research
and development (“R&D”) expenses increased $18,000, or 9%, to $210,000 for
the three months ended June 30, 2008 from $192,000 for the three months ended
June 30, 2007.  The higher level of R&D expenses during the
current quarter is a result of an increase in preclinical and manufacturing
costs as well as patent fees offset by a decline in consulting and clinical
expenses.   The Company’s R&D activities were focused on
preclinical activities during the three months ended June 30, 2008 whereas
during the three months ended June 30, 2007 our research activities were focused
on our clinical program.  The Company has four pre-clinical programs
underway for the study of the effects of our drug candidates on exposure of
mustard gas on the skin, the effects of our drug candidates on the exposure of
mustard gas in the lungs, for the treatment of colitis and for the treatment of
Parkinson’s disease.





R&D
expenses for our antioxidant program have totaled $34,266,000 from inception
through June 30, 2008.  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 $40,000, or 13%, to $360,000
for the three months ended June 30, 2008 from $320,000 for the three months
ended June 30, 2007.  G&A expenses were higher during the three
months ended June 30, 2008 versus June 30, 2007 due to the engagement of a
consulting firm to assist the Company in strategic activities resulting in
$35,000 in consulting fees.  In addition, legal fees increased due to
increased United States Securities and Exchange Commission compliance
activities.





Nine months ended June 30,
2008 versus nine months ended June 30, 2007





We had a
net loss of $1,918,000 for the nine months ended June 30, 2008, versus a net
loss of $2,002,000 for the nine months ended June 30, 2007.





R&D
expenses decreased $137,000, or 16%, to $732,000 for the nine months ended June
30, 2008 from $869,000 for the nine months ended June 30,
2007.   The lower level of R&D expenses during the current
period reflects a lower amount of employment, consulting and manufacturing
expenses offset by a higher level of pre-clinical and patent
expenses.  Employment and consulting expenses were $103,000 during the
nine months ended June 30, 2008 versus $371,000 during the nine months ended
June 30, 2007.  The decline in employment and consulting expenses
reflects that we were completing our multiple dose clinical trail and were in
the process of manufacturing bulk quantities of our lead drug candidate, AEOL
10150 during the nine months ended June 30, 2007, whereas during the current
period we had restructured our research program to utilize outside research
institutions and grants to perform our research activities and therefore had a
lower level of employment and consulting expenses.   During the
nine months ended June 30, 2008, manufacturing costs were $117,000 compared to
$226,000 during the nine months ended June 30, 2007.  Offsetting these
declines was an increase of $255,000 in outside research services as a result
of


13


our
transition to outsourcing of research activities during the current period and
$173,000 in patent fees as a result of an increase in patent filing
activity.





G&A
expenses decreased $258,000, or 18%, to $1,138,000 for the nine months ended
June 30, 2008 from $1,396,000 for the nine months ended June 30,
2007.  G&A expenses were lower during the nine months ended June
30, 2008 versus the nine months ended June 30, 2007 due to a decline in
employment costs, stock compensation expense, investor relations expense and
insurance expense.  Employment costs declined by $159,000 during the
nine months ended June 30, 2008 compared to the nine months ended June 30, 2007,
as the current period reflects employment costs of our sole employee, our Chief
Executive Officer, whereas the prior year period includes employment costs of
two additional executive officers as well as severance and bonus costs to three
executive officers.  Stock compensation expense decreased by $54,000
as a result of the lower headcount during the current
period.  Investor relations expenses declined by $49,000, as a result
of a decrease in the level of activity for our investor relations
program.  In addition, insurance expense declined by $27,000 as a
result of lower premiums.





During
the nine months ended June 30, 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
June 30, 2008 received from UBS Financial Services, Inc.   During
the nine months ended June 30, 2008, the auction rate securities which the
Company has invested in have experienced auction failures as a result of the
current disruptions in the credit markets.  This is the first time the
Company has experienced this type of event for its holdings of auction-rate
securities and the Company believes that prior to February 13, 2008, the
Company’s investment advisor, UBS, had not had a failed auction.  The
Company understands that the failure of auctions is broad based and not limited
to those securities held by the Company.  As a result of the failed
auctions, our auction-rate securities are currently not liquid. Furthermore, the
Company cannot predict how long they will remain illiquid.





During
the three months ended June 30, 2007, we recognized $225,000 in income as a
result of the forgiveness of a portion of the principal balance of a note
payable from Elan.





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 June 30, 2008, we had
$181,000 of cash, a decrease of $1,546,000 from September 30, 2007. The decrease
in cash was primarily due to the $1,870,000 loss from operations for the nine
months ended June 30, 2008.  On August 1, 2008, the Company completed
a $500,000 convertible note financing with an additional $500,000 expected to be
invested over the next four months (See Note I).  The investors also
have an option to invest an additional $4.0 million over the next eighteen
months.  We believe we have adequate financial resources to conduct
operations through the second quarter of fiscal year 2009, 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 $1,870,000 and $3,300,000, and
cash outflows from operations of $1,383,000 and $3,079,000, for the nine months
ended June 30, 2008 and for the fiscal year ended September 30, 2007,
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.





14


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, cash equivalents and investments available for sale, 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
June 30, 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.





As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Accounting Officer, of the effectiveness of
our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant
to Rule 13a-15 of the Securities and Exchange Act of 1934 as amended. Based upon
their evaluation, our Chief Executive Officer and Chief Accounting Officer have
concluded that our disclosure controls and procedures are
effective.





No change
in our internal control over financial reporting occurred during our last fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.





Management
is aware that there is a lack of segregation of duties due to the small number
of employees and consultants addressing the Company’s general administrative and
financial matters. However, management has determined that, considering the
employees involved and the control procedures in place, risks associated with
such lack of segregation are not significant and any potential benefits of
adding employees or consultants to clearly segregate duties do not justify the
expenses associated with such increases at this time.





PART
II. - OTHER INFORMATION





ITEM
1.                      Legal
Proceedings.





Information
regarding reportable legal proceedings is set forth in Part I, Item 1, Note E,
Notes Payable.





ITEM
1A.                      Risk
Factors.





The
Company included in its Annual Report on Form 10-K for the fiscal year ended
September 30, 2007 a description of certain risks and uncertainties that could
affect the Company’s business, future performance or financial condition (“Risk
Factors”). There have been no material changes to the risk factors previously
disclosed.





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





None.





ITEM
3.                      Defaults
Upon Senior Securities.





None.




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





None.





ITEM
5.                      Other
Information.




None.





15


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:                         August 4,
    2008
            By:
            /s/
      John L. McManusJohn
      L. McManus
              President
      and Chief Executive Officer
              (Principal
      Executive Officer)Date:                         August 4,
    2008
            By:
            /s/
      Michael P. McManusMichael
      P. McManus
              Chief
      Financial Officer, Treasurer and Secretary
              (Principal
      Financial and Accounting Officer)