**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-K**

**(MARK ONE)**

**x**                               Annual ReportPursuant to Section 13 or 15(d) of the Securities Exchange Act of1934

**Forthe Fiscal Year Ended December 31, 2006**

**Or**

**o**                                  TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe Transition Period From            To        **

**COMMISSIONFILE NUMBER 33-90516**

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**NEOPHARM, INC.**

(Exact Name of Registrantas Specified in its Charter)

| **DELAWARE**                                                    |   | **51-0327886**                           |
|-----------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |

 

**1850 LAKESIDE DRIVEWAUKEGAN, ILLINOIS 60085**

(Address of PrincipalExecutive Offices) (Zip Code)

**(847) 887-0800**

(Registrant’s Telephone Number,Including Area Code)

SECURITIES REGISTEREDPURSUANT TO SECTION 12(b) OF THE ACT:  **NONE**

SECURITIES REGISTEREDPURSUANT TO SECTION 12(g) OF THE ACT:

**COMMON STOCK, $.0002145 PARVALUEPREFERRED STOCK PURCHASE RIGHTS**

(Title of each class)

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o  No x

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

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

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

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

Large acceleratedfiler o              Acceleratedfiler x            Non-acceleratedfiler o

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

The aggregate market valueof the registrant’s common stock held by non-affiliates (affiliates being, forthese purposes only, directors, executive officers and holders of 10% of theregistrant’s stock) of the registrant, par value $.0002145 per share, (based onthe closing price of such shares on the NASDAQ on June 30, 2006) was $79,872,000.As of March 1, 2007 there were 28,080,408 shares of common stockoutstanding.

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**DocumentsIncorporated by Reference**

Certain informationrequired in Part III of the registrant’s Annual Report on Form 10-Kfor December 31, 2006 is incorporated by reference to portions of the registrant’sdefinitive proxy statement for its 2007 Annual Meeting of Stockholders, whichwill be filed with the Securities and Exchange Commission not later than120 days after the end of the fiscal year ended December 31, 2006.

 

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**FORM 10-KTABLE OF CONTENTS**

|               | ** ** | ** **                                                                                                               | ** ** | **Page** | ** ** |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I   |       |                                                                                                                     |       |     |       |   |   |
| Item 1.       |       | Business                                                                                                                 |       |     | 3          |   |   |
| Item 1A.      |       | Risk Factors                                                                                                             |       |     | 17         |   |   |
| Item 1B.      |       | Unresolved  Staff Comments                                                                                               |       |     | 35         |   |   |
| Item 2.       |       | Properties                                                                                                               |       |     | 36         |   |   |
| Item 3.       |       | Legal  Proceedings                                                                                                       |       |     | 36         |   |   |
| Item  4.      |       | Submission  of Matters to a Vote of Security Holders                                                                     |       |     | 36         |   |   |
| PART II  |       |                                                                                                                     |       |     |       |   |   |
| Item  5.      |       | Market  for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer  Purchases of Equity Securities |       |     | 38         |   |   |
| Item 6.       |       | Selected  Financial Data                                                                                                 |       |     | 40         |   |   |
| Item  7.      |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operation                               |       |     | 41         |   |   |
| Item  7A.     |       | Quantitative  and Qualitative Disclosures About Market Risk                                                              |       |     | 47         |   |   |
| Item  8.      |       | Financial  Statements and Supplementary Data                                                                             |       |     | 47         |   |   |
| Item  9.      |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                    |       |     | 47         |   |   |
| Item 9A.      |       | Controls  and Procedures                                                                                                 |       |     | 47         |   |   |
| Item 9B.      |       | Other  Information                                                                                                       |       |     | 51         |   |   |
| PART III |       |                                                                                                                     |       |     |       |   |   |
| Item  10.     |       | Directors  and Executive Officers of the Registrant                                                                      |       |     | 51         |   |   |
| Item 11.      |       | Executive  Compensation                                                                                                  |       |     | 51         |   |   |
| Item  12.     |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                         |       |     | 51         |   |   |
| Item  13.     |       | Certain  Relationships and Related Transactions                                                                          |       |     | 52         |   |   |
| Item  14.     |       | Principal  Accounting Fees and Services                                                                                  |       |     | 52         |   |   |
| PART IV  |       |                                                                                                                     |       |     |       |   |   |
| Item  15.     |       | Exhibits,  Financial Statement Schedules                                                                                 |       |     | 52         |   |   |
|          |       | Signatures                                                                                                               |       |     | 57         |   |   |

 

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**PART I**

**ITEM 1.**                BUSINESS

**FORWARD LOOKINGSTATEMENTS**

This annual report on Form 10-K includesforward looking statements within the meaning of The Private SecuritiesLitigation Reform Act of 1995. We have based these forward looking statementslargely on our current expectations and projections about future events andfinancial trends affecting the financial condition of our business. Theseforward looking statements are subject to a number of risks, uncertainties, andassumptions about us, including, among other things:

·       failureto achieve positive results in clinical trials sufficient to advance productcandidates through the regulatory process;

·       abilityto successfully manage our product candidates through the regulatory process;

·       failureto successfully manufacture, or cause to be manufactured, product for clinicaltrials, regulatory filings and potential commercial sale;

·       competitivefactors;

·       generaleconomic conditions;

·       theability to attract and retain qualified management;

·       availablefinancial resources and inability to secure adequate funding for developmentprojects;

·       relationshipswith pharmaceutical and biotechnology companies;

·       theability to develop safe and efficacious drugs;

·       variabilityof royalty, license, and other revenue;

·       uncertaintyregarding the outcome of current legal proceedings;

·       failureto satisfy performance obligations in our licenses or other contracts;

·       abilityto enter into future collaborative agreements;

·       uncertaintyregarding our patents and patent rights (including the risk that we may beforced to engage in costly litigation to protect such patent rights and thematerial harm to us if there were an unfavorable outcome of any suchlitigation);

·       governmentalregulation;

·       technologicalchange;

·       changesin industry practices; and

·       one-timeevents.

In addition, in this annual report, the words “believe,”“may,” “will,” “estimate,” “possible,” “potential,” “hope,” “continue,” “anticipate,”“intend,” “expect” and similar expressions, as they relate to us, our business,or our management, are intended to identify forward looking statements. All ofour forward looking statements are qualified in their entirety by reference tothe factors discussed in this document under the heading ITEM 1A.—RISK FACTORS,and any documents incorporated by reference that describe risks and factorsthat could cause results to differ materially from those projected in theseforward looking statements.

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We caution you that therisk factors contained herein are not exhaustive. We operate in a continuallychanging business climate which can be expected to impact our forward lookingstatements, whether as a result of new information, future events, orotherwise, after the date of this annual report. In light of these risks anduncertainties, the forward looking events and circumstances discussed in thisannual report may not occur and actual results could differ materially fromthose anticipated or implied in the forward looking statements. Accordingly,you should not rely on forward looking statements as a prediction of actualresults.

**BUSINESS OVERVIEW**

NeoPharm, Inc. is a Delaware corporationincorporated on June 15, 1990.

We area biopharmaceutical company engaged in the research, development, andcommercialization of drugs for the treatment of cancer. We have built our drugdevelopment program around our two proprietary technology platforms: atumor-targeting toxin platform and NeoLipid liposomal drug delivery system. Wehave advanced four drug product candidates in various stages of clinicaldevelopment for the treatment of cancer. The following table summarizes keyinformation about our current drug product candidate pipeline:

| Drug product candidate   | ** ** | ** **                                      | ** ** | **Clinical indication(s)** | ** ** | **2007 Clinical development status** | ** ** | **Commercialization rights** |
|--------------------------|------------|-------------------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|------------------------------|
| CINTREDEKIN BESUDOTOX    |       | Glioblastoma multiforme                         |       | Completed Phase 3(1)       |       | Worldwide(2)                         |
| *(IL13-PE38QQR)*         |       | (brain cancer)                             |       |                       |       |                                 |
| LE-SN38                  |       | Colorectal cancer and  other solid tumors       |       | Phase 1                    |       | Worldwide                            |
| LEP-ETU                  |       | Breast cancer, lung                             |       | Planning possible Phase  3 |       | Worldwide                            |
| *(Liposomal Paclitaxel)* |       | cancer, ovarian cancer,  and other solid tumors |       |                       |       |                                 |
| LE-DT                    |       | Cancer                                          |       | Pre-IND                    |       | Worldwide                            |
| *(Liposomal Docetaxel)*  |       |                                            |       |                       |       |                                 |

 

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(1)          Meeting currently scheduledwith the U.S. FDA late in first-quarter 2007 to discuss possible regulatorypaths forward, if any.

(2)          Development andcommercialization rights for Japan have been sublicensed to Nippon KayakuCo., Ltd.

The drug product candidate which we have advanced thefarthest is CINTREDEKIN BESUDOTOX, a tumor-targeting toxin being developed as atreatment for glioblastoma multiforme, or GBM, a deadly form of brain cancer.In December 2006, we reached the final efficacy endpoint at 215 deaths inour Phase 3 PRECISE clinical trial, the PRECISE Trial, for the treatmentof recurrent GBM. The PRECISE Trial did not meet the primary endpoint at 215deaths, which was a statistically significant difference, or separation, in theoverall survival curves versus the Gliadel Wafer®, or Gliadel. See “DRUGPRODUCT CANDIDATES—CINTREDEKIN BESUDOTOX” below.

In 2006, we reassessed and reprioritized our NeoLipid®platform and strategy to focus development efforts on LE-SN38, LEP-ETU andLE-DT and ceased development of LErafAON.

LE-SN38 is a liposomal formulation of SN-38; theactive metabolite of irinotecan, or Pfizer’s Camptosar®, a chemotherapeuticpro-drug used in the treatment of first- and second-line colorectal cancer.During the second quarter of 2006, in conjunction with the Colorectal andLeukemia Group B 

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(CALGB), we initiatedenrollment in a Phase 2 clinical trial for LE-SN38 in metastatic colorectalcancer patients and completed enrollment of the 21st patient in December 2006. We expect aninterim analysis of data from this LE-SN38 Phase 2 trial in the second quarterof 2007, after the first 21 patients have completed treatment.

LEP-ETU is a liposomal formulation of paclitaxel, theactive ingredient in the widely used cancer drug Taxol®, which is approved inthe U.S. for the treatment of breast, lung and ovarian cancers. We are currentlyin ongoing discussion with the FDA on clinical and regulatory plans forLEP-ETU.

Pre-clinical work also advanced on our earlier stageliposomal formulation of the anti-cancer agent docetaxel, LE-DT, which is theactive ingredient in Sanofi Aventis’ Taxotere® which is approved for use incertain breast cancer, non-small cell lung cancer, gastric adenocarcinoma andhead and neck cancer indications. We anticipate filing an LE-DT InvestigationalNew Drug Application, or IND, with the U.S. FDA in late 2007.

The NeoLipid® drug delivery technology combines drugsor other compounds with our proprietary lipids and allows for the creation of astable liposome. This physical property is especially important during drugstorage and after the drug has been administered intravenously to the patient.We believe our NeoLipid technology may have applications in a variety of otherareas in addition to our drug product candidates in clinical development.

During 2006, we continued to realign our organization,consolidate our operations into a single facility and reduce our cost structureto better support our business objectives. During the first nine months of2006, we reduced our workforce by 26 associates under an organizationalrestructuring initiative and consolidated all of our operations into ourWaukegan, Illinois facility. In May 2006, Dr. Imran Ahmad resigned asour Executive Vice President and Chief Scientific Officer and, in June 2006,we entered into a separation and consulting agreement with our former ChiefFinancial Officer, Mr. Larry Kenyon, which became effective August 31,2006. In December 2006, we completed an additional organizationalrestructuring which resulted in a workforce reduction of an additional 14positions, or approximately 20% of the workforce at that time and recordedrelated expense of $230,000. Aggregate 2006 employee termination costs relatedto 2006 reorganization and separation agreements were $1,528,000. As a resultof the facility consolidation, we also recorded a $339,000 charge in 2006related to the estimated lease exposure for our former Lake Forest, Illinoisoffice space and wrote off $94,000 in related equipment and leaseholdimprovements.

In January 2006, wecompleted the sale of 4,025,000 shares of our common stock to the public.Proceeds to the Company were $38.7 million net of underwriting fees but beforeexpenses. The proceeds from this sale of stock are being used to fund clinicaltrials of our drug product candidates; preclinical studies for other potentialdrug product candidates; and for working capital, capital expenditures, andother general corporate purposes.

**MARKET OVERVIEW**

According to the American Cancer Society, or ACS, *2007 Cancer Facts and Figures*, cancer is the second leadingcause of death in the United States, accounting for one in every four deaths.The ACS *2007 Cancer Facts and Figures* alsoestimates that doctors will diagnose approximately 1.4 million new cases of cancerin the United States in 2007. The National Institutes of Health, or NIH,estimate that the annual cost of cancer in 2006 was approximately $206.3billion, including $78.2 billion in direct medical costs and $17.9 billion formorbidity costs, which includes the cost of lost productivity.

Cancer is characterized by uncontrolled cell divisionresulting in the growth of a mass of cells commonly known as a tumor. Canceroustumors can arise in almost any tissue or organ and cancer cells, if 

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not eradicated, spread, ormetastasize, throughout the body. Cancer is believed to occur as a result of anumber of factors, including hereditary and environmental factors.

For the most part, cancer treatment depends on thetype of cancer and the stage of disease progression. Generally, staging isbased on the size of the tumor and whether the cancer has metastasized orspread. Following diagnosis, solid tumors are typically surgically removed orthe patient is given radiation therapy. Chemotherapy is the principal treatmentfor tumors that are likely to, or have, metastasized. Chemotherapy involves theadministration of drugs which are designed to kill cancer cells, affect thegrowth of tumors, or reduce blood flow to tumors, in an effort to reduce oreliminate cancerous tumors.

Because in most cases cancer is fatal, cancerspecialists attempt to attack the cancer aggressively, with as many therapiesas available and with as high a dose as the patient can tolerate. Sincechemotherapy attacks both normal and cancerous cells, treatment often tends toresult in complicating side effects. Additionally, cells which have beenexposed to several rounds of chemotherapy develop a resistance to the cancerdrugs that are being administered. This is known as “multi-drug resistance.”The side effects of chemotherapy often limit the effectiveness of treatment.Cancers often recur and mortality rates remain high. Despite large sums ofmoney spent on cancer research, current treatments are largely inadequate andimproved anti-cancer agents are needed.

Theproducts we currently have under development potentially target a broad rangeof solid tumors. The table below shows the incidence and mortality estimatedfor the year 2007 for various types of solid tumor cancers that our productsseek to treat:

| **Cancer Indication** | ** ** | ** ** | ** ** | **New Cases** | ** ** | **Deaths** | ** ** |
|----------------------------|------------|------------|------------|--------------------|------------|------------|------------|
| Brain                      |       |       | 20,500     |               |       | 12,740     |       |
| Breast                     |       |       | 180,510    |               |       | 40,910     |       |
| Colorectal                 |       |       | 153,760    |               |       | 52,180     |       |
| Lung                       |       |       | 213,380    |               |       | 160,390    |       |
| Ovarian                    |       |       | 22,430     |               |       | 15,280     |       |
| Prostate                   |       |       | 218,890    |               |       | 27,050     |       |

 

**Source:American Cancer Society, 2007 Cancer Facts and Figures**

**BUSINESS STRATEGY**

We are a biopharmaceuticalcompany focused on discovering, developing, and commercializing innovativeanti-cancer treatments. Our strategy consists of the following key elements:

*Focus on thegrowing cancer market*

Cancer is the secondleading cause of death in the US, yet there remain unmet needs, and currenttreatments remain ineffective and inadequate for some populations. Given thelife-threatening nature of cancer, the FDA has adopted procedures to acceleratethe approval of cancer drugs. We intend to continue to use our expertise in thefield of cancer research to target this significant market opportunity forcancer drug development.

*Develop ourexisting product portfolio*

We currently have fourclinical and pre-clinical stage anti-cancer drug product candidates underdevelopment in cancer and certain other indications. We intend to furtherdevelop these drug product candidates both by using our internal resources andby continuing to collaborate with other companies and leading governmental andeducational institutions. In 2006, we reassessed and reprioritized our 

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NeoLipid®platform and strategy to focus our NeoLipid development efforts on LE-SN38,LEP-ETU and LE-DT and ceased development of LErafAON.

*Create new productsby capitalizing on our NeoLipid® drug delivery platform*

We intend to furtherexplore the use of our proprietary NeoLipid® liposomal drug delivery technologyto create new products in two ways: life cycle management, therefore extendingthe patent life and/or modifying the pharmacokinetic profile of existing cancerdrugs, and by utilizing our platform to develop new drugs. We are aware ofseveral widely used cancer drugs that are nearing patent expiration, as well asother widely used cancer drugs with patents that have expired. When a drug iscombined with another agent or delivery system in a novel way, its patent lifemay be extended. Secondly, while many chemotherapeutic drugs have beeneffective for the treatment of cancer, these drugs have been limited in theiruse because of adverse side effects and difficulties in administration. Usingour NeoLipid® drug delivery technology, we believe opportunities exist for usto increase the usefulness of these compounds as improved anti-cancertreatments. Thirdly, we believe that our liposomal drug delivery technology mayprovide us with a platform for the development of novel therapeutic agents forcancer drug development.

*Increase thepotential for commercial success through diversification*

We are developing our drugproduct candidates simultaneously in an attempt to increase our chances ofcommercial success through diversification as well as potential partnershipswith third parties.

*Commercializepharmaceutical products focused on cancer in selected markets*

Our goal is to bring tomarket novel drugs that address significant unmet needs in cancer treatment. InNorth America, we may develop a specialized cancer sales and marketingcapability or work with third parties to market our future products tospecialty physicians. As appropriate, we may establish collaborations withpharmaceutical companies, or others, to assist in the commercialization anddevelopment of our drug product candidates outside of North America.

**DRUG PRODUCTCANDIDATES**

**CINTREDEKIN BESUDOTOX (*IL13-PE38QQR*)**

The drug product candidate which we have advanced thefarthest is CINTREDEKIN BESUDOTOX a tumor-targeting toxin being developed as atreatment for glioblastoma multiforme, or ^GBM^, a deadly form of brain cancer.In December 2006, we announced that the Phase 3 PRECISE Clinical trial ofCINTREDEKIN BESUDOTOX in the treatment of recurrent GBM did not meet theprimary endpoint at 215 deaths, which was a statistically significant difference,or separation, in the overall survival curves versus the Gliadel Wafer®, orGliadel.

Since the announcement ofthe PRECISE trial results, the Company has been working with its ScientificAdvisory Board to identify a potential regulatory path forward based on thetotality of the clinical data gathered to date. The top-line PRECISE Trialresults were as follows:

**Median Survival CB = 36.4 weeks**

**MedianSurvival Gliadel = 35.3 weeks**

| **Months** | ** ** | ** ** | ** ** | **CB (% Survival)** | ** ** | **Gliadel (% Survival)** | ** ** |
|------------|------------|------------|------------|-------------------------------|------------|------------------------------------|------------|
| 6          | ** ** |       | 69.4       |                          |       |                               | 62.4       | ** ** |   |
| 12         | ** ** |       | 35.1       |                          |       |                               | 30.1       | ** ** |   |
| 18         | ** ** |       | 20.0       |                          |       |                               | 14.5       | ** ** |   |
| 24         | ** ** |       | 14.4       |                          |       |                               | 14.5       | ** ** |   |

 

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We plan to meet with FDA in late March 2007 todiscuss the possibility of approval on the strength of our data and analyses.We cannot predict the outcome of that meeting. FDA could evaluate the data a differentway, for example using different statistical methods, and reach differentconclusions about the PRECISE trial altogether. FDA could agree with ourconclusions about the PRECISE trial, but still reject the argument that theseconclusions may support product approval. Even if FDA agreed that theseconclusions may support product approval, it could require statisticallysignificant results from a second Phase 3 trial. There is no assurancethat we would or could generate these additional data. The agency could alsoreject the data from the PRECISE trial for other reasons, including humanerrors in the conduct of the clinical trial. See Item 1A—“Risk Factors”.

We have exclusively licensed CINTREDEKIN BESUDOTOXfrom the NIH and the FDA, and have been developing this drug product candidateunder a Cooperative Research and Development Agreement, or CRADA, with the FDACenter for Biologics Evaluation and Research, or CBER. CINTREDEKIN BESUDOTOXhas received orphan drug designation in the US and Europe and fast track drugdevelopment program status from the FDA. In addition, CINTREDEKIN BESUDOTOX hadbeen selected to participate in the FDA’s Continuous Marketing Application,CMA, Pilot 2 program. We also hold a non-exclusive license to utilize apatented process owned by the U.S. government relating to convection enhanceddelivery, or CED, for us to use with drugs, including CINTREDEKIN BESUDOTOX inthe treatment of cancer.

Conventional, non-specific chemotherapeutic drugsattack abnormal cancer cells by stopping them from dividing and reproducing,but can also damage normal healthy cells because they do not discriminatebetween cancerous and healthy cells. Furthermore, standard chemotherapy drugsare usually administered systemically, which leads to their distributionthroughout the body rather than to one area, such as a tumor in the brain.Common side effects of chemotherapy that are caused by damage to bone marrowinclude the body’s inability to produce enough: red blood cells, causingweakness and fatigue; white blood cells, lowering the body’s resistance toinfections; or platelets, preventing blood from clotting properly, which canlead to excessive bleeding.

CINTREDEKIN BESUDOTOX, onthe other hand, is being developed as a highly specific tumor-targeting agent.CINTREDEKIN BESUDOTOX is a recombinant protein consisting of a single moleculecomposed of two parts: a tumor-targeting molecule and a cytotoxic agent. Thetargeting component consists of interleukin-13, an immune regulatorycytokine, IL-13. Malignant glioma cells, as compared to normal braincells, express IL-13 receptors at a higher density. IL-13 is animmune regulatory cytokine, or protein, secreted by cells. The cytotoxic agentis a potent bacterially derived toxin called PE38. CINTREDEKIN BESUDOTOX isdesigned to detect and bind IL-13 receptors on the surface of malignantglioma cancer cells and selectively deliver PE38 to destroy tumor cells whilesparing healthy surrounding cells. CINTREDEKIN BESUDOTOX is administered by atechnique known as convection-enhanced delivery, or CED, in which thedrug is delivered through catheters inserted in brain tissue surrounding thetumor (peritumoral administration) or into the tumor (intratumoraladministration) following surgical resection of the tumor. CED is designed toinfuse CINTREDEKIN BESUDOTOX directly to the tumor site and adjacent braintissue with the goal of killing resident tumor cells and preventing recurrenceof tumor cell growth.

***LE-SN38***

LE-SN38 is our NeoLipid liposomal formulation of SN-38,the active metabolite of Camptosar® (Pfizer, Inc.), a chemotherapeuticpro-drug, which is used as a first-line and second-line colorectal cancertreatment. At the present time, without the NeoLipid system, SN-38 isinsoluble and can only be used to treat cancer by administering the pro-drugCamptosar®. A pro-drug is a compound that is converted into the active drug inthe body. However, Camptosar® is converted into SN-38 in colorectalcancer cells at different rates by different patients, and this variability inconversion rates can result in suboptimal dosing 

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and adverse side effects,such as severe diarrhea. By employing our proprietary NeoLipid technology todeliver SN-38, we hope to deliver the active drug to the tumor cellswithout the need for conversion, therefore minimizing variability andoptimizing dose with minimal side effects.

During 2004, we completed a Phase 1 clinical trial forLE-SN38. The primary objectives of the Phase 1 study were to determine thepharmacogenomics, pharmacokinetics, and safety of LE-SN38 in patients withadvanced local or metastatic solid tumors who have failed conventional therapy.Tumor progression was also monitored. In this trial, groups of patientsreceived escalating doses of intravenous LE-SN38 infusion over 90 minutes every21 days until disease progression or unacceptable toxicity levels were reached.Results from this Phase 1 study demonstrated the safety and tolerability ofLE-SN38 and established a maximum tolerated dose, or MTD, for all but a smallsubset of patients that metabolize SN-38 slowly. Pharmacokinetic analysisof blood samples from patients treated with LE-SN38 showed that blood levelsand systemic drug exposure to SN-38 were comparable to or greater thanthat expected from the marketed Camptosar® dose based on previously publishedstudies. In addition, dose limiting diarrhea was not observed.

During the second quarterof 2006, in conjunction with the Colorectal and Leukemia Group B, or CALGB, weinitiated enrollment in a Phase 2 clinical trial for LE-SN38 in metastaticcolorectal cancer patients and completed enrollment of the 21st patient in December 2006. We expect aninterim analysis of data from this LE-SN38 Phase 2 trial in the second quarterof 2007, after the first 21 patients have completed treatment.

***LEP-ETU***

LEP-ETU is our NeoLipid liposomal formulation of thewidely used cancer drug, paclitaxel. Paclitaxel, also known as Taxol®(Bristol-Myers Squibb Company), has been approved in the US for the treatmentof ovarian, breast and lung cancers. Despite paclitaxel’s wide use and itstumor cytotoxic characteristics, its effectiveness can be limited by its adverseside effects, which can include nausea, vomiting, hair loss and nerve andmuscle pain. Because of the chemical characteristics of paclitaxel, it cannotbe introduced into the body unless it is first formulated in a mixture ofcastor oil (Cremophor®) and ethanol, which can lead to significant side effectssuch as hypersensitivity reactions. We believe that by using our proprietaryNeoLipid technology, which eliminates the need for Cremophor and ethanol,LEP-ETU may overcome many current limitations of paclitaxel treatment forcancer patients and may limit the adverse side effects of current treatments.

During 2004, we completeda Phase 1 clinical trial for LEP-ETU. Results of the study indicated thatLEP-ETU appeared to be well tolerated in terms of typical paclitaxel sideeffects by the majority of patients, including those receiving the higher dosesof drug, as well as those who were not premedicated with antihistamines andsteroids. We are in ongoing discussion with the FDA on clinical and regulatoryplans for LEP-ETU.

***LE-DT***

Pre-clinical work has alsoadvanced on our earlier stage liposomal formulation of the anti-cancer agentdocetaxel, LE-DT, which is the active ingredient in Sanofi Aventis’ Taxotere®which is approved for use in certain breast cancer, non-small cell lung cancer,gastric adenocarcinoma and head and neck cancer indications. We anticipatefiling an LE-DT Investigational New Drug Application, or IND, with the U.S. FDAin late 2007.

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**Competition**

Eachof the drug product candidates will face competition from products currently onthe market or under development. The following table lists our currentprincipal competitors and their products which would compete with our drugproduct candidates in the future:

| **Our drug product candidate** | ** ** | ** **                                              | ** ** | **Principal competitor**       | ** ** | **Competitor’s product** |
|--------------------------------|------------|---------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|
| CINTREDEKIN BESUDOTOX(1)       |       | MGI Pharma, Inc.                                   |       | Gliadel® Wafer            |
| LE-SN38                        |       | Pfizer Inc.                                        |       | Camptosar®                |
| LEP-ETU                        |       | Bristol-Myers  Squibb Co. Abraxis BioScience, Inc. |       | Taxol®(2)  Abraxane® |
| LE-DT                          |       | Sanofi Aventis.                                         |       | Taxotere®                 |

 

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(1)   Meeting currentlyscheduled with the U.S. FDA late in first-quarter 2007 to discuss possible regulatorypaths forward, if any.

(2)   Thisproduct is currently off-patent and generics are available.

We also compete with drugdevelopment companies for access to novel technologies as well as in potentialcollaborations with large pharmaceutical and other life sciences companies.

**RESEARCH ANDDEVELOPMENT PROGRAM**

We conduct pre-clinicalresearch to investigate other compounds that could potentially benefit from ourNeoLipid technology. Our pre-clinical research is generally conducted inlaboratories in our Waukegan, Illinois facility. As of December 31, 2006,we employed 30 individuals in research and development, down from 71individuals at December 31, 2005, as we have been aggressivelyreprioritizing our workforce to better conserve our working capital. We haveincurred research and development expenses to advance our drug productcandidates and pre-clinical compounds totaling $21.2 million, $31.9 millionand $44.5 million in 2006, 2005 and 2004, respectively, with research anddevelopment expenditures decreasing over time due to the timing of completionof the PRECISE trial, advancement of other product candidates from thelaboratory toward clinical testing and the reprioritization of our NeoLipiddevelopment efforts and resulting reduction in the number of persons working inthis area.

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**COLLABORATIVERELATIONSHIPS AND LICENSES**

**License andResearch Agreements**

*Nippon Kayaku Co.Ltd. License Agreement*

In December 2004,we signed a license agreement with Nippon Kayaku Co., Ltd., licensing to themcertain rights to develop and commercialize CINTREDEKIN BESUDOTOX in Japan. Thelicense agreement provides for up to $16 million in payments to us fromNippon Kayaku, as follows:

·       a$2 million non-refundable up-front license fee payable within 15 days ofexecution of the license agreement;

·       upto an additional $14 million in license fees and milestone payments.

We received a $2 million non-refundable up-frontlicense fee in January 2005 and the right to receive royalties on futurecommercial sales. Under the license agreement, Nippon Kayaku assumes responsibilityfor, and the costs associated with, the development and testing of CINTREDEKINBESUDOTOX and obtaining regulatory approvals in Japan although we are requiredto provide Nippon Kayaku with supplies of CINTREDEKIN BESUDOTOX free of chargeto conduct pre-clinical, Phase 1 and Phase 2 testing. If CB were to becommercialized in Japan, we would be obligated to supply Nippon Kayaku withCINTREDEKIN BESUDOTOX for commercial sale at a pre-determined price. Currently,we are working with Nippon Kayaku to assess the results of the PRECISE trialand to determine what future action, if any, will be taken pursuant to thelicense agreement.

The initial term of thelicense agreement is ten years from the date of the first commercial sale inJapan, and the agreement may be extended at the option of Nippon Kayaku, for amutually agreed upon period. Under the terms of the license agreement, eachparty may terminate the license agreement upon the occurrence of certaindefaults by the other.

*GeorgetownUniversity Agreements*

We currently have three license agreements withGeorgetown University relating to various liposome- related products.

Under the Georgetownlicenses, and in return for sponsoring related research, we were grantedexclusive licenses to manufacture and sell LED (liposome encapsulateddoxorubicin), LEP (liposome encapsulated paclitaxel), and LErafAON. We areobligated to pay royalties to Georgetown on commercial sales of these products.In addition, through December 31, 2006, we have paid an up-front licensingfee and advance royalty payments (which may be credited against futureroyalties) of $75,000. Additionally, we may be obligated to make milestonepayments upon achieving certain development objectives for these compounds. ForLEP, we have potential maximum aggregate milestone payments remaining of$250,000 and would pay a royalty rate of 2.5% on any commercial sales of theproduct. The Georgetown licenses expire in 2013 for LED, 2014 for LEP and 2020for LErafAON. The licenses may also be terminated by either party in the eventof a default by the other party. At this time, we have ceased development ofLErafAON.

*National Institutesof Health*

In September 1997, we entered into an exclusiveworldwide licensing agreement with the NIH (an agency of the United StatesPublic Health Service, or PHS, within the Department of Health and HumanServices, DHHS) whereby we were granted the right to develop and commercializeCINTREDEKIN BESUDOTOX, IL13-PE38QQR, for the treatment of cancer. TheCINTREDEKIN BESUDOTOX license required us to pay NIH an initial $75,000non-refundable payment and requires minimum annual royalty payments to NIH of$10,000 that increase to $25,000 after the first commercial sale. The 

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CINTREDEKIN BESUDOTOXlicense also requires us to pay to NIH milestone payments of up to $585,000upon completion of various phases of development of CINTREDEKIN BESUDOTOX, anda maximum royalty of 4% based on future product sales, if any. The licenseagreement terminates in 2018. However, we have the unilateral right toterminate the license agreement at any time upon 60 days written notice.The NIH may terminate the agreement upon our default in performing any materialobligations under the agreement or if they determine that such action isnecessary to meet the requirements for public use specified by federalregulations and we were not reasonably satisfying such requirements. Whileproviding us with an exclusive license, it should be noted that, as is typicalin such agreements, the NIH does not make any representations or warranties inthe license agreement as to the validity or enforceability of the licensedrights and does retain certain rights of use for the government.

On May 30, 2006 weentered into a non-exclusive Patent License Agreement with the PHS providing uswith a non-exclusive license to utilize a patented process owned by the U.S.government relating to convection enhanced delivery, or CED, for use withdrugs, including CINTREDEKIN BESUDOTOX, in the treatment of gliomas, in theU.S., its territories and possessions. Under the terms of this Patent LicenseAgreement, we have paid PHS a noncreditable, nonrefundable license issueroyalty of $5,000 and have agreed to pay a nonrefundable, minimum annualroyalty of $2,000, which will be credited against earned royalties, which arefixed at one-half of one percent (0.5%) on aggregate future product sales over$100 million. An additional benchmark royalty of $20,000 is payable withinthirty (30) days of receiving approval from the U.S. FDA to use the licensedCED process in administrating a drug for the treatment of gliomas. Pursuant toan amendment to this Patent License Agreement entered into in August 2006,we expanded the field of use to cover the treatment of cancer, were given theright to sublicense our rights and extended the time for us to reach certainbenchmarks. In return for these additional rights, we agreed to pay additionalsublicensing royalties of one and one-half percent (1.5%), to a maximum of$200,000, on the fair market value of any upfront consideration received forgranting a sublicense.

*U.S. Food and DrugAdministration*

In August 1997, we entered into a cooperativeresearch and development agreement with the FDA, the FDA CRADA, covering theCINTREDEKIN BESUDOTOX compound licensed from the NIH. Pursuant to the FDACRADA, we agreed to commercialize CINTREDEKIN BESUDOTOX and the FDA agreed tocollaborate on the clinical development and commercialization of the licensedcompound. Under the terms of the FDA CRADA, we paid $130,000 to the FDA in2005. Funding for the FDA CRADA expired April 30, 2006. Termination of theFDA CRADA, however, did not affect our rights under our license agreement withthe NIH for CINTREDEKIN BESUDOTOX.

In summary, the amountspaid to our research and development collaborators under our variousagreements, as well as our potential aggregate future commitments under theseagreements, are included in the following table:

***Research andDevelopment Collaboration Expenses***

| ** **                    | ** ** | **Aggregate Payments  Made through  December 31, 2006** | ** ** | **Additional Aggregate  Potential Payments(1)** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Georgetown                    |       |                                                                        | $          | 2,562,000                                                 |       |   |   | $ | 250,000 |   |   |
| NIH                           |       |                                                                        | 1,343,000  |                                                      |       |   | 400,000 |   |   |
| FDA                           |       |                                                                        | 2,075,000  |                                                      |       |   | — |   |   |
| Total Collaboration  Expenses |       |                                                                        | $          | 5,980,000                                                 |       |   |   | $ | 650,000 |   |   |

 

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(1)          Theseamounts do not include potential sales-based royalty payments that may berequired under the various license agreements

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**ManufacturingAgreements**

In order to successfully commercialize our drugproduct candidates, we, or third parties with whom we contract, must be able tomanufacture products in commercial quantities in compliance with the FDA’scurrent Good Manufacturing Practices, or cGMP, at acceptable costs and in atimely manner. As we do not currently own a cGMP manufacturing facility, wehave contracted with third parties to provide us with cGMP production capacity.

In August 2002, we entered into an agreement withDiosynth RTP, Inc., or Diosynth, to produce CINTREDEKIN BESUDOTOX for thePRECISE trial. In September 2005, we amended the Diosynth agreement toencompass work necessary to support a potential CINTREDEKIN BESUDOTOX BLAsubmission. Further, in late 2006, to secure access to manufacturing capacity for the potential manufacture,scale-up of manufacturing and regulatory advancement of CINTREDEKIN BESUDOTOXthrough early 2008, we entered into contractual commitments with Diosynth,under take or pay agreements, under which we are obligated to pay half of thecommitted processing costs, or approximately $1.8 million at December 31,2006, should we elect not to utilize such capacity. We have not yetsecured potential longer-term commercial manufacturing capacity for CINTREDEKINBESUDOTOX from Diosynth, but believe that we would be able to do so, or,alternatively, we believe there are other sources of supply available to us,although securing such alternative sources would significantly delayproduction.

Currently, all of our liposome compounds are producedon a purchase order basis at the Center for Advanced Development, the Center,which is affiliated with the University of Iowa Pharmacy School. The Center hasindicated that it is currently able to meet our needs for research and clinicaltrials, but we cannot offer any assurance that they will be able to do so in atimely manner or on a cost effective basis in the future. We do not have aformal manufacturing agreement with the Center and, therefore, have limitedongoing obligation to manufacture our compounds at this facility.

Our current laboratory facility generally provides uswith the capacity to produce the quantities of our compounds intended solelyfor our pre-clinical research and development purposes.

We believe there are othersources of raw materials and contract manufacturing that would be acceptable tous and would comply with the requirements of the FDA. However, there can be noassurances that we could enter into agreements with these alternative suppliersor manufacturers on terms and conditions acceptable to us, if at all or thathaving to obtain alternative sources of supply would not substantially delay orcurtail development or potential commercialization of our drug candidates.

**Patents andProprietary Rights**

We either own or have in-licensed over 50 UnitedStates patents or patent applications relating to our drug product candidatesand compounds. We have also filed applications in a number of foreignjurisdictions which are counterparts of our issued United States patents andpending patent applications, many of which have issued into patents in therespective countries. We believe all of our drug product candidates andcompounds under development are protected by patents owned or licensed to usand that we will not be infringing upon anyone else’s patented rights uponentry into the marketplace.

Patent protection is important to our business. Thepatent position of companies in the pharmaceutical field generally is highlyuncertain, involves complex legal and factual questions, and has recently beenthe subject of much litigation. Therefore, we cannot assure you that any patentapplications relating to our products or processes will result in patents beingissued, or that the resulting patents, if any, will provide protection againstcompetitors who successfully challenge our patents, obtain patents that we maybe found to infringe and, therefore, adversely affect our ability to conductbusiness or are able to circumvent our patent position by designing around ourpatented technology. It is possible that other parties have invented compoundsor processes that would precede any of our discoveries in the United 

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States. Finally, there canbe no assurance that others will not independently develop similar pharmaceuticalproducts which will compete against ours, or cause our drug product candidatesand compounds to become obsolete.

Our competitive position is also dependent uponunpatented trade secrets. In an effort to protect our trade secrets, we have apolicy of requiring our employees, consultants, and advisors to executeproprietary information and invention assignment agreements upon commencementof employment or consulting relationships with us. These agreements providethat all confidential information developed or made known to the individualsduring the course of their relationship with us must be kept confidential,except in specified circumstances. However, we cannot assure you that theseagreements will provide meaningful protection for our trade secrets or otherproprietary information in the event of unauthorized use or disclosure ofconfidential information. Further, invention assignment agreements executed byconsultants and advisors may conflict with, or be subject to, the rights ofthird parties with whom such individuals have employment or consultingrelationships. In addition, we cannot assure you that others will notindependently develop equivalent proprietary information and techniques orotherwise gain access to our trade secrets, that such trade secrets will not bedisclosed, or that we can effectively protect our rights to unpatented tradesecrets.

We may be required toobtain licenses to patents or proprietary rights of others. We cannot assureyou that any licenses required under any such patents or proprietary rightswould be made available on terms acceptable to us or at all. If we do notobtain such licenses, we could encounter delays in product market introductionswhile we attempt to investigate any possible infringement upon or design aroundsuch patents, or we could find that the development, manufacture, or sale ofproducts requiring such licenses could be foreclosed due to infringement uponthose rights. Litigation may be necessary to defend against or assert claims ofinfringement, to enforce patents issued or exclusively licensed to us, toprotect trade secrets or know-how owned by us or to determine the scope andvalidity of the proprietary rights of others. In addition, we may becomeinvolved in oppositions in foreign jurisdictions or interference proceedingsdeclared by the United States Patent and Trademark Office to determine thepriority of inventions with respect to our patent applications or those of ourlicensors. Litigation, opposition, or interference proceedings could result insubstantial costs to and diversion of effort by, and may have a materialadverse impact on, us. In addition, we cannot assure you that our efforts willbe successful. See Item 1A.—RISK FACTORS.

**GovernmentRegulation**

Regulation by governmental authorities in the UnitedStates and foreign countries is a significant factor in the development,manufacture, and marketing of our drug product candidates and in our ongoingresearch and development activities. The nature and scope of this regulationwill depend on the nature of the products we develop. We anticipate, however,that each of our drug product candidates will be subject to extensiveregulation during the pre-approval research and development phase, and thateach will require approval by the Food and Drug Administration, or FDA, priorto commercialization in the United States (and approval by comparable foreigngovernment authorities prior to commercialization in those countries). Inparticular, human therapeutic products are subject to extensive oversightduring the preclinical and clinical phases, as well as a rigorous approvalstandard and elaborate approval procedures, both in the United States and inforeign countries. Various Federal statutes and regulations also govern orinfluence the manufacturing, packaging, labeling, and storing of humantherapeutic products both during the pre-approval period and after approval.Various Federal statutes and regulations impose record-keeping and reportingrequirements with respect to these products both before and after approval andregulate the promotion and marketing of these products after approval. Theprocess of obtaining approval and compliance with the appropriate Federalstatutes and regulations both before and after approval requires substantial timeand financial resources.

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The stepsordinarily required before a new drug may be marketed in the United States,which are similar to the steps required in most other countries, include:

·       preclinicallaboratory tests, preclinical studies in animals, formulation studies, and thesubmission to FDA of an investigational new drug application, or IND;

·       adequateand well-controlled clinical trials to establish the safety and efficacy of thedrug for each indication sought;

·       thesubmission of a new drug application, NDA, or biologics license application, BLA,to FDA; and,

·       FDAreview and approval of the NDA or BLA.

Preclinical tests include laboratory evaluation ofproduct chemistry, formulation, and toxicity, as well as animal studies. FDAregulates the laboratory work and facilities through good laboratory practice,GLP, regulations. The results of preclinical testing are submitted to FDA aspart of an IND. There is a 30-day waiting period after the filing of eachinvestigational new drug application before clinical testing in humans maybegin. At any time during the 30-day period, FDA may place the proposedstudy on clinical hold. A clinical hold means that the trial may not beginuntil FDA notifies the sponsor that it may begin. FDA may impose a clinicalhold, for example, if it finds that human subjects will be exposed to anunreasonable and significant risk of injury, or if the IND does not containsufficient information to assess the risks to subjects of the proposed study.

Clinical trials to support new drug applications aretypically conducted in three sequential phases, although the phases mayoverlap. During Phase 1, clinical trials are conducted with a small number ofsubjects to assess the metabolism, pharmacokinetics, and pharmacological actionsof the drug, to determine the side effects associated with increasing doses,and if possible to gain early evidence of the drug’s efficacy. Phase 2 usuallyinvolves studies in a limited patient population to assess the efficacy of thedrug in specific, targeted indications; assess dosage tolerance and optimaldosage; and determine common short-term side effects and risks associated withthe drug.

If a compound is found to be potentially effective andto have an acceptable safety profile in Phase 2 evaluations, Phase 3 trials areundertaken to further demonstrate efficacy and to further test for safety in anexpanded patient population at geographically dispersed clinical trial sites.Phase 3 trials are intended to gather the additional information about safetyand efficacy that is needed to support product approval.

Any clinical trial conducted under an IND is subjectto FDA regulations, including its good clinical practices, or GCP, requirements(which include safety reporting requirements), informed consent requirements,and institutional review board, or IRB, requirements. FDA may at any time haltan ongoing clinical trial, if the agency believes that patients participatingin the trial will be or are being exposed to unacceptable health risks. FDA mayalso terminate an IND and require the sponsor to end all clinical trials underthe IND, if it finds deficiencies in the IND or in the conduct of the trialunder the IND. The regulatory authorities of foreign countries have comparableauthority to regulate, suspend, and terminate clinical trials. The clinicaltrial process is extremely costly, and positive results in the preclinicalphase do not necessarily ensure positive results in the subsequent clinicaltrials.

After successful completion of the required clinicaltrials, a new drug application or biologics license application (collectivelyan “application”) is generally submitted. In order for a new drug to beapproved, the application must demonstrate that it is safe and effective andthat it is manufactured in compliance with current good manufacturingpractices, or cGMP. FDA may request additional information before accepting anapplication for filing, in which case the application must be resubmitted withthe additional information. Once an application has been accepted for filing,FDA reviews the application and responds to the applicant. FDA requests foradditional information or clarification often significantly extend the reviewprocess. FDA may refer the application to an appropriate advisory committee forreview, 

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evaluation, andrecommendation as to whether the application should be approved, but FDA is notbound by the recommendations of its advisory committees. FDA will typicallyalso inspect the manufacturing facility to ensure cGMP compliance.

FDA review of a BLA or NDA can take several years. IfFDA’s evaluations of the application and the manufacturing facilities arefavorable, FDA may issue an approval letter or an “approvable” letter. Anapprovable letter will usually contain a number of conditions that must be metin order to secure final approval of the application and authorization tomarket the drug commercially for the approved indications. FDA may also refuseto approve the application or issue a “not approvable” letter outlining the deficienciesin the submission. In this case, additional clinical testing may be necessarybefore a new application will be ready for submission.

FDA has the authority to expedite its review of a drugintended for the treatment of a serious or life-threatening condition, if thesponsor demonstrates that the product has the potential to address an unmetmedical need. Such products are designated as “fast track products.” Anapplication for a fast track product may be approved if FDA determines that theproduct has an effect on a surrogate endpoint that is reasonably likely topredict clinical benefit. This means, for example, FDA has the authority toapprove a cancer therapy not only on the basis of patient survival rates andimproved quality of life, but also partial tumor shrinkage. FDA’s “fast track”authority can significantly shorten the clinical trial process and regulatoryreview period for new cancer therapies. Approval of a fast track product may besubject to the requirement that the sponsor conduct post-approval studies toconfirm the product’s effect on a clinical endpoint. Failure to conduct thesestudies with due diligence, or a negative result in these studies, can resultin expedited withdrawal of product approval. FDA often asks the sponsor of afast track product to agree to distribution restrictions or a risk managementplan.

Under the Orphan Drug Act, FDA may designate a drugproduct as an “orphan drug” if there is no reasonable expectation of recoveryof the costs of research and development from sales in the United States or ifthe drug is intended to treat a rare disease or condition, which is defined asa disease or condition that affects fewer than 200,000 persons in the UnitedStates. If FDA designates a drug product as an orphan drug, then once FDAapproves the product for marketing, it is entitled to seven years of marketexclusivity. This means the agency may not approve another sponsor’s marketingapplication for the same drug for the same orphan indication for seven years.There are two exceptions to the bar on new approvals. Specifically, FDA mayapprove a second application for the same orphan drug if (1) the firstapplication holder consents, or (2) the first application holder cannotassure the availability of sufficient quantities of the drug to meet the needsof persons with the disease or condition. In addition, the market exclusivityprovision does not prevent FDA from approving a different orphan drug for thesame use or the same orphan drug for a different use. The Orphan Drug Act hasbeen controversial, and legislative proposals have from time to time beenintroduced in Congress to modify this law, particularly the market exclusivityprovisions.

Once a new drug is approved for sale in the UnitedStates, the product and its manufacturer continue to be subject to strictregulation by FDA. FDA imposes recordkeeping and reporting requirements,requires the manufacture of the product to comply with cGMP, and reviews themanufacturer’s promotional activities. The company is also subject to regularinspection by FDA. Serious unexpected adverse events after approval can resultin a change to the product’s labeling, a new or expanded risk management plan,and, in extreme situations, withdrawal of the product from the market andwithdrawal of the approved application. There are legislative proposals thisyear to significantly expand the FDA’s authority in the post-approval period.

Many of the legal requirements described in thepreceding paragraphs stem from the Federal Food, Drug, and Cosmetic Act, or FDCA.Violation of the FDCA can result in product seizure, injunctions against thecompany, civil penalties, and criminal prosecution.

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Sales of new drug products outside the United Statesare regulated under comparable laws. The requirements vary from country tocountry, but typically the pre-approval process takes several years, is heavilyregulated, and requires the investment of significant resources. As in theUnited States, manufacturing, labeling, distribution, and promotion continue tobe regulated after product approval.

In most cases, if the FDA has not approved a productfor sale in the United States, the product may be exported for sale outside ofthe United States only if it complies with the laws of, and has valid marketingauthorization from the appropriate authority in: the European Union, a countryin the European Economic Area, Australia, Canada, Israel, Japan, New Zealand,South Africa, or Switzerland. FDA regulations govern this process.

We are also subject to various Federal, state, andlocal laws, regulations, and recommendations relating to safe workingconditions, laboratory and manufacturing practices, and the use and disposal ofhazardous or potentially hazardous substances, including radioactive compoundsand infectious disease agents, used in connection with our research work.

Any of the Federal andstate laws, regulations, and requirements described in this section may changeat any time.

**Employees**

As of December 31,2006, we employed 53 people. Our employees are not represented by anycollective bargaining agreement and we believe our employee relations are good.

**AvailableInformation**

Copies of our AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 are available free of charge through our website (*www.NEOPHARM.com*) as soon as reasonably practicable after weelectronically file the material with, or furnish it to, the Securities andExchange Commission, or SEC. You may read and copy any document we file withthe SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W.,Washington, DC 20549. Please call the SEC at 1-800-SEC-0330for further information on the Public Reference Room. Our SEC filings are alsoavailable to the public at the SEC’s website at *http://www.sec.gov.*Additionally, we have also adopted a Code of Conduct and Business Ethicsapplicable to all officers, directors, and employees, which is also availableon our website.

**ITEM 1A.**        RISKFACTORS

You should carefullyconsider the following risk factors, in addition to the other information setforth in this document as well as other information filed in periodic reportswe file with the SEC. Each of these risk factors could adversely affect ourbusiness, operating results and financial condition, as well as the value of aninvestment in our common stock.

We are highly dependent onobtaining approval of our most advanced drug product candidate, CINTREDEKINBESUDOTOX. This drug product candidate failed to meet the statistical endpointestablished in its Phase 3 PRECISE clinical trial. As a result, it may neverbe approved for commercial use, or, if approved, it may not have the marketpotential that we had hoped for. If we are unable to successfully commercializeCINTREDEKIN BESUDOTOX, our ability to generate revenues would be impaired andour business would be harmed.

We have invested a significant portion of our time andfinancial resources in the development of CINTREDEKIN BESUDOTOX, a tumortargeting toxin developed as a treatment for gioblastoma 

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multiforme, or GBM, adeadly form of brain cancer. In December 2006, we suffered a significantsetback with the results of our Phase 3 clinical trial of CINTREDEKINBESUDOTOX, the PRECISE trial, for the treatment of recurrent GBM. Patients inthe PRECISE trial received treatment either with CINTREDEKIN BESUDOTOX or withGliadel® Wafers, a product currently approved to treat GBM. Theprimary endpoint of the study was to determine if there was a statisticallysignificant overall patient survival difference between patients treated with CINTREDEKINBESUDOTOX and patients treated with Gliadel® Wafers. ThePhase 3 PRECISE Clinical trial did not meet the primary endpoint at 215deaths.

Since the announcement of the PRECISE trial results,the Company has been working with its Scientific Advisory Board to identifypotential regulatory paths forward, meaning a rationale for FDA approval, basedon the totality of the clinical data gathered to date. We plan to meet with theFDA in late March 2007 to discuss the possibility of approval on the strengthof our data and analysis. We cannot predict the outcome of that meeting. TheFDA could evaluate the data in a different way, for example using differentstatistical methods, and could reach different conclusions about the PRECISEtrial altogether. The FDA could agree with our conclusions about the PRECISEtrial, but still reject the argument that these conclusions may support productapproval. Even if the FDA agreed that these conclusions may support productapproval, it could require statistically significant results from a second Phase 3trial. There is no assurance that we would or could generate these additionaldata. The agency could also reject the data from the PRECISE trial for otherreasons, including human errors in the conduct of the trial. Even if we believethat we have submitted all of the data and information necessary to satisfy FDArequirements for approval of the BLA, there is a risk that the FDA will requireadditional data and information that we are unable to provide. Also, anyadverse safety findings in the PRECISE trial, or in future clinical trials,could delay or prevent regulatory approval.

Even if the FDA agrees that the results of the PRECISEtrial provide a basis for regulatory approval, prior to commercialization ofCINTREDEKIN BESUDOTOX in the United States, we will have to submit, and the FDAwill have to approve, a BLA for CINTREDEKIN BESUDOTOX. A BLA is a lengthy,complex submission to the FDA, which must comply in format and content withelaborate and detailed FDA requirements. We have never submitted a BLA before.The FDA may refuse to accept a BLA for filing if it is incomplete. The lengthand outcome of the FDA’s review of the BLA is uncertain. The FDA’s approval iscontingent on many factors, including its evaluation of our preclinical andclinical trial results, its assessment of the manufacturing process we proposeas well as the process controls, its review of our drug substancespecifications and proposed analytical procedures, the data we provide on thedrug’s stability, and its inspection of the facilities where CINTREDEKINBESUDOTOX is manufactured. The FDA may ask an advisory committee for itsrecommendations on the BLA, and we cannot predict the outcome of the advisorycommittee process.

Because the PRECISE trial did not show thatCINTREDEKIN BESUDOTOX is superior to Gliadel, the medical community may beunwilling, or less willing, to accept CINTREDEKIN BESUDOTOX as an alternativeto Gliadel, or other treatment options. This could diminish the marketpotential for CINTREDEKIN BESUDOTOX. In addition, because the PRECISE trial didnot show that CINTREDEKIN BESUDOTOX is superior to Gliadel, public and privatehealthcare payors may not provide reimbursement for the drug if it is moreexpensive than Gliadel. This could also diminish the market potential for CINTREDEKINBESUDOTOX.

We rely heavily on third parties with respect to,among other things, the production and testing of CINTREDEKIN BESUDOTOX. Evenif, despite CINTREDEKIN BESUDOTOX’ failure to meet the primary endpoint of itsPhase 3 PRECISE trial, we are able to submit a BLA for CINTREDEKINBESUDOTOX, the failure of any of these third parties to fulfill its contractualobligations, to perform key tasks appropriately or in a timely manner, or tocomply with applicable government regulations, could require us to find alternativethird parties to fulfill these functions. This could significantly slow the filing

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of a BLA, preclude itstimely approval or even preclude its approval altogether. For example, we havecontracted with Diosynth RTP. Inc., or Diosynth, to assist in the developmentof manufacturing processes in connection with the scale-up of manufacturing ofCINTREDEKIN BESUDOTOX from preclinical testing and clinical development tocommercial-scale operations, including the preparation and filing of documentsfor process development, method development, and process validation. Theseprograms must be developed in compliance with applicable governmentregulations, including the FDA’s cGMP requirements for biological products,which are extremely complex and require considerable time, resources, andongoing investment to comply with. Manufacturing establishments, includingcontract manufacturers such as Diosynth, are subject to inspections by the FDAfor compliance with cGMP. Any errors or omissions in completing the process ormethod development or process validation, if not promptly corrected by usand/or Diosynth, could significantly delay any potential BLA filing. If FDAapproval is delayed, or the FDA requires additional clinical testing or otherinformation, or the FDA does not approve a BLA, our ability to achieve revenuesfrom product sales would be impaired and our stock price would be materiallyand adversely affected.

Even though the FDA hasawarded orphan drug designation to CINTREDEKIN BESUDOTOX, a competitor couldobtain orphan drug designation for the same drug for the same indication. TheFDA could approve that competitor’s product first and give it seven years ofmarket exclusivity. In this case, even if the FDA were to accept a BLA for CINTREDEKINBESUDOTOX (and there is no assurance that it will) it would not be able toapprove the BLA for seven years. This would have a material adverse effect onour business. The law would permit the FDA to approve our product during theseven years if certain conditions were met, but there is no assurance we couldsatisfy these conditions. We might be able to market the product outside theUnited States, if certain conditions were met, but there is no guarantee thatwe would be able to satisfy those conditions. The export process can becomplex, and there are no assurances that export would be permitted or that anothercountry would accept the product. Even if the FDA were to approve CINTREDEKINBESUDOTOX as an orphan drug, and there is no assurance at this point that wewill even be able to pursue such approval, and then award us seven years ofexclusivity in connection with its use, the law permits the FDA, in certainsituations, to approve a competitor’s product. This could have a materialadverse effect on the commercial success of our product.

**If we are unable tosuccessfully develop, obtain regulatory approval for, cause to be manufactured,and market our drug product candidates, our business would be harmed.**

The process for developing new therapeutic products isinherently long, complex, and uncertain. We must make long-term investments andcommit significant resources before knowing whether our development programswill eventually result in products that will receive regulatory approval andachieve market acceptance.

We currently have three drug product candidates invarious stages of clinical development. We decided in 2006 based on our reviewof clinical and commercial data for LE-rafAON not to pursue further developmentof that drug product candidate at this time. Each current drug productcandidate is the subject of an effective Investigation New Drug application, orIND, that we filed with FDA. The protocols for any clinical trials we performunder these INDs must have institutional review board, or IRB, approval, andthe trials must comply with the FDA’s good clinical practices, or GCP, andother regulations. There is no assurance that the clinical trials we may seekto conduct under these INDs will obtain IRB approval. There is also noassurance that FDA will allow us to continue the clinical trials that we havebegun. FDA may suspend a clinical trial at any time if the agency believes thatthe patients participating in the study are or will be exposed to unacceptablehealth risks. FDA may also terminate an IND and require the sponsor to end allclinical trials under that IND, if it finds deficiencies in the IND or in theconduct of a trial under the IND. An IRB also may suspend or terminate aclinical trial. Some of our clinical trials are conducted in foreign countries,and the regulatory authorities of those countries have comparable authority tosuspend 

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and terminate clinicaltrials. Suspension or termination of the clinical trials of our drug productcandidates could substantially delay or even prevent regulatory approval of thedrug product candidates. There is no guarantee that clinical studies, ifperformed, will demonstrate the safety and efficacy of any drug productcandidate we have in development.

Sales of our drug product candidates would be subjectto pre-market approval requirements in the United States and in othercountries. These requirements vary widely from country to country. We cannotassure you that we will receive approval to market any of our drug productcandidates in any country, or that any approval we obtain will be oncommercially viable terms. We have yet to submit an application for marketingapproval for any of the drug product candidates we currently have underdevelopment. We cannot predict with certainty if or when we might submit any ofthese drug product candidates for regulatory review. We cannot assure you thatonce we submit a drug product candidate for review, the FDA or any otherregulatory agency will approve that product on a timely basis or at all.

Approval of our drug product candidates in the UnitedStates or a foreign country may depend on our agreement to perform burdensomeand expensive post-marketing studies or our agreement to a burdensome riskmanagement plan that could interfere with physician and patient acceptance ofour product. We cannot assure you that we will agree to perform such additionalstudies or to accept such a risk management plan. If we agree to performpost-market studies and then fail to conduct those studies with due diligence,or if those studies fail to verify the product’s clinical benefit, the FDA maywithdraw its approval of the product. The FDA may also withdraw its approval ofthe product if it determines, based on other information, that the product doesnot present an acceptable balance of benefits and risks

If the FDA or a foreign regulatory authority approvesone of our drug product candidates, we will need to manufacture, or contractwith third parties to manufacture, a sufficient volume of that product to meetmarket demand. This will require accurate forecasting of market demand. Thereis no guarantee that we will accurately forecast the market demand for any ofour drug product candidates or that there will be any market demand. There isalso no assurance that we will be able to successfully manufacture, or find athird party to manufacture, adequate quantities of any of our drug productcandidates to meet any market demand.

The drug product candidate which we have advanced thefarthest is CINTREDEKIN BESUDOTOX, IL13-PE38QQR. In September 1997,we exclusively licensed worldwide rights to CINTREDEKIN BESUDOTOX from theNational Institute of Health, or NIH, and FDA. In December 2006, weannounced that the Phase 3 PRECISE Clinical trial of CINTREDEKIN BESUDOTOX inthe treatment of recurrent glioblastoma multiforme did not meet the primaryendpoint at 215 deaths, which was a statistically significant difference, orseparation, in the overall survival curves versus the Gliadel Wafer®, orGliadel. There are no assurances that CINTREDEKIN BESUDOTOX will prove to besafe and effective or receive regulatory approval for any indication.

We also have two other drug product candidates inclinical development for the treatment of various cancers: LE-SN38 and LEP-ETU.We have initiated enrollment, currently ongoing, in a Phase 2 clinical trialfor LE-SN38 and have completed two Phase 1 clinical trials and we are currentlyplanning a Phase 3 clinical trial for LEP-ETU. We are in ongoing discussionwith the FDA on clinical and regulatory plans for LEP-ETU. There are noassurances that any of these drug product candidates will proceed to the nextphase of clinical development, or prove to be safe and effective, or that anyof them will receive regulatory approval for the treatment of the indicationswhich we may pursue.

Even if we receive regulatory approval for one of ourdrug product candidates in the United States or a foreign country, there are noassurances that the product will prove to be commercially successful orprofitable.

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**We depend on thirdparties for a variety of functions, including the research and development,manufacturing, clinical testing, and regulatory compliance of our drug productcandidates. No assurance can be given that these third parties arrangementswill allow us to successfully or timely develop, manufacture and market ourdrug product candidates.**

We do not have the internal infrastructure to conductclinical trial management or certain other aspects of clinical testingourselves. On December 31, 2006, we had 53 full-time employees. Wetherefore rely on third parties to perform a variety of functions with respectto the clinical development of our drug product candidates, including clinicaltrial management and manufacturing of our drug product candidates. If wedevelop additional drug product candidates with commercial potential, we willhave to either hire additional personnel skilled in clinical testing or engagethird parties to perform such services.

We have engaged PPD to oversee certain aspects of ourPRECISE trial for CINTREDEKIN BESUDOTOX. Our agreement with PPD obligates us tocompensate PPD on a monthly basis and make milestone payments as the trialprogresses. We have engaged other companies on a per study basis for assistancein the management and testing for our Phase I and Phase II clinical trials. Tooversee data management in our clinical trials we have contracted, on a perstudy basis, with Advanced Clinical Services. To conduct our large animaltesting, we have engaged, again on a per study basis, Southern ResearchInstitute.

While we have been satisfied with the performance ofthese various organizations, we do not directly control them. We depend onthese organizations to apply the appropriate expertise and resources toexpeditiously and competently perform the services for which they have beenretained. If any of these third parties with whom we contract breaches itsagreement with us or fails to comply with an applicable government regulation,we might be required to find a satisfactory alternative service provider. Inaddition, our drug development efforts could be delayed or impaired. We areaware of other entities that could offer similar services. We frequently changevendors and consider such items as price, vendor capabilities to meet ourneeds, and ease of transition in choosing new vendors.

In order to commercialize our drug product candidatessuccessfully, we, or third parties with whom we contract, must be able tomanufacture products in commercial quantities in compliance with the FDA’s cGMPrequirements at acceptable costs and in a timely manner. We do not currentlyhave commercial scale cGMP compliant manufacturing capacity for any of the drugproduct candidates we are developing. Currently, all of our liposome compoundsare produced at the Center for Advanced Drug Development, the Center, which isaffiliated with the University of Iowa Pharmacy School. The Center hasindicated that it is currently able to meet our needs for research and clinicaltrials, but we cannot be sure that it will be able to meet our needs in atimely manner or on a cost-effective basis in the future. If the Center wereunable to meet our needs in the future, we cannot be sure that suitablealternatives could be found in a timely manner, or at all.

We have an agreement with Diosynth pursuant to whichDiosynth produced CINTREDEKIN BESUDOTOX for our Phase 3 PRECISE clinical trial.If, despite CINTREDEKIN BESUDOTOX’ failure to meet its primary endpoint in thistrial, we are nevertheless able to submit a BLA for CINTREDEKIN BESUDOTOX,Diosynth would manufacture on a take-or-pay basis, the  drug product substance for the BLA. Thereafter,we would expect to expand our existing agreement with Diosynth to obtain ourinitial commercial requirements of CINTREDEKIN BESUDOTOX, if it were approved. Wewould also need to contract with a suitable third party to provide fill andfinish services for CINTREDEKIN BESUDOTOX. While we are currently negotiatingwith third parties to provide these services, we have not yet entered into anagreement.

If either the Center or Diosynth were to breach itsagreement with us, or fail to comply with any applicable governmentalrequirement, or fail to deliver drug product substance in a timely manner, wemight be required to find a satisfactory alternate provider. This couldsignificantly delay or impair our drug 

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development efforts aswell as submission of  any eventual BLA.If we fail to secure third-party services for the filling and finishing of ourdrug product candidates, this too could significantly delay or impair our drugdevelopment efforts and submission of any eventual BLA.

We also in-licensetechnology from governmental and academic institutions in order to minimize ourinvestment in basic research, and we enter into collaborative arrangements withcertain of these entities with respect to research and development of our drugproduct candidates. No assurance can be given that we will enter into more ofthese relationships, that we will be able to maintain or renew the researchagreement with FDA, that this relationship will provide benefits to us, or thatwe will be able to establish new relationships on beneficial terms, withoutundue delays or expenditures.

**Because all of ourdrug product candidates are in pre-clinical or clinical development, there is ahigh risk that further development and testing will demonstrate that our drugproduct candidates are not approvable or suitable for commercialization, whichcould cause our business to suffer.**

None of our drug product candidates has receivedregulatory approval for commercial sale. Before we can obtain regulatoryapproval for the commercial sale of any of our drug product candidates, we mustdemonstrate through pre-clinical testing and clinical trials that the drugproduct candidate is safe and effective. Conducting pre-clinical and clinicaltesting is a lengthy, expensive, and uncertain process and may take severalyears or more. Success in pre-clinical testing does not assure success inclinical trials, and positive results in early phase clinical trials do notassure a positive outcome in later trials.

Clinicaldevelopment of any of our drug product candidates, including, but not limitedto, CINTREDEKIN BESUDOTOX, may be curtailed, redirected, delayed, or eliminatedat any time for any of the following reasons or for other reasons:

·       ourinability to demonstrate superiority to existing treatments for targeteddiseases;

·       ourdetermination that the applicable market, or competition within the market,makes competition uneconomic;

·       ourinability to manufacture, or secure third party sources to manufacture,sufficient quantities of drug compounds for use in clinical trials;

·       ourinability to attract suitable and willing investigators for our trials;

·       ourinability to locate, recruit, and qualify a sufficient number of patients forour trials;

·       negativeor ambiguous results regarding the effectiveness of the drug product candidate;

·       undesirableside effects that delay or extend the trials, or other unforeseen orundesirable safety issues that make the drug product candidate not medically orcommercially viable;

·       ourfailure, or the failure of any third party with whom we contract, to complyfully with the investigational new drug regulations and other regulationsapplicable to clinical trials;

·       delays,suspension, or termination of trials imposed by us or an independentinstitutional review board for a clinical trial site, or a clinical hold placedupon the trial by the FDA;

·       regulatorydelays or other regulatory actions, including changes in regulatoryrequirements;

·       ourinability to adequately follow patients after treatment; and

·       delaysin importing or exporting clinical trial materials.

A delay or termination ofany of our clinical trials would have an adverse effect on our business. If anyof our clinical trials is unsuccessful, this could preclude us from obtainingregulatory approval, which would 

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have anadverse effect on our business. If any of our clinical trials is perceived asunsuccessful by the FDA or physicians, our business, financial condition, andoperations would be harmed.

**Our business issubject to extensive governmental regulation, and failure to comply with thoseregulations can lead to unanticipated delays in product development andapproval and can prevent commercialization.**

The FDA regulates the research, development, andtesting of our drug product candidates. If any of our drug product candidatesis approved for marketing and introduced into the market, the FDA will continueto regulate the manufacturing, labeling, distribution, marketing, andadvertising activities of that product. Public health authorities in foreigncountries have comparable authority. Compliance with these requirements beforeand after approval is expensive and time consuming. Failure to comply can leadto regulatory action that would have a negative impact on our business.

In order to market a new therapeutic product in theUnited States, we must prove that the product is safe and effective for itsintended uses and that the product is manufactured in compliance with currentGood Manufacturing Practices, or cGMP. Completing the pre-clinical and clinicaltesting necessary to prove the safety and effectiveness of a new therapeuticproduct, and establishing the capability to comply with cGMP, can take manyyears, be very costly, and still be unsuccessful. The results of pre-clinicaltesting and Phase 1 and 2 studies are not necessarily indicative of the resultsin larger patient populations, as evaluated in Phase 3 studies.

In order to market any of our drug product candidates,once this lengthy research and development process is completed, we will needto submit a BLA or NDA to the FDA. This will need to contain pre-clinical,clinical, manufacturing, labeling, and other information, and it mustdemonstrate that the drug product candidate is safe and effective for use inhumans for each proposed indication. The FDA may refuse to accept any of ourapplications if it views the application as incomplete. The manufacturingfacilities must also comply with cGMP, and FDA may inspect the facility beforeit approves the application.

Even if we completethe lengthy and expensive research and development process for one of our drugproduct candidates and file a BLA or NDA seeking approval to market thecandidate, we do not know whether the FDA will approve the application on atimely basis, on commercially viable terms, or at all. The FDA’s review of aBLA or NDA that it accepts can take several years. The FDA can delay, limit, ordeny approval for many reasons, including if:

·       itdetermines that our drug product candidate is not safe or is not effective, ordoes not present an acceptable benefit-risk profile;

·       itinterprets the data from our pre-clinical testing and clinical trialsdifferently than we do;

·       itdetermines that our manufacturing processes or facilities, or the processes orfacilities of third parties involved in the manufacture of our drug productcandidates, do not comply with cGMP;

·       itchanges its approval policies or adopts new regulations; or

·       Congressamends the Food, Drug and Cosmetics Act, the Public Health Service Act, orother applicable laws.

The process of obtaining approvals in foreigncountries is subject to uncertainty, delay, and failure for similar reasons.

In addition, the FDA (and foreign regulatoryauthorities) may approve a drug product candidate for fewer than all theindications requested or require that the drug product be labeled in a way thatdiffers from our proposed labeling. Even if the FDA (or a foreign regulatoryauthority) approves one of our drug 

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product candidates, it mayrequire that we perform burdensome post-marketing studies and it may imposeother burdensome requirements, including the requirement that we institute andmaintain a special risk management plan to monitor and manage potential safetyissues. These requirements could reduce or eliminate the drug product’s marketpotential.

A drug product and its manufacturer are subject tostrict regulation after product approval by the FDA and comparable foreignauthorities. The FDA regulates manufacturing, labeling, distribution, andpromotional activities after product approval, as do comparable foreignregulatory agencies. We must also report certain adverse events andmanufacturing issues involving our drug products to these agencies. Applicationholders must submit new or supplemental applications and obtain FDA approvalfor certain changes to the approved product, product labeling or manufacturingprocess. In addition to FDA requirements, sales, marketing andscientific/education grant programs must comply with the anti-fraud and abuseprovision of the Social Security Act, the False Claims Act and similar statelaws, each as amended. Pricing and rebate programs must comply with theMedicaid rebate requirements of the Omnibus Budget Reconciliation Act of 1990,and the Veteran’s Health Care Act of 1992, each as amended. If products aremade available to authorized users of the Federal Supply Schedule of theGeneral Services Administration, additional laws and requirements apply. All ofthese activities are also potentially subject to federal and state consumerprotection and unfair competition laws.

Failure to comply with applicable legal and regulatoryrequirements can result in, among other things, product seizure, civilpenalties, suspensions and withdrawals of regulatory approvals, import andexport problems, product recalls, operating restrictions, and criminalprosecution. The restriction, suspension, or revocation of regulatory approvalsor other adverse action taken on the basis of failure to comply with applicableregulatory requirements could have a material adverse effect on our business,financial condition, and operations.

Previously unidentifiedadverse events or an increased frequency of adverse events that may occurpost-approval could result in the FDA, or other agencies, requiring us toconduct further clinical research, which could be expensive and could lead tonew and unfavorable information about the safety or the effectiveness of ourproduct. New safety or effectiveness information after approval can result in achange in the labeling of our drug products, new or more extensive distributionrestrictions, a new or expanded risk management program, product recalls,withdrawal of the drug product from the market, or withdrawal of productapproval, any of which could materially affect the commercial success of theproduct. Any unforeseen problems with one of our drug product candidates afterapproval could preclude successful commercialization of that product and harmour business and stock price.

**We have a historyof operating losses, expect to continue to incur losses for the foreseeablefuture, and may never be profitable.**

We have a limitedoperating history, and our operations consist primarily of the development ofour drug product candidates and the sponsorship of research and clinicaltrials. Over the past three fiscal years ended December 31, 2006, we haveincurred aggregate net losses of $129.5 million, with aggregate net lossessince inception of $261.2 million. We expect to incur additional losses and, asour development and commercialization efforts and clinical testing activitiescontinue, our losses may increase. We also expect to experience negative cashflows for the foreseeable future as we fund our losses and capitalexpenditures. Our losses have adversely impacted, and will continue toadversely impact, our working capital, total assets and stockholders’ equity.To date, we have not sold or received approval to sell any drug productcandidates, and it is possible that revenues from drug product sales will neverbe achieved. In the past, we have generated only very limited revenue fromlicense fees and sales of products. We cannot at this time predict when or ifwe will be able to develop sources of revenue or when or if our operations willbecome profitable, even if we are able to commercialize some of our drugproduct candidates.

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**Budget constraintshave in the past and may in the future force us to delay our efforts to developcertain drug product candidates in favor of developing others, which preventsus from commercializing all drug product candidates as quickly as possible.**

Because we are a smallcompany with limited resources, and because research and development is anexpensive process, we must regularly assess the most efficient allocation ofour research and development budget. As a result, we have been forced toprioritize development activities with the result that we will not be able tofully realize the value of some of our drug product candidates in a timelymanner, as they will be delayed in reaching the market, if at all. In 2006, wecompleted a reprioritization of the NeoLipid® program in an effort tosubstantially decrease our expenses, including a restructuring of our workforceand a reduction in research and development spending. If we are not successfulin maintaining the planned level of spending, our efforts to commercialize ourdrug product candidates will be seriously eroded. Additionally, the reductionin spending on our drug product candidates will necessitate a delay in ourcommercialization efforts and negatively impact our strategy to diversify ourdevelopment risk across our drug product candidates.

**Competition in thebiopharmaceutical field is intense and subject to rapid technological change.Our principal competitors have substantially greater resources to develop andmarket products that may be superior to ours.**

If we obtain regulatory approval for any of our drugproduct candidates, the extent to which they achieve market acceptance willdepend, in part, on competitive factors. Competition in our industry isintense, and it is increased by the rapid pace of technological development.Existing drug products or new drug products developed by our competitors may bemore effective or have fewer side effects, or may be more effectively marketedand sold, than any that we may develop. Many of our principal competitors havesubstantially greater research and development capabilities and experience andgreater manufacturing, marketing, financial, and managerial resources than wedo. Competitive drug compounds may render our technology and drug productcandidates obsolete or noncompetitive prior to our recovery of research,development, or commercialization expenses incurred through sales of any of ourdrug product candidates. The FDA’s policy of granting “fast track” approval forcancer therapies may also expedite the regulatory approval of our competitors’drug product candidates.

Eachof the drug product candidates currently in clinical development will facecompetition from drug products currently on the market or under development.The following table lists our current principal competitors and their productswhich compete with the listed drug product candidates we currently have underdevelopment:

| **Our drug  product candidate** | ** ** | ** **                                              | ** ** | **Principal competitor**       | ** ** | **Competitor’s product** |
|---------------------------------|------------|---------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|
| CINTREDEKIN BESUDOTOX(1)        |       | MGI Pharma, Inc.                                   |       | Gliadel® Wafer            |
| LE-SN38                         |       | Pfizer Inc.                                        |       | Camptosar®                |
| LEP-ETU                         |       | Bristol-Myers  Squibb Co. Abraxis BioScience, Inc. |       | Taxol®(2)  Abraxane® |
| LE-DT                           |       | Sanofi Aventis.                                         |       | Taxotere®                 |

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(1)          Meeting currently scheduledwith the U.S. FDA late in first-quarter 2007 to discuss possible regulatorypaths forward, if any.

(2)          This product iscurrently off-patent and generics are available.

Additionally, other drug companies are currentlyconducting clinical trials, which are in various stages, for numerous drugcompounds that, if ultimately approved for marketing, could be competitive withour drug product candidates, including, but not limited to, clinical trialsinvolving drug compounds for the treatment of glioblastoma multiforme which, ifapproved, could compete with CINTREDEKIN 

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BESUDOTOX, if developmentof that drug in the treatment of recurrent glioblastoma multiforme is continuedand if it then is eventually approved for the treatment of that disease.

We also compete with otherdrug development companies for licenses to novel technologies as well as forcollaborations with large pharmaceutical and other companies.

**Our stock price hasbeen and is likely to continue to be volatile, and an investment in our commonstock could decline in value.**

The stock market hasexperienced significant price and volume fluctuations, which often have beenunrelated to the operating performance of particular companies. In addition,the market price of our common stock has been highly volatile and is likely tocontinue to be so. For example, during 2006, the market price of our commonstock fluctuated between $1.66 and $12.67 per share and during 2005 the marketprice of our common stock fluctuated between $15.47 and $7.16 per share.

Thefollowing factors, among others, could have a significant impact on the marketprice of our stock:

·       ourability, or inability, to persuade the FDA that a plausible regulatory pathwayexists for CB, that the FDA would approve a BLA for CB, were one to besubmitted, or that the FDA would require additional data or testing.

·       thesuccess or failure of our clinical trials or those of our competitors;

·       ourability to prepare, file and obtain approval of a BLA for CINTREDEKIN BESUDOTOXin a timely manner, if one is ultimately filed.

·       ourability to conserve our cash resources or to obtain financing, when needed;

·       litigation,including, but not limited to, current class action lawsuits;

·       actualor anticipated fluctuations in our financial results;

·       economicconditions in the US and abroad;

·       commentsby or changes in Company assessments or financial estimates by securitiesanalysts;

·       adverseregulatory actions or decisions;

·       lossesof key management;

·       changinggovernmental regulations;

·       ourability to secure adequate third party reimbursement for products developed byus;

·       developmentsor disputes concerning patents or other proprietary rights;

·       productor patent litigation; and

·       publicconcern as to the safety of products developed by us.

Additionally, volatility or a lack of positiveperformance in our stock price may adversely affect our ability to retain keyemployees, all of whom have been granted stock options.

These factors and fluctuations, as well as politicaland market conditions, may materially adversely affect the market price of ourcommon stock.

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**We will need toraise additional capital in the future. If additional capital is not available,or can not be obtained on favorable terms, we may have to curtail or ceaseoperations.**

We estimate that asof December 31, 2006, our then existing cash reserves, should besufficient to finance our operations at current and projected levels ofdevelopment and general corporate activity into 2008. We do not anticipatebeing able to generate revenues from product sales in the near term at a ratesufficient to fund our operations. We will need additional future financingdepending on a number of factors, including, but not limited to, the following:

·       ourdegree of success in gaining approval for and thereafter successfullycommercializing our drug product candidates;

·       therate of progress and cost of research and development and clinical trialactivities relating to our drug product candidates;

·       apossible obligation to pay damages arising from the ongoing consolidated classaction lawsuit, to the extent these possible damages exceed, or are not coveredby, our insurance;

·       thecosts of preparing, filing and prosecuting patent applications, maintaining andenforcing our patent claims and other intellectual property rights andinvestigating and defending against infringement claims asserted against us byothers;

·       emergenceof competing technologies and other adverse market developments;

·       changesin or terminations of our existing licensing arrangements;

·       theamount of milestone payments we may receive from future collaborators, if any;

·       thecosts of acquiring or licensing new technology, products or businesses if wedesire to expand our product portfolio; and

·       thecost of manufacturing scale-up and development of marketing operations, if weundertake those activities.

Additional financing maynot be available when we need it or be on terms acceptable to us. If adequatefinancing is not available, we may be required to delay, scale-back, oreliminate certain of our research and development programs, to relinquish rightsto some of our technologies or products, or to grant licenses to third partiesto commercialize products or technologies that we would otherwise seek todevelop ourselves. We could also be required to cease operations. If additionalcapital is raised through the sale of equity, our stockholders’ ownershipinterest could be diluted and such securities may have rights, preferences, orprivileges superior to those of our other stockholders. The terms of any debtsecurities we may sell to raise additional capital may place restrictions onour operating activities. Failure to secure additional financing may cause usto delay or abandon some or all of our development programs.

**If we, or oursuppliers, fail to comply with FDA and other government regulations, ourmanufacturing operations could be interrupted, and our drug productdevelopment, future sales, and profitability would suffer.**

All new drugs, including our drug product candidatesunder development, are subject to extensive and rigorous regulation by the FDAand comparable foreign authorities. These regulations govern, among otherthings, the development, pre-clinical and clinical testing, manufacturing,labeling, storage, pre-market approval, advertising, promotion, sale, anddistribution of our drug product candidates. We rely on third parties toperform a variety of functions, including research and development, clinicaltrial management and testing, and manufacturing of our drug product candidates.We currently obtain the necessary raw materials for our drug productcandidates, as well as certain services, such as testing, from third parties.We currently contract with suppliers and service providers that are required tocomply with 

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strict standardsestablished by us. Certain suppliers and service providers are required tofollow good laboratory practices, or GLP, good clinical practices, or GCP, and currentgood manufacturing practices, or cGMP, requirements and are subject to routineunannounced periodic inspections by the FDA and by certain state and foreignregulatory agencies for compliance with those requirements and other applicableregulations. There can be no assurance that the FDA and other regulatoryagencies will find the manufacturing process or facilities or other operationsof our suppliers and other service providers to be in compliance with GLP, GCP,cGMP, or other applicable requirements.

While to our knowledgenone of our principal suppliers or service providers has been found to be outof compliance with GLP, GCP, cGMP, or other applicable requirements withrespect to the goods or services they provide to us, failure of any of ourprincipal third party suppliers or service providers to maintain satisfactorycompliance with applicable requirements could have a material adverse effect onour ability to develop, market, and distribute our drug product candidates inthe future and, in the most serious cases, could result in the issuance ofwarning letters, seizure or recall of drug products, criminal prosecution,civil penalties, or closure of such manufacturing facilities until complianceis achieved.

**We have limitedsales and marketing personnel and do not yet have distribution organizations,processes or capabilities in place, which means we must either enter intoagreements with third parties to provide such capabilities or we must developsuch capabilities ourselves.**

We currently havelimited internal sales and marketing, and do not have distribution resources.If we were ever to receive the required regulatory approvals for one of ourdrug product candidates, of which there can be no assurance, we could elect tomarket and sell our drug product candidates through distribution, co-marketing,co-promotion, or licensing arrangements with third parties. If we elect tomarket our drug product candidates directly, significant additionalexpenditures and management resources will be required to develop an internalmarketing or sales force. We have no historical experience in establishing ormaintaining an effective sales or marketing effort. If we were ever to developand obtain approval of a drug, and we decided to perform sales and marketingactivities ourselves, we could face a number of additional risks, including,but not limited to:

·       theinability to attract and retain a marketing or sales force with relevantpharmaceutical experience;

·       thecosts of establishing a marketing or sales force may not be recoverable ifproduct revenues are lower than expected; and

·       therecould be delays in product launch due to the time needed to develop and trainan effective marketing organization or sales force.

On the other hand, to the extent that we elect toenter into arrangements with third parties for the marketing and sale of ourdrug product candidates, any economic benefit we received would dependprimarily on the efforts of these third parties, and the resulting economicbenefit received may be lower than if we marketed our drug products directly.In addition, we may not be successful in entering into sales and distributionrelationships with third parties and, even if we are successful, we may notcontrol the amount and timing of marketing resources such third parties devoteto our drug product candidates.

There can be no assurancethat we would be able to establish an effective marketing or sales force shouldwe choose to do so. The inability to successfully employ qualified marketingand sales personnel or to develop other sales and marketing capabilitiesthrough third parties would be harmful to our overall business operations.

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**We are currentlynamed as a defendant in a number of securities class action lawsuits. Thevolatility of our stock increases the risk that additional securities classaction litigation could be instituted against us in the future.**

Securities class actionlitigation is often brought against a company following periods of volatilityin the market price of its securities. We, along with certain of our formerofficers, are currently named as defendants in a number of class actionlawsuits which have been consolidated for trial and are currently pending inthe U.S. District Court for the Northern District of Illinois, and each ofwhich alleges various violations of the federal securities laws in connectionwith certain of our public statements as they relate to our LEP drug productcandidate. We may be named as a defendant in similar litigation in the future.While we are vigorously defending this litigation, this litigation hasresulted, and can be expected to continue to result, in substantial costs andin a diversion of management’s attention and our resources, which could harmour business and financial condition, as well as the market price of our stock.Moreover, it may result in an adverse judgment against us or a settlement,either of which could require us to make a payment to the plaintiffs to theextent a possible payment exceeds or is not covered by our insurance.

**Our lack ofoperating experience may cause us difficulty in managing any future growth.**

We have no historicalexperience in selling pharmaceutical or other products or in manufacturing orprocuring drug products in commercial quantities in compliance with FDA rules andwe have only limited experience in negotiating, establishing and maintainingcollaborative relationships and conducting later stage phases of the regulatoryapproval process. Our ability to manage our growth, if any, will potentiallyrequire us to maintain, improve and expand our management and our operationaland financial systems and controls. If our management is unable to managegrowth effectively, our business and financial condition would be adverselyaffected. In addition, if rapid growth occurs, it may strain our operational,managerial and financial resources, which are limited.

**We depend onintellectual property rights licensed from third parties. If we fail to meetour obligations under our license agreements, or if technology licensed to usis subject to the rights of others, we could lose our rights of exclusivity ofuse to key technologies on which our business depends.**

Our business depends on our technology, which is basedin part on patents and patent applications licensed from third parties. Thosethird-party license agreements impose obligations on us, such as paymentobligations and obligations to diligently pursue development of commercialproducts under the licensed rights. Our license agreement regarding CINTREDEKINBESUDOTOX requires us to engage in clinical trials of the compound in patientswith renal cell carcinoma. Previous trials demonstrated that CINTREDEKINBESUDOTOX is toxic in those patients. However, we have instead focused ondeveloping this compound for treating patients with glioblastoma multiforme. Wehave informed the governmental agency from which we licensed these patents ofthis change, and we received no objections to it.

Because of our dependence on intellectual propertyrights licensed to us by third parties, any adverse development in ourrelationship with these licensors, including a dispute regarding our rightsunder the agreements or the grant of rights by our licensors to others, couldmaterially and adversely affect our right to commercialize the products we aredeveloping or preclude others from commercializing these products.

If a licensor believes that we have failed to meet ourobligations under a license agreement, the licensor could seek to limit orterminate our licensed rights, which could lead to costly and time-consuminglitigation and, potentially, a loss of the licensed rights. During the periodof any such litigation, our ability to carry out the development andcommercialization of potential products could be significantly and negativelyaffected. If our licensed rights were restricted or ultimately lost, ourability to continue our business based on the affected technology platformwould be adversely affected.

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We depend in large part on our licensors to have andmaintain the patent rights licensed to us. Where our licensors cannot licensetechnologies to us to the exclusion of third parties, our competitive positioncould be impaired. In this regard, we understand that co-rights to thetechnologies exclusively licensed to us by NIH relating to CINTREDEKINBESUDOTOX are claimed by one of the inventors, who has subsequently enteredinto an agreement assigning such rights as he may have to a third party. We arein the process of determining the nature of his claimed rights and whether ornot this assignment is valid.

We have been granted “orphan drug” status with respectto the use of CINTREDEKIN BESUDOTOX for malignant gliomas (a class of braintumors which includes glioblastoma multiforme), and we are thus potentiallyeligible to receive orphan drug exclusivity upon approval. In order to receiveorphan drug exclusivity, we must be the first CINTREDEKIN BESUDOTOX productapproved for malignant glioma. If we receive orphan drug exclusivity, it wouldprevent the FDA for a period of seven years from approving another sponsor’smarketing application for the same drug for the same indication, except that asubsequent applicant with the same drug could be approved if it demonstratedits product were clinically superior to our product or if we were unable tomanufacture sufficient supplies of product. If it were determined that we donot have exclusive rights to the technology licensed to us by NIH, we might beunable to preclude third parties—during or after any period of orphan drugexclusivity—from commercializing a drug based on CINTREDEKIN BESUDOTOX forother indications. Competing CINTREDEKIN BESUDOTOX products, if suitable, couldbe prescribed by physicians for malignant glioma, even though not FDA-approvedfor that use. This could cause our business to suffer. Moreover, if it weredetermined that we do not have exclusive rights to the technology licensed tous by NIH, a third party might be able to develop a CINTREDEKIN BESUDOTOX baseddrug for the treatment of malignant glioma. If this competitor completed itsclinical trials before we complete ours, the FDA could approve that competitor’sproduct first and give it seven years of market exclusivity. In such a case, wemight not be allowed to market our product in the United States for sevenyears. Further, even if we receive seven years of market exclusivity, otherapplicants could receive approval of compounds other than CINTREDEKIN BESUDOTOXfor malignant glioma, which would compete with our product.

It should be noted that,even if it were determined at a future date that we do not have exclusivitywith respect to the patents and patent applications licensed from NIH, we havealso filed various additional patent applications related to the methods ofadministration and use of CINTREDEKIN BESUDOTOX which are not part of the NIHpatents. While we believe that patents that may eventually be granted underthese patent applications would provide us with additional exclusivity of usefor CINTREDEKIN BESUDOTOX, these patent applications are still pending, may notbe granted, and are subject to the risks described herein relating to patentsin general.

**If we are unable toadequately protect our proprietary technologies this could harm our competitiveposition and have a material adverse effect on our business.**

The success of our business depends, in part, on ourability to obtain patents and maintain adequate protection of our intellectualproperty for our proprietary technology and products in the United States andother countries. The laws of some foreign countries do not protect proprietaryrights to the same extent as the laws of the United States, and many companieshave encountered significant problems in protecting their proprietary rights inthese foreign countries. These problems can be caused, for example, by a lackof rules and processes allowing for meaningful defense of intellectualproperty rights. If we do not adequately protect our intellectual property,competitors may be able to use our technologies and impair our competitiveposition, with the result that our business and operating results could beharmed.

The patent positions of pharmaceutical companies,including our patent positions, are often uncertain and involve complex legaland factual questions. We will be able to protect our proprietary rights fromunauthorized use by third parties only to the extent that our proprietarytechnologies are covered by valid and enforceable patents or are effectivelymaintained as trade secrets. We apply for patents covering our 

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technologies and drugproduct candidates, as we deem appropriate. Currently, we either own or haveobtained licenses to more than 50 United States patents and patent applicationsrelating to our technology, compounds, and drug product candidates, many ofwhich have foreign counterparts either as issued patents or pending patentapplications. However, we may not obtain patents on all inventions for which weseek patents, and any patents we obtain may be challenged and may be narrowedin scope or extinguished as a result of such challenges. Our existing patentsand any future patents we obtain may not be sufficiently broad to preventothers from practicing our technologies or from developing competing products.Others may independently develop similar or alternative technologies or designaround our patented technologies or drug product candidates. These companieswould then be able to develop, manufacture, and sell products, which competedirectly with our drug product candidates. In that case, our revenues andoperating results would decline.

We rely upon trade secretprotection for certain of our confidential information, including certain ofour trade secrets, know-how, technology advances and processes. While we havetaken measures to protect our confidential information, and to date have notexperienced any difficulties in maintaining the confidentiality of ourinformation, these measures may not provide adequate protection for our tradesecrets, know-how or other confidential information in the future. We seek toprotect our confidential information by entering into confidentialityagreements with employees, collaborators, and consultants. Nevertheless,employees, former employees, collaborators, or consultants may still discloseor misuse our confidential information, and we may not be able to meaningfullyprotect our trade secrets. In addition, others may independently developsubstantially equivalent information or techniques or otherwise gain access toour trade secrets. Disclosure or misuse of our confidential information wouldharm our competitive position and could cause our revenues and operatingresults to decline.

**We may be sued forinfringing on the intellectual property rights of others.**

Our commercial success also depends in part onensuring that we do not infringe the patents or proprietary rights of thirdparties. The biotechnology industry has produced a proliferation of patents,and it is not always clear to industry participants, including us, whichpatents cover various types of products. The coverage of patents is subject tointerpretation by the courts, and the interpretation is not always uniform.While we have not been sued for infringing the intellectual property rights ofothers, there can be no assurance that the drug product candidates that we haveunder development do not or will not infringe on the patent or proprietaryrights of others. Third parties may assert that we are employing theirproprietary technology without authorization. We know of patents issued tothird parties relating to antisense and oligonucleotide technology, includingpatents about which such third parties have communicated with us suggestingpossible infringement, but the claims of which we believe we do not infringe orare invalid. Moreover, United States patent applications filed in recent yearsare confidential for 18 months, while older applications are not publisheduntil the patent issues. Further, some applications are kept secret during theentire length of their pendency by request of the applicant in specialcircumstances. As a result, there may be patents of which we are unaware, andavoiding patent infringement may be difficult. Patent holders sometimes sendcommunications to a number of companies in related fields, suggesting possibleinfringement, and we, like a number of biotechnology companies, have receivedthis type of communication. If we are sued for patent infringement, we wouldneed to demonstrate that we either do not infringe the patent claims of therelevant patent and/or that the patent claims are invalid, which we may not beable to do. Proving invalidity, in particular, is difficult since it requires ashowing of clear and convincing evidence to overcome the presumption ofvalidity enjoyed by issued patents. Parties making claims against us may beable to obtain injunctive or other equitable relief that could effectivelyblock our ability to further develop, commercialize and sell products, and suchclaims could result in the award of substantial damages against us. In theevent of a successful claim of infringement against us, we may be required topay damages and obtain one or more licenses from third parties. We may not beable to obtain these licenses at a reasonable cost, if at all. In that event,we could 

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encounter delays inproduct introductions while we attempt to develop alternative methods orproducts or be required to cease commercializing affected products and ouroperating results would be harmed.

In the future, others mayfile patent applications covering technologies that we may wish to utilize withour proprietary technologies, or products that are similar to productsdeveloped with the use of our technologies. If these patent applications resultin issued patents and we wish to use the claimed technology, we would need toobtain a license from the third party, and this would increase our costs ofoperations and harm our operating results.

**We may in thefuture be a party to patent litigation, which could be expensive and divert ourmanagement’s attention.**

The field of biotechnologyhas been characterized by extensive litigation regarding patents and otherintellectual property rights, and companies in the industry have usedintellectual property litigation to gain a competitive advantage. We may becomea party to patent infringement claims and litigation or interferenceproceedings declared by the US Patent and Trademark Office to determine thepriority of inventions. The defense and prosecution of these matters are bothcostly and time consuming. We may need to commence proceedings against othersto enforce our patents, trade secrets or other know-how or defend againstclaims of infringement asserted against us, which would require investigationand determination of the enforceability, scope and validity of the respectiveproprietary rights. These proceedings could result in substantial expense to usand significant diversion of efforts by our technical and management personnel.

**If we lose keymanagement personnel or are unable to attract and retain the talent requiredfor our business, our business could be harmed.**

We are highly dependent onthe principal members of our management staff, our President and ChiefExecutive Officer, Mr. Guillermo A. Herrera, our Executive Vice President,or EVP and Chief Medical Officer, Dr. Jeffrey W. Sherman and our EVP,Commercial Operations, Timothy P. Walbert. These principal members of ourmanagement and scientific staff, other than Mr. Herrera, acceptedemployment on the basis of written offers which set forth the salary andbenefits to be provided, including, but not limited to, salary continuationpayments upon termination of employment. Mr. Herrera has a writtenemployment contract with us. We do not have key man insurance on any of ourmanagement. If we were to lose the services of Mr. Herrera, or otherprincipal members of our management staff, and were unable to replace them, ourproduct development and the achievement of our strategic objectives could bedelayed. In addition, our success will depend on our ability to attract andretain qualified commercial, scientific, technical, and managerial personnel.While we have not experienced unusual difficulties to date in recruiting andretaining personnel, there is intense competition for qualified staff and noassurance can be given that we will be able to retain existing personnel orattract and retain qualified staff in the future.

**The demand for ourdrug product candidates, if any, may be adversely affected by health carereform and potential limitations on third-party reimbursement.**

In recent years, there have been numerous proposals tochange the health care system in the U.S. Some of these proposals have includedmeasures that would limit or eliminate payments for medical procedures andtreatments or subject the pricing of pharmaceutical products to governmentcontrol. We cannot predict the effect that health care reforms may have on ourbusiness, and it is possible that such reforms will hurt our business. In addition,in both the U.S. and elsewhere, sales of prescription pharmaceutical productsare dependent in part on the availability of reimbursement to the consumer fromthird party payors, such as government and private insurance plans. Third partypayors are increasingly challenging the prices charged for medical products andservices with respect to new drug products in particular. If we succeed inbringing any of our drug product candidates to the market, we cannot be 

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certain that our productswill be considered cost effective or that reimbursement to the consumer will beavailable or will be sufficient to allow us or our collaborators to sell ourproducts on a competitive basis.

In addition, manyhealth maintenance organizations and other third party payors use formularies,or lists of drugs for which coverage is provided under a health care benefitplan, to control the costs of prescription drugs. Each payor that maintains adrug formulary makes its own determination as to whether a new drug will beadded to the formulary and whether particular drugs in a therapeutic class willhave preferred status over other drugs in the same class. This determinationoften involves an assessment of the clinical appropriateness of the drug andsometimes the cost of the drug in comparison to alternative products. We cannotbe assured that:

·       ourfuture drug products, if any, will be added to payors’ formularies;

·       suchfuture drug products will have preferred status to alternative therapies; or

·       theformulary decisions will be conducted in a timely manner.

We may also decide toenter into discount or formulary fee arrangements with payors, which couldresult in us receiving lower or discounted prices for drug products we maydevelop in the future.

**Physicians,patients, payors, or the medical community in general may be unwilling toaccept, utilize, or recommend any of our drug product candidates, and thefailure to achieve market acceptance will harm our business.**

Even if approvedfor marketing, our drug product candidates may not achieve market acceptance.The degree of market acceptance of our drug product candidates will depend upona number of factors, including:

·       theestablishment and demonstration in the medical community of the safety andclinical efficacy of our drug product candidates and their potential advantagesover existing therapeutic products, including current treatments for GBM andnon-liposomal forms of the active agents included in our drug products; and

·       pricing and reimbursementpolicies of government and third party payors such as insurance companies,health maintenance organizations and other plan administrators.

**Material weaknessesor deficiencies in our internal control over financial reporting could harmstockholder and business confidence in our financial reporting, our ability toobtain financing, and other aspects of our business.**

As of September 30, 2006, management hadconcluded that a control deficiency with respect to the review and verificationof the accuracy of the calculation estimating the fair value of non-employeestock options constituted a material weakness in internal control overfinancial reporting. A material weakness is a control deficiency, orcombination of control deficiencies that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. This control deficiency resultedin an adjustment to the unaudited interim condensed consolidated financialstatements for the quarter ended March 31, 2006 affecting derivativefinancial instruments and change in fair value of derivative financialinstruments.

During 2006, management revised its policies andprocedures with respect to its controls over the review and verification of theaccuracy of the calculation estimating the fair value of non-employee stockoptions to ensure that all reasonable steps will be taken to correct thismaterial weakness. As of December 31, 2006, the deficiency was consideredto be remediated as the new internal controls were operational for a period oftime, were tested, and management concluded that the controls are operatingeffectively at that time.

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Internal control overfinancial reporting can provide only reasonable and not absolute assurance thatdeficiencies or weaknesses are identified. Additionally, potential controldeficiencies that are not yet identified could emerge and internal controlsthat are currently deemed to be in place and operating effectively are subjectto the risk that those controls may become inadequate because of changes inconditions, or that the degree of compliance with the policies or proceduresmay deteriorate. Identification and corrections of these types of potentialcontrol deficiencies could have a material impact on our business, financial position,results of operations and disclosures and impact our ability to raise funds.

**Our investmentscould lose market value and consequently harm our ability to fund continuingoperations.**

The primary objective of our investment activities isto preserve principal while at the same time maximizing yields withoutsignificantly increasing risk. To achieve this objective, we maintain ourportfolio of cash, cash equivalents and short-term investments in a variety ofsecurities, including government and corporate obligations and money marketfunds. The market values of these investments may fluctuate due to marketconditions and other conditions over which we have no control. Fluctuations inthe market price and valuations of these securities may require us to recordlosses due to impairment in the value of the securities underlying ourinvestment. This could result in future charges to our earnings. All of ourinvestment securities are denominated in US dollars.

Investments in bothfixed-rate and floating-rate interest earning instruments carry varying degreesof interest rate risk. Fixed-rate securities may have their fair market valueadversely impacted due to a rise in interest rates. In general, securities withlonger maturities are subject to greater interest rate risk than those withshorter maturities. While floating-rate securities generally are subject toless interest rate risk than fixed-rate securities, floating-rate securitiesmay produce less income than expected if interest rates decrease. Due in partto these factors, our investment income may fall short of expectations or wemay suffer losses in principal if securities are sold that have declined inmarket value due to changes in interest rates.

**We handle hazardousmaterials and must comply with environmental laws and regulations, which can beexpensive and restrict how we do business. We could also be liable for damages,penalties, or other forms of censure if we are involved in a hazardous wastespill or other accident.**

Our research and developmentprocesses involve the controlled storage, use, and disposal of hazardousmaterials and biological hazardous materials. We are subject to federal, state,and local laws and regulations governing the use, manufacture, storage,handling, and disposal of hazardous materials and certain waste products.Although we believe that our safety procedures for handling and disposing ofthese hazardous materials comply with the standards prescribed by law andregulation, the risk of accidental contamination or injury from hazardousmaterials cannot be completely eliminated. In the event of an accident, even bya third party, we could be held liable for any damages that result, and suchliability could exceed our current general liability insurance coverage of$1,000,000 and our financial resources. In the future, we may not be able tomaintain insurance on acceptable terms, or at all. We could also be required toincur significant costs to comply with current or future environmental laws andregulations.

**We may have productliability exposure, and insurance against such claims may not be available tous at reasonable rates or at all.**

While we maintaininsurance to cover the use of our drug product candidates in clinical trials,we currently do not have any product liability insurance for marketed humantherapeutic products. Although we plan to obtain product liability insurancewhen and if any of our drug product candidates become commercially available,we cannot assure you that we will be able to obtain or maintain this insuranceon acceptable terms or that any insurance we obtain will provide us withadequate coverage against potential 

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liabilities.Claims or losses in excess of any liability insurance coverage we obtain couldhave a material adverse effect on our business.

**Anti-takeoverprovisions could make a third party acquisition of us or the removal of ourboard of directors or management more difficult.**

In June 2003, weadopted a stockholder rights plan that provided for the issuance of rights topurchase shares of our Series A Participating Preferred Stock, the Series APreferred. Under the plan, we distributed one preferred share purchase rightfor each outstanding share of common stock. Each purchase right entitles theholder to purchase from us one one-thousandth (1/1000th) of a share of Series APreferred at a price of $112.00 per share, subject to adjustment. The rightsbecome exercisable, with certain exceptions, ten business days after any party,without prior approval of our Board of Directors, acquires, or announces anoffer to acquire, beneficial ownership of 15% or more of our common stock. Anexception to this policy exists in the case of our largest shareholder, Dr. JohnN. Kapoor, who, along with parties affiliated with him, is permitted to acquireup to 30% of our common stock without triggering the rights issuance. In theevent that any party acquires 15% or more of our common stock (other than Dr. Kapoorfor whom the threshold is 30%), we are acquired in a merger or other businesscombination, or 50% or more of our assets are sold after the time that therights become exercisable, the rights provide that each right holder willreceive, upon exercise, shares of the common stock of the surviving oracquiring company, as applicable, having a market value of twice the exerciseprice of the right. The stockholder rights plan may discourage or preventcertain types of transactions involving an actual or potential change incontrol, which transactions may be beneficial to our shareholders, by causingsubstantial dilution to a party that attempts to acquire us on terms notapproved by our Board of Directors. In addition, Section 203 and otherprovisions of the Delaware General Corporation Law as well as provisions of ourcharter and by-laws could make a takeover of us or the removal of the membersof the board of directors or management more difficult.

**The issuance ofpreferred stock could adversely affect the holders of our common stock.**

Our board of directors hasthe authority, without further stockholder approval, to issue from time to timeshares of preferred stock in one or more designated series or classes.Depending upon the rights and preferences which may be granted to any class ofpreferred shares which we may elect to issue, issuance of preferred stock couldadversely affect the voting power of holders of our common stock and reduce thelikelihood that our common stockholders will receive dividend payments andpayments upon liquidation. The issuance of preferred stock could also decreasethe market price of our common stock, or have terms and conditions that coulddiscourage a takeover or other transaction that might involve a premium pricefor our shares or that our stockholders might believe to be in their bestinterests.

**If there aresubstantial sales of common stock, the market price of our common stock coulddecline.**

Sales of substantialnumbers of shares of common stock could cause a decline in the market price ofour stock. We have filed Form S-8 registration statementsregistering shares issuable pursuant to our equity compensation plans. Anysales by existing stockholders or holders of options may have an adverse effecton our ability to raise capital and may adversely affect the market price ofour common stock.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

**None**

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**ITEM 2.**                PROPERTIES

The Company’sadministrative offices and pre-clinical research and development personnel arelocated in approximately 35,500 square feet of leased space in Waukegan,Illinois.

**ITEM 3.**                LEGALPROCEEDINGS

In December 2006, we were advised by the staff ofthe U.S. Securities and Exchange Commission, the SEC, that the SEC’sinvestigation of the Company, which the Company believes concerned the Company’sdisclosures regarding the development of its LEP and LED drug productcandidates, had been terminated and no enforcement action had been recommended.The decision by the SEC to terminate its investigation is not a finding orjudgment regarding the matters investigated.

NeoPharm, Inc. andcertain of our former officers have been named in a consolidated amendedcomplaint, which alleges various violations of the federal securities laws inconnection with our public statements regarding our LEP drug product candidateduring the period from October 31, 2001 through April 19, 2002. On November 4,2002, we moved to have the complaint dismissed. Our motion to dismiss wasgranted in part and denied in part in February 2003. In November 2004,the plaintiffs filed a motion to amend and a motion for summary adjudication.The motion to amend seeks to include certain pre-class period statements in thecomplaint. The motion for summary adjudication asks the Court to rule thatcertain statements made in an arbitration award regarding the LEP drug productcandidate be deemed facts established in this proceeding. On February 23,2007, the Court entered an order denying both the plaintiffs’ motion to amendand the plaintiffs’ motion for summary adjudication. The Court has set a fact discoverycut-off date of August 24, 2007. No trial date has yet been set. We intendto vigorously defend each and every claim in the complaint. Management isunable to estimate the potential outcome or range of possibilities, if any. Inaddition, we maintain insurance coverage to mitigate the financial impact ofany potential loss.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submittedto a vote of security holders during the quarter ended December 31, 2006.

**EXECUTIVE OFFICERSOF NEOPHARM**

The following persons were executive officers ofNeoPharm as of March 14, 2007:

*GuillermoA. Herrera, 53,*joined NeoPharm in October 2005as President and Chief Executive Officer. Previously, in 2004, Mr. Herrerajoined Rosetta Partners LLC to serve as the Partner and Principal in charge ofthe private equity division. Prior to Rosetta, Mr. Herrera spent 24 yearsat Abbott Laboratories most recently serving as Senior Vice President,International Operations and President of Abbott International. Mr. Herrerareceived his MBA from the Kellogg Graduate School of Management at NorthwesternUniversity and his B.A. in Industrial Economics from the Universidad del Valle,Colombia.

*RonaldE. Pauli, 46,*joined us in August 2006, asExecutive Vice President, Chief Financial Officer and Corporate Secretary.Previously, Mr. Pauli was employed at Abraxis BioScience, Inc.(formerly American Pharmaceutical Partners, Inc.), where he has served asInterim CFO from May to August 2006 and held the position ofCorporate Controller since 2002. Previously, Mr. Pauli was Vice President,Controller and CFO of ERSCO Corporation. Mr. Pauli received his B.S. inAccounting from Michigan State University and a M.S., Finance, from WalshCollege, Troy, Michigan. On March 2, 2007, Mr. Pauli advised theCompany of his intention to resign his position as of March 21, 2007 topursue other opportunities in the private sector.

*DrJeffrey W. Sherman, M.D., F.A.C.P., 52,*joined us in September 2000as Executive Vice President and Chief Medical Officer. Previously, Dr. Shermanwas employed by Searle/Pharmacia where, since 

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joining that company in1992, he held a variety of positions, most recently serving as ExecutiveDirector, Clinical Research, with his focus being on Oncology Clinical Researchand Head of Oncology Global Medical Operations in Medical Marketing. Dr. Shermanreceived his medical degree from The Chicago Medical School and is a member ofnumerous professional societies and a Diplomate of the National Board ofMedical Examiners and the American Board of Internal Medicine.

*TimothyP. Walbert, 39**,* ExecutiveVice President, Commercial Operations, joined the Company in January 2006.Previously, Mr. Walbert held several positions of increasingresponsibility at Abbott Laboratories from 2001 until joining NeoPharm, mostrecently serving as Vice President, International Marketing. From 1998 to 2001,Mr. Walbert was a marketing director for Searle/Pharmacia. Mr. Walbertholds a Bachelor of Arts in Business and Marketing from Muhlenberg College.

Officers are appointed to serve annually, subject tothe discretion of the Board of Directors, or until their successors areappointed. There are no family relationships between any of our directors orexecutive officers.

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**PART II**

**ITEM 5.**                MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUERPURCHASES OF EQUITY SECURITIES

TheCompany’s common stock is listed on the NASDAQ National Market under the symbolNEOL. The following table provides the high and low sales prices as reported onthe exchange on which the Company’s stock was listed for the periods indicated.

| **2006**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 12.67      |     | $          | 8.25    |       |
| Second Quarter |       | 8.51       |       | 4.80     |       |
| Third Quarter  |       | 5.61       |       | 4.32     |       |
| Fourth Quarter |       | 8.49       |       | 1.66     |       |
|                |            |            |            |          |            |         |            |  |  |

 

| **2005**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 13.43      |     | $          | 7.56    |       |
| Second Quarter |       | 10.73      |       | 7.16     |       |
| Third Quarter  |       | 15.47      |       | 9.87     |       |
| Fourth Quarter |       | 13.03      |       | 7.75     |       |
|                |            |            |            |          |            |         |            |  |  |

 

As of March 1, 2007,there were 65 holders of record of the common stock. The calculation of holdersof record was based on reports received from Computershare Investor ServicesLLC, the Company’s transfer agent, based on information provided by the holdersof record, and maintained by the transfer agent.

**Dividends**

The Company has never paida cash dividend on its common stock and has no present intention of paying cashdividends in the foreseeable future. Any determination in the future to paycash dividends will depend on the Company’s financial condition, capitalrequirements, results of operations, contractual limitations and other factorsdeemed relevant by the Board of Directors.

**Equity CompensationPlan Information**

The information called forby Item 5(a) relating to related stockholder information is incorporatedherein by reference to Item 12—Security Ownership of Certain Beneficial Ownersand Management and Related Stock Matters.

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**Performance Graph**

The following graphcompares the percentage change in cumulative total stockholder return onNEOPHARM’s Common Stock with the cumulative return on the NASDAQ Stock MarketIndex and the NASDAQ Pharmaceutical Stock Index during the period beginning December 31,2001 through December 31, 2006. The price of the Common Stock as reflectedin the graph has been adjusted to reflect a 15% stock dividend paid in June 2003.The below comparison assumes that $100 was invested on December 31, 2001in each of the Company’s Common Stock and presented indices and assumes thereinvestment of dividends.

**Cumulative TotalReturn**(in dollars)

****

| **Performance Information:** | ** ** | ** ** | ** ** | **12/31/2001** | ** ** | ** ** | ** ** | **12/31/2002** | ** ** | ** ** | ** ** | **12/31/2003** | ** ** | ** ** | ** ** | **12/31/2004** | ** ** | ** ** | ** ** | **12/31/2005** | ** ** | ** ** | ** ** | **12/31/2006** | ** ** |   |
|-----------------------------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|--------|
| NeoPharm, Inc.                    |       |       |       |           | 100        |       |       |           |       |       | 40         |           |       |       |       |           | 84         |       |       |           |       |       | 57         |           |       |   |   |   | 50 |   |   |   |   |   | 8 |   |   |
| NASDAQ Market Index-U.S. Cos.     |       |       |       |           | 100        |       |       |           |       |       | 69         |           |       |       |       |           | 103        |       |       |           |       |       | 112        |           |       |   |   |   | 115 |   |   |   |   |   | 126 |   |   |
| NASDAQ  Pharmaceutical Index      |       |       |       |           | 100        |       |       |           |       |       | 65         |           |       |       |       |           | 95         |       |       |           |       |       | 101        |           |       |   |   |   | 111 |   |   |   |   |   | 109 |   |   |
|                                   |            |            |            |                |            |            |            |                |            |            |            |                |            |            |            |                |            |            |            |                |            |            |            |                |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 6.**                SELECTEDFINANCIAL DATA

Thefollowing selected five-year financial data is derived from our consolidatedfinancial statements included in Item 15 of Part IV of this Form 10-K.

| ** **                            | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                            | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Statement of Operations  Data:        |       |                                                          |        |   |   |   |   |   |   |   |   |
| Revenue                               |       | $                                                             | 11,000      |   | $ | 543,000 |   | $ | 157,000 |   | $ | — |   | $ | — |   |
| Loss from operations                  |       | (35,735,000                                                   | )           | (40,231,000 | ) | (58,728,000 | ) | (53,606,000 | ) | (38,835,000 | ) |
| Interest income                       |       | 2,527,000                                                     |        | 1,506,000 |   | 1,119,000 |   | 815,000 |   | 2,343,000 |   |
| Net loss                              |       | $                                                             | (33,208,000 | ) | $ | (38,725,000 | ) | $ | (57,609,000 | ) | $ | (52,791,000 | ) | $ | (36,492,000 | ) |
| Net loss per basic  and diluted share |       | $                                                             | (1.20       | ) | $ | (1.64 | ) | $ | (2.51 | ) | $ | (2.80 | ) | $ | (1.95 | ) |

 

| ** **                                        | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Balance Sheet and Other  Data:                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term investments |       | $                                     | 38,587,000 |   | $ | 30,262,000 |   | $ | 63,107,000 |   | $ | 36,959,000 |   | $ | 87,592,000 |   |
| Working capital(1)                                |       | 29,637,000                            |       | 21,608,000 |   | 55,336,000 |   | 36,257,000 |   | 87,665,000 |   |
| Total assets                                      |       | 40,689,000                            |       | 33,370,000 |   | 67,434,000 |   | 46,081,000 |   | 95,937,000 |   |
| Accumulated deficit                               |       | (261,233,000                          | )          | (228,025,000 | ) | (189,300,000 | ) | (131,691,000 | ) | (78,900,000 | ) |
| Total  stockholders’ equity                  |       | 28,871,000                            |       | 21,945,000 |   | 58,230,000 |   | 40,017,000 |   | 91,909,000 |   |
|                                                   |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)    Workingcapital is calculated as current assets minus current liabilities.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The following discussion of our financial conditionand results of operations should be read together with our consolidatedfinancial statements and notes to those statements included in Item 15 of Part IVof this Form 10-K.*

**Overview**

We are a biopharmaceutical company engaged in theresearch, development, and commercialization of drugs for the treatment ofvarious cancers. Our corporate strategy is to advance the research,development, and commercialization of new and innovative anti-cancertreatments. Our corporate office and research and development facility islocated in Waukegan, Illinois and we had 53 active employees as of December 31,2006.

Since we began business in June 1990, we haveprincipally devoted our resources to funding research and product developmentprograms. To date, we have not received United States Food and DrugAdministration, or FDA, approval of any of our drug product candidates. Weexpect to continue to incur losses for the foreseeable future as we continueour research and development activities, which include the sponsorship of humanclinical trials for our drug product candidates. If and until we are able toconsistently generate profitable revenue through the sale of drug or non-drugproducts, we anticipate that we will continue to be required to fund thedevelopment of our pre-clinical compounds and drug product candidatesprimarily by other means, including, but not limited to, selling stock in theCompany, licensing the development rights to some of our drug productcandidates to third parties, or collaborating with third parties to developformulations of their compounds using our technology.

In December 2006, we announced that the Phase 3PRECISE Clinical trial of CINTREDEKIN BESUDOTOX in the treatment of recurrent glioblastomamultiforme did not meet the primary endpoint at 215 deaths, which was astatistically significant difference, or separation, in the overall survivalcurves versus the Gliadel Wafer®, or Gliadel.

Since the announcement of the PRECISE trial results,the Company has been working with its Scientific Advisory Board to identify apotential regulatory path forward based on the totality of the clinical datagathered to date. We plan to meet with the FDA in late March 2007 to discussthe possibility of approval on the strength of our data and analysis. We cannotpredict the outcome of that meeting. The FDA could evaluate the data in adifferent way, for example using different statistical methods, and could reachdifferent conclusions about the PRECISE trial altogether. The FDA could agreewith our conclusions about the PRECISE trial, but still reject the argumentthat these conclusions may support product approval. Even if the FDA agreedthat these conclusions may support product approval, it could requirestatistically significant results from a second Phase 3 trial. There is noassurance that we would or could generate these additional data. The agencycould also reject the data from the PRECISE trial for other reasons, includinghuman errors in the conduct of the trial. See Item 1-A—“RiskFactors”.

In 2006, we reassessed and reprioritized our NeoLipid®platform and strategy to focus development efforts on LE-SN38, LEP-ETU andLE-DT and ceased development of LErafAON.

LE-SN38 is a liposomal formulation of SN-38; theactive metabolite of irinotecan, or Pfizer’s Camptosar®, a chemotherapeuticpro-drug used in the treatment of first- and second-line colorectal cancer. Duringthe second quarter of 2006, in conjunction with the Colorectal and LeukemiaGroup B (CALGB), we initiated enrollment in a Phase 2 clinical trial forLE-SN38 in metastatic colorectal cancer patients and completed enrollment ofthe 21st patient in December 2006. We expect aninterim analysis of data from this LE-SN38 Phase 2 trial in the second quarterof 2007, after the first 21 patients have completed treatment.

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LEP-ETU is a liposomal formulation of paclitaxel theactive ingredient in the widely used cancer drug Taxol® which is approved inthe U.S. for the treatment of breast, lung and ovarian cancers. We are currentlyin ongoing discussion with the FDA on clinical and regulatory plans forLEP-ETU.

Pre-clinical work also advanced on our earlier stageliposomal formulation of the anti-cancer agent docetaxel, LE-DT, which is theactive ingredient in Sanofi Aventis’ Taxotere® which is approved for use incertain breast cancer, non-small cell lung cancer, gastric adenocarcinoma andhead and neck cancer indications. We anticipate filing an LE-DT InvestigationalNew Drug Application, or IND, with the U.S. FDA in late 2007.

It is difficult to predict with any certainty thetiming of and total estimated costs to complete development of drug productcandidates in early stage, or Phase 1/2, clinical development, as well as the estimateddate such drug product candidates would be available for sale, if approved bythe FDA or foreign regulatory agencies. A number of factors contribute to thisuncertainty, including: side effects encountered in early stage clinicaltrials, ability to scale up manufacturing for commercial supply, and the factthat the size and scope of pivotal Phase 3 clinical trials are unknown untilsufficient data is available to present a Phase 3 plan to the FDA for approval.In addition, our drug product candidates are required to be approved by the FDAafter completing Phase 3 clinical trials before we can sell the drugs togenerate revenue and, potentially, realize net cash inflows. Additionalclinical trial expenses may also be incurred for CINTREDEKIN BESUDOTOX if theFDA requires additional data in a BLA for treatment of glioblastoma multiforme,or if we decide to investigate the use of CINTREDEKIN BESUDOTOX in other formsand stages of malignant glioma or other indications beyond recurrentglioblastoma multiforme. We will also incur additional expenses related to thepreparation of a BLA submission if, despite the fact that CINTREDEKIN BESUDOTOXdid not meet its primary endpoint in the Phase 3 trial, we decide to seekregulatory approval of the use of CINTREDEKIN BESUDOTOX in the treatment of glioblastomamultiforme without any new clinical data.

Thetable below includes a summary of identified direct project costs incurred todate for our major research and development projects. Generally, identifiedproject costs include expenses incurred specifically for clinical trials andpre-clinical studies we conduct, and exclude expenses incurred for salariespaid to our professional staff, facility overhead expenses and generallaboratory supplies used in our research, which are included with non-projectspecific.

| ** **                                | ** ** | **Total Direct Costs Incurred** | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Since Beginning** | ** ** |
| **Research Project**                 | ** ** | ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **of Project** | ** ** |
| CINTREDEKIN  BESUDOTOX                    |       | $                                              | 11,534,000 |   | $ | 15,755,000 |   | $ | 19,912,000 |   |   | $ | 66,259,000 |   |   |
| LEP-ETU                                   |       | 876,000                                        |       | 2,684,000 |   | 3,085,000 |   |   | 7,583,000 |   |   |
| LE-SN38                                   |       | 254,000                                        |       | 506,000 |   | 1,866,000 |   |   | 5,228,000 |   |   |
| Non-project  specific and other           |       | 8,535,000                                      |       | 12,906,000 |   | 19,650,000 |   |   | N/A |   |   |
| Total research  and  development expenses |       | $                                              | 21,199,000 |   | $ | 31,851,000 |   | $ | 44,513,000 |   |   | N/A |   |   |
|                                           |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Results ofOperations**

***Year Ended December 31, 2006 as compared to YearEnded December 31, 2005***

The sole source of product revenue in both 2006 and2005 was from limited sales of our NeoPhectin products and, in 2005, fromrecognition of $0.5 million in revenue resulting from NeoPhectinTM collaborationfees.

Generally, our 2006 results of operations reflect thebenefit of recent cost rationalization initiatives, reduced clinical trialexpense following the December 2005 completion of enrollment in the Phase3 

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PRECISE trial and ouractivities, and the timing of those activities, to prepare CINTREDEKINBESUDOTOX for potential commercialization in the event the Company decides toseek approval. Accordingly, in 2006 the mix of expenses shifted from Researchand Development activities to Selling, General and Administrative activitiesreflecting our focus during the year on preparing for the possibility oflaunching our first product.

Research and development, or R&D, expensedecreased by $10.7 million, to $21.2 million, in 2006 as compared to 2005 dueprimarily to reduced costs related to the CINTREDEKIN BESUDOTOX Phase 3 PRECISEtrial which completed patient enrollment in December 2005, advancement ofNeoLipid products from the lab into the clinic and to the 2006 reprioritizationof R&D spending and related headcount reductions, partially offset by a$0.7 million increase in R&D expense related to employee stock compensationdue to our 2006 adoption of Statement of Financial Accounting Standards, orSFAS, SFAS No. 123 (revised 2004), *Share-Based Payment*,or SFAS 123(R).

Selling, general and administrative, or SG&A,expenses increased $2.7 million, to $14.1 million, in 2006 due primarily to initiationof exploratory commercialization efforts for CINTREDEKIN BESUDOTOX and to $0.6million increase in share-based compensation expense resulting from our 2006adoption SFAS 123(R), partially offset by $0.5 million in 2005 expense relatedto our licensing of CINTREDEKIN BESUDOTOX rights in Japan to Nippon.

In 2006, following our adoption of SFAS 123(R), werecorded a $1.6 million benefit, due primarily to the impact of a decline inour stock price on the estimated fair value of derivative financial instruments,relating to stock options previously granted to non-employee consultants.

Employee termination, lease and fixed asset write-offsrelated to the 2006 organizational changes and the July 2006 consolidationof our facilities resulted in a $2.0 million charge. During the first ninemonths of 2006, we reduced our workforce by 26 associates under anorganizational restructuring initiative. In May 2006, Dr. Imran Ahmadresigned as the Company’s Executive Vice President and Chief Scientific Officerand, in accordance with the terms of his original offer letter, Dr. Ahmadis scheduled to receive a twelve-month salary continuation and he received a separationpayment of $20,000. Additionally, in June 2006, we entered into aseparation and consulting agreement with our former Chief Financial Officer, Mr. LarryKenyon which became effective August 31, 2006. Under this agreement, Mr. Kenyonis scheduled to receive nine-month salary continuation, reimbursement ofmedical and dental coverage and his previously granted options continue to vestduring the consulting period. In December 2006, we completed an additionalorganizational restructuring which resulted in a workforce reduction of 14positions, or approximately 20% of the workforce at that time. Aggregate 2006employee termination costs related to 2006 reorganization and separationagreements were $1.5 million. Accrued but unpaid employee termination costs at December 31,2006 totaled $0.4 million and are expected to be paid in the first half of2007.

In May 2005, we accepted $2.5 million as paymentin full for all outstanding principal and interest due and owing on apromissory note that we had previously determined to be impaired. As a resultof the payment, in 2005 we recorded a $2.5 million benefit as Recovery of NoteReceivable.

The Company generatedinterest income on cash and investments of $2.5 million and $1.5 million in2006 and 2005, respectively. The 2006 increase in interest income was primarilydue to an increase in average cash and short-term investment balances as aresult of a secondary public stock offering in January 2006 and to highershort-term interest rates in 2006 than in 2005.

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***Year Ended December 31, 2005 as compared to YearEnded December 31, 2004***

We recorded collaboration revenues of $0.5 million in2005 related to development of a customized NeoPhectinTM formulation and nocollaboration revenue in 2004. We recorded $0.05 million of product NeoPhectinTMrevenue in 2005 and $0.2 million in 2004.

R&D expense decreased by $12.7 million in 2005 ascompared to 2004 due principally to the benefit of a fourth quarter 2004 costrationalization initiative which scaled back the R&D workforce and spendingand reduced the number of clinical trials we conducted in 2005. This fourthquarter 2004 cost rationalization resulted in reduction of 2005 direct R&Dexpenses of $6.8 million, reduced R&D payroll expense by $4.2 million andreduced non-project specific research expense by $1.7 million.

SG&A expenses, including related party expenses in2004, totaled $11.4 million and $13.2 million in 2005 and 2004, respectively.The 2005 $1.8 million reduction was due primarily to the inclusion in 2004 of$2.0 million in legal fees related to the conclusion of the Pharmacia, nowPfizer, arbitration case, to 2004 legal fees associated with a consentsolicitation, and a $0.2 million reduction in corporate insurance costs,partially offset by a $0.5 million charge resulting from product licensingmilestone payments. Additionally, 2005 non-cash share-based compensation expensewas reduced by $0.5 million as compared to 2004 as a result of the terminationof certain executive stock option grants.

In May 2005, NeoPharm accepted $2.5 million aspayment in full for all outstanding principal and interest due and owing on apromissory note previously deemed impaired. As a result, in 2005, a $2.5million benefit was recorded as Recovery of Note Receivable.

We incurred $1.1 million in employee termination costsin 2004 as a result of a reduction in workforce completed in November 2004encompassing 30 employees. No additional employee termination expense relatedto the November 2004 reduction in workforce was subsequently incurred.

Interest income for 2005and 2004 totaled $1.5 million and $1.1 million, respectively. The increase in interestincome in 2005 versus 2004 was due primarily to higher short-term interestrates, offset by lower average cash and short-term investment balances in 2005.

***Liquidity and Capital Resources***

Our primary source of cash has been proceeds fromissuance of our common shares.

As of December 31, 2006, we had $38.6 million incash, cash equivalents and short-term investments and no debt. We currentlybelieve that our cash, cash equivalents and short-term investments on hand at December 31,2006 is sufficient to support our activities  into 2008 at currently projected levels ofdevelopment and general corporate activity.

Reduced operating expenses resulted in a reduced useof cash for operation in each of 2006 and 2005. Net cash and cash equivalentsused in operating activities was $31.2 million, $33.8 million and $52.2 millionin 2006, 2005 and 2004, respectively. Capital expenditures totaled $0.2million, $0.6 million and $0.5 million in 2006, 2005 and 2004, respectively.Fiscal 2006 and 2004 included $38.7 million and $73.5 million in net proceedsfrom the issuance of common stock to fund our operating activities.

Our primary use of cash over the next 12-24months would be to fund our regulatory and possible commercial efforts forCINTREDEKIN BESUDOTOX in the event we elect to proceed forward with thisproduct in the treatment of Glioblastoma Multiforme and to advance ourliposomal clinical and pre-clinical research and development efforts. The mostsignificant expenses would be incurred if we elect to proceed with CINTREDEKINBESUDOTOX and therefore move forward with a possible CINTREDEKIN BESUDOTOX BLAsubmission and pre-commercial activity. Additional expenses are also expectedto be incurred as we continue to move our other drug product candidates towardsthe next phase of clinical development.

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We may seek to satisfy future funding requirementsthrough public or private offerings of securities or with collaborative orother arrangements with corporate partners. Additional financing may not be availablewhen needed or on terms acceptable to us. If adequate financing is notavailable, we may be required to delay, scale back, or eliminate certain of ourresearch and development programs, relinquish rights to certain of ourtechnologies, drugs or products, or license third parties to commercializeproducts or technologies that we would otherwise seek to develop ourselves.

NeoPharm has no debt, exposure to off-balance sheetarrangements, special purpose entities, or activities that includenon-exchange-traded contracts accounted for at fair value.

Thefollowing table summarizes our estimated contractual obligations as of December 31,2006:

| ** **                                             | ** ** | **Payments Due by Period** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                       | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  one year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More  than five  years** | ** ** |
| Operating lease                                        |       | $                                         | 554,000    |   | $ | 434,000 |   | $ | 119,000 |   | $ | 1,000 |   |   | $ | — |   |   |
| Capital lease                                          |       | 155,000                                   |       | $ | 38,000 |   | $ | 76,000 |   | $ | 41,000 |   |   | $ | — |   |   |
| Manufacturing commitments(1)                           |       | 1,808,000                                 |       | 1,808,000 |   | — |   | — |   |   | — |   |   |
| License agreements—milestone based payments(2)(3) |       | 1,050,000                                 |       | 250,000 |   | 800,000 |   | — |   |   | — |   |   |
| Total                                                  |       | $                                         | 3,567,000  |   | $ | 2,530,000 |   | $ | 995,000 |   | $ | 42,000 |   |   | $ | 0 |   |   |
|                                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          These amounts includeguaranteed contractual commitments related to retaining our capability for thepotential manufacture of CINTREDEKIN BESUDOTOX in 2007.

(2)          These amounts do notinclude potential sales-based royalty payments that may be required underthe various license agreements.

(3)          Milestone-basedpayment obligations are contingent upon successfully reaching objectivelydeterminable stages in the development of drug product candidates. The Companyhas estimated the period the payment may be due, if at all, based upon itsexpectations of the timeline for continued successful development of the drugproduct candidates.

**Recent AccountingPronouncements**

A description of recentaccounting pronouncements is included in Note 1 “Notes to ConsolidatedFinancial Statements” under the caption “Recent Accounting Pronouncements”.

**Critical AccountingPolicies**

In preparing NEOPHARM’sfinancial statements in conformity with U.S. generally accepted accountingprinciples, management must make a variety of decisions which impact thereported amounts and related disclosures. Such decisions include the selectionof the appropriate accounting principles to be applied, the assumptions onwhich to base accounting estimates and the consistent application of thoseprinciples. Due to the type of industry in which we operate and the nature ofour business, the following policies are those that management believes are themost important to the portrayal of our financial condition and results and thatrequire management’s most difficult, subjective or complex judgments, often asa result of the need to make estimates about the effect of matters that areinherently uncertain.

***Income Taxes***

In assessing therealizability of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of 

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deferredtax assets is dependent upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Managementconsiders the scheduled reversal of deferred tax liabilities, projected futuretaxable income, and tax planning strategies in making this assessment.Significant judgments are required to estimate the generation of future taxableincome and the timing of the reversal of deferred tax liabilities.

***Contingencies***

To properly account forand provide disclosure of loss contingencies, management must apply judgment indetermining whether a loss contingency is: probable, reasonably possible, orremote. In instances where management has determined that a loss contingency isprobable, it must make use of estimates to determine the amount of probableloss. Management must apply judgment in determining whether or not it can makea reasonable estimate. Management must also apply judgment in determiningwhether or not disclosure of loss contingencies that have been accrued shouldbe made for the consolidated financial statements not to be misleading.

***Share-based Compensation***

We account for share-basedcompensation in accordance with SFAS No. 123 (revised 2004), *Share-Based Payment*, or SFAS 123(R). Under the provisions ofSFAS 123(R), share-based compensation cost is estimated at the grant date basedon the award’s fair value as calculated by the Black-Scholes option-pricingmodel and is recognized as expense over the requisite service period. We alsouse the Black-Scholes model to estimate the fair value of non-employee optionsgrants that are accounted for as derivative instruments. The Black-Scholesmodel requires various highly judgmental assumptions including volatility andexpected option life. If any of the assumptions used in the Black-Scholes modelchange significantly, share-based compensation expense may differ materially inthe future from that recorded in the current period.

***Revenue Recognition***

We follow the provisions as set forth by currentaccounting rules, which primarily include Staff Accounting Bulletin, or SAB,104, *Revenue Recognition,*and Emerging IssuesTask Force, or EITF, No. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*in recognition of revenue*.*Generally, revenue is recognized when evidence of anarrangement exists, delivery has occurred or services have been rendered, theprice is fixed and determinable, and collectibility is reasonably assured.

In the past we have provided for general rights ofreturn of products sold to our distributors. Appropriately determining revenuerecognition when the general right of return exists requires the use ofjudgment in estimating the level of returns. In certain circumstances, we maynot be able to develop a reasonable estimate of the level of returns. Makingsuch a determination requires the use of significant judgment. We havedetermined that given the limited sales history of NeoPhectinTM, we are unableto develop a reasonable estimate of the level of expected returns. Accordingly,we recognized revenue for products shipped to distributors upon the expirationof the right of return, which occurred upon the earlier of the shipment by thedistributor to an end user or, depending on the distributor, 60 to 180 days.

We have entered incollaboration and license agreements with third parties that contain multipledeliverables. Under the provisions of EITF 00-21, a determination must bemade on each contract as to whether a deliverable constitutes a separate unitof accounting. The amount of revenue to be recognized is based on the fairvalue for each unit of accounting within the arrangement. Management’s judgmentis required to determine, based upon the facts and circumstances of eacharrangement, whether or not each deliverable has standalone value and whether ornot there exists a sufficient level of objective and reliable evidence of fairvalue of the undelivered items. Additionally, units of accounting may bedelivered over an 

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indeterminateperiod of time. Management judgment is required to estimate the period overwhich recognition of allocated revenue occurs.

**ITEM7A.**        QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

As of December 31,2006, we did not own any derivative instruments, but we were exposed to marketrisks, primarily the impact of changes in United States interest rates on ourshort-term investments. As of December 31, 2006, we held total cash andcash equivalents of $1,852,000 and short-term investments in auction ratecertificates of $36,735,000. All cash equivalents have a maturity less than 90days. Declines in interest rates over time would reduce our interest incomefrom our investments. Based upon our cash, cash equivalents, and short-terminvestments as of December 31, 2006, a decrease in interest rates of 1.0%would cause a corresponding decrease in our annual interest income ofapproximately $400,000.

**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTAL DATA

The Financial Statements and Supplementary Data areincorporated herein by reference to the Company’s Consolidated Financial Statementsincluded as follows:

| ** **                                               | ** ** | **Page** |
|----------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm |       | 58       |
| Consolidated  Balance Sheets                             |       | 59       |
| Consolidated Statements of Operations                    |       | 60       |
| Consolidated Statements of Stockholders’ Equity     |       | 61       |
| Consolidated Statements of Cash Flows                    |       | 62       |
| Notes to Consolidated Financial Statements               |       | 63       |

 

**ITEM9.**                CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

There were no changes inor disagreements with accountants on accounting or financial disclosures in thepast two fiscal years.

**ITEM9A.**        CONTROLS AND PROCEDURES

**DISCLOSURE CONTROLSAND PROCEDURES**

As required by Rules 13a-15and 15d-15 of the Securities Exchange Act of 1934, the Company hasevaluated, with the participation of management, including the Chief ExecutiveOfficer and the Chief Financial Officer, as of the end of the period covered bythis report, the effectiveness of the design and operation of its disclosurecontrols and procedures. Based on such evaluation, the Chief Executive Officerand Chief Financial Officer have concluded that such disclosure controls andprocedures are effective in ensuring that material information relating to theCompany, including its consolidated subsidiary, is made known to the certifyingofficers by others within the Company and its consolidated subsidiary,particularly during the period in which this report is being prepared. Fromtime to time, the Company reviews the disclosure controls and procedures, and mayfrom time to time make changes aimed at enhancing their effectiveness and toensure that the Company’s systems evolve with its business.

**INTERNAL CONTROLOVER FINANCIAL REPORTING**

**Management’s Reporton Internal Control over Financial Reporting**

The management of NeoPharm, Inc. (the Company),including the Company’s President and Chief Executive Officer and ChiefFinancial Officer, is responsible for establishing and maintaining adequateinternal control over financial reporting.

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The Company’s internal control over financialreporting is a process designed to provide reasonable assurance to the Company’smanagement and Board of Directors regarding the reliability and preparation ofpublished financial statement in accordance with U.S. generally accepted accountingprinciples. All internal control systems, no matter how well designed, haveinherent limitations. Therefore, even those systems determined to be effectivecan provide only reasonable assurance with respect to financial statementpreparation and presentation and may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

The Company’s management assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2006. In making this assessment, the Company used the criteria set forth in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organization of the Treadway Commission (“COSO”). Basedon management’s assessment, the Company believes that as of December 31,2006, the Company’s internal control over financial reporting is effectivebased on the criteria established in *Internal Control—IntegratedFramework*.

Management’s assessment ofthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2006, has been audited by the Company’s independentregistered public accounting firm whose report follows this report.

**Changes in InternalControl over Financial Reporting**

There was no change in the Company’s internal controlover financial reporting that occurred during the quarter ended December 31,2006 that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersNeoPharm, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over FinancialReporting, that NeoPharm, Inc. maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).**NeoPharm, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that NeoPharm, Inc.maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Also, in our opinion, NeoPharm, Inc. maintained, in all materialrespects, effective internal control over financial reporting as of December 31,2006, based on criteria established *in Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).

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Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofNeoPharm, Inc. and subsidiary as of December 31, 2006 and 2005, andthe related consolidated**statementsof operations, stockholders’ equity, and cash flows for each of the years inthe three-year period ended December 31, 2006, and our report dated March 16,2007 expressed an unqualified opinion on those consolidated financialstatements.
| /s/ KPMG LLP         |   |
|----------------------|--------|
| Chicago, Illinois    |
| March 16,  2007 |

 

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**ITEM 9B.**       OTHERINFORMATION

None.

**PART III**

**ITEM 10.**         DIRECTORSAND EXECUIVE OFFICERS OF THE REGISTRANT

Information regarding the Directors of the Company isincorporated by reference to the information under the caption “Election ofDirectors” in the Company’s Proxy Statement for the 2007 Annual Meeting ofStockholders, (the “2006 Proxy Statement”) which is to be filed within 120 daysof the Company’s fiscal year ended December 31, 2006.

Information regarding the Executive Officers of theCompany can be found in Part I Item 4 of this annual report on Form 10-K.

Information regarding the Audit Committee FinancialExpert is incorporated by reference to the information under the caption “Reportof the Audit Committee” in the 2007 Proxy Statement, which is to be filedwithin 120 days of the Company’s fiscal year ended December 31, 2006.

Information regarding the identification of the AuditCommittee is incorporated by reference to the information under the caption “Boardof Directors and Its Committees” in the 2007 Proxy Statement, which is to befiled within 120 days of the Company’s fiscal year ended December 31,2006.

Information regarding compliance with Section 16(a) ofthe Exchange Act is incorporated by reference to the information under thecaption “Section 16(a) Beneficial Ownership Reporting Compliance” inthe 2007 Proxy Statement, which is to be filed within 120 days of the Company’sfiscal year ended December 31, 2006.

Information regarding theCompany’s Code of Ethics that applies to the Company’s Chief Executive Officer,Chief Financial Officer, and key financial and accounting personnel isincorporated by reference to the information under the caption “CorporateGovernance Policies and Practices” in the 2007 Proxy Statement, which is to befiled within 120 days of the Company’s fiscal year ended December 31,2006.

**ITEM 11.**         EXECUTIVECOMPENSATION

The information requiredby this item as to executive compensation is hereby incorporated by referencefrom the information appearing under the captions “Executive Compensation,” “Compensationof Directors” and “Election of Directors—Compensation Committee Interlocks andInsider Participation” in the 2007 Proxy Statement which is to be filed withthe Commission within 120 days of the Company’s fiscal year ended December 31,2006.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information required by this item as to theownership of management and others of securities of the Company is herebyincorporated by reference from the information appearing under the caption “SecurityOwnership” in the 2007 Proxy Statement, which is to be filed with theCommission within 120 days of the Company’s fiscal year ended December 31,2006.

51

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Thefollowing table sets forth certain information as of December 31, 2006with respect to compensation plans under which shares of NEOPHARM’s commonstock may be issued:

| **Plan category**                                   | ** ** | ** ** | ** ** | **Number of securities to be  issued upon exercise of  outstanding stock options** | ** ** | **Weighted-average  exercise price of  outstanding options** | ** ** | **Number of securites  remaining available for  future issuance** | ** ** |
|----------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders |       |       | 2,765,808  |                                                                                                                            |       |                                                                        | $          | 11.28                                                                                      |       |   |   | 360,593 |   |   |
| Equity  compensation plans not approved by stockholders  |       |       | —     |                                                                                                                            |       |                                                                        | —     |                                                                                       |       |   | $ | — |   |   |
| Total                                                    |       |       | 2,765,808  |                                                                                                                            |       |                                                                        | $          | 11.28                                                                                      |       |   |   | 360,593 |   |   |
|                                                          |            |            |            |                                                                                                                                 |            |                                                                             |            |                                                                                            |            |  |  |  |  |  |  |  |  |

 

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information requiredby this item as to certain business relationships and transactions withmanagement and other related parties of the Company is hereby incorporated byreference from the information appearing under the caption “CertainRelationships and Related Transactions” in the 2007 Proxy Statement, which isto be filed with the Commission within 120 days of the Company’s fiscal yearended December 31, 2006.

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES

The information requiredby this item as to expenses for principal accounting fees and services incurredby the Company is hereby incorporated by reference from the informationappearing under the caption “Ratification of the Appointment of IndependentRegistered Public Accounting Firm” in the 2007 Proxy Statement which is to befiled with the Commission within 120 days of the Company’s fiscal year ended December 31,2006.

**PART IV**

**ITEM 15.**         EXHIBITS,FINANCIAL STATEMENT SCHEDULES

(a)   Thefollowing documents are filed as part of this Annual Report on Form 10-Kbeginning on the pages referenced below:

(1)   Financial Statements:
|                                                          | ** ** | **Page** |
|----------------------------------------------------------|------------|----------|
| Report  of Independent Registered Public Accounting Firm |       | 58       |
| Consolidated  Balance Sheets                             |       | 59       |
| Consolidated  Statements of Operations                   |       | 60       |
| Consolidated  Statements of Stockholders’ Equity    |       | 61       |
| Consolidated  Statements of Cash Flows                   |       | 62       |
| Notes to Consolidated Financial Statements               |       | 63       |

 

(2)   Financial Statement Schedule:
| Report of Independent  Registered Public Accounting Firm                                                   |   | 81 |
|------------------------------------------------------------------------------------------------------------|--------|----|
| Schedule II—Valuation and Qualifying Accounts for the  years ended  December 31, 2006, 2005, and 2004 |   | 82 |

                                                                                                
| (3) | Exhibits |   |
|-----|----------|--------|

 

52

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**Item15(a)(3) Exhibit List**

| Exhibit Number | ** ** | ** **                                                                                                                                                                                                                                                                                                     | ** ** | **Description** |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1                 |       | Amended and Restated Certificate of Incorporation,  incorporated by reference from Exhibit 3.1 in the Company’s registration  statement on Form S-3/A filed on September 6, 2000 (File  No. 333-44396).                                                                               |
| 3.1.1               |       | Amendment to the Amended and Restated Certificate of  Incorporation incorporated by reference from Exhibit 3.01 contained in  the Company’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2002. (File No. 001-12493).                                                 |
| 3.2                 |       | Amended and Restated Bylaws of the Company  incorporated by reference from Exhibit 3.1 contained in the Company’s  Current Report on Form 8-K filed September 7, 2004 (File  No. 001-12493)                                                                                           |
| 4.1                 |       | Specimen Common Stock Certificate incorporated by  reference from Exhibit 4.3 in the Company’s registration statement on  Form S-3 filed on October 1, 2003 (File No. 333-109340)                                                                                                     |
| 4.1.1               |       | Preferred Stock Rights Agreement between  NeoPharm, Inc. and Computershare Investor Services L.L.C. dated as of  June 30, 2003, incorporated by reference from Exhibit 4.1 contained  in the Company’s Current Report on Form 8-K filed July 7,  2003 (File No. 001-12493). |
| 4.1.2               |       | First Amendment to Rights Agreement between  NeoPharm, Inc. and Computershare Investor Services L.L.C. dated as of  September 10, 2004, incorporated by reference from the Company’s Current  Report on Form 8-K filed September 24, 2004 (File  No. 001-12493).                 |
| 4.1.3               |       | Second Amendment to Rights Agreement between  NeoPharm, Inc. and Computershare Investor Services, L.L.C. dated as of  November 11, 2004, incorporated by reference from the Company’s Current  Report on Form 8-K filed November 17, 2004 (File No. 001-12493).                  |
| 10.1                |       | Cooperative Research and Development Agreement  between the Company and the National Cancer Institute dated  September 13, 1993, incorporated by reference from Exhibit 10.4 in  the Company’s registration statement on Form S-1 (File No. 33-90516).                                |
| 10.2                |       | License Agreement between the Company and Georgetown  University dated July 1990, incorporated by reference from  Exhibit 10.5 to the Company’s registration statement on Form S-1  (File No. 33-90516).                                                                              |
| 10.3                |       | License Agreement between the Company and Georgetown  University dated April 18, 1994, incorporated by reference from Exhibit 10.6  to the Company’s registration statement on Form S-1 (File  No. 33-90516).                                                                    |
| 10.4                |       | Consulting Agreement, dated July 1, 1994, by  and between the Company and EJ Financial Services, Inc,  incorporated by reference from Exhibit 10.8 to the Company’s  registration statement on Form S-1 (File No. 33-90516).                                                |
| 10.5                |       | Cooperative Research and Development Agreement  between the Company and the Food and Drug Administration dated  August 27, 1997, incorporated by reference from Exhibit 10.11 of  the Company’s Annual Report on Form 10-K for the calendar year  ended December 31, 1998.            |
| 10.6                |       | License Agreement between the Company and the  National Institute of Health dated September 23, 1997, incorporated by  reference from Exhibit 10.12 of the Company’s Annual Report on  Form 10-K for the calendar year ended December 31, 1998 (File  No. 001-12493).            |
| *10.7               |       | 1998 Equity Incentive Plan, incorporated by  reference from Exhibit 4.1 to the Company’s registration statement on  Form S-8 filed on October 30, 1995 (File No. 333-66365).                                                                                                          |

53

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| 10.8   |   | Collaboration Agreement by and between the Company  and BioChem Therapeutics dated May 12, 1997, incorporated by reference  from Exhibit 10.15 of the Company’s Annual Report on Form 10-K  for the calendar year ended Dcember 31, 1998 (File No. 001-12493).                                                                       |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9   |   | License Agreement by and between the Company and  Pharmacia and Upjohn Company dated February 19, 1999, incorporated by  reference from Exhibit 10.1 of the Company’s report on Form 8-K  (File No. 33-09516).                                                                                                                            |
| 10.10  |   | Stock Purchase Agreement by and between the Company  and Pharmacia and Upjohn dated February 19, 1999, incorporated by  reference from Exhibit 10.2 of the Company’s Report on Form 8-K  (File No. 33-09516).                                                                                                                             |
| 10.11  |   | Amendment No. 1 dated January 22, 1999 to  the License Agreement between the Company and Georgetown University dated  January, 1990, incorporated by reference from Exhibit 10.18 of the  Company’s Annual Report on Form 10-K for the calendar year ended December 31,  1998 (File No. 001-12493).                             |
| 10.12  |   | Amendment No. 1 dated January 22, 1999 to  the License Agreement between the Company and Georgetown University dated  April 18, 1994, incorporated by reference from Exhibit 10.19 of the  Company’s Annual Report on Form 10-K for the calendar year ended December 31,  1998 (File No. 001-12493).                       |
| 10.13  |   | Promissory Note dated as of December 20, 2001  by and between the Company and Akorn, Inc., incorporated by reference  from Exhibit 10.2 to the Company’s Annual Report on Form 10-K  for the fiscal year ended December 31, 2001.                                                                                                    |
| 10.14  |   | Processing Agreement dated as of December 20,  2001 by and between the Company and Akorn, Inc., incorporated by  reference from Exhibit 10.3 to the Company’s Annual Report on  Form 10-K for the fiscal year ended December 31, 2001.                                                                                               |
| 10.15  |   | Subordination and Intercreditor Agreement dated as  of December 20, 2001 by and between the Company and John N. Kapoor, as  Trustee under the John N. Kapoor Trust, dated September 20, 1989,  incorporated by reference from Exhibit 10.4 to the Company’s Annual Report  on Form 10-K for the fiscal year ended December 31, 2001. |
| 10.16  |   | Subordination, Standby and Intercreditor Agreement  dated as of December 20, 2001 by and between the Company and the  Northern Trust Company, incorporated by reference from Exhibit 10.5 to  the Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2001.                                                      |
| *10.17 |   | Amendment to the 1998 Equity Incentive Plan,  incorporated by reference from Appendix A to the Company’s Definitive Proxy  Statement on Schedule 14A for the Annual Meeting of Stockholders held  June 6, 2002.                                                                                                                                     |
| 10.18  |   | First Amended and Restated Synthetic Cardiolipin  Supply Agreement dated as of November 1999, by and between Avanti Polar  Lipids, Inc. and NeoPharm, Inc., incorporated by reference from  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the quarter ended September 30, 2003 (File No. 001-12493).    |
| 10.19  |   | Conditional Option Agreement between Avanti Polar  Lipids and NeoPharm, Inc. dated as of January 26, 1999,  incorporated by reference from Exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2003  (File No. 001-12493).                                                    |
| 10.20  |   | Form of Amendment to Processing Agreement dated  as of October 7, 2003 by and between NeoPharm, Inc. and  Akorn, Inc., incorporated by reference from Exhibit 10.30 to the  Company’s Annual Report on Form 10-K for the calendar year ended December 31,  2003 (File No. 001-12493).                                 |
| 10.21  |   | Form of Amended and Restated Promissory Note  dated as of October 7, 2003 by and between the Company and  Akorn, Inc., incorporated by reference from Exhibit 10.31 to the  Company’s Annual Report on Form 10-K for the calendar year ended  December 31, 2003 (File No. 001-12493).                                      |

54

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| 10.22  |   | Subordination and Intercreditor Agreement dated as  of October 7, 2003 by and between the Company and LaSalle Bank National  Association, incorporated by reference from Exhibit 10.32 to the  Company’s Annual Report on Form 10-K for the calendar year ended  December 31, 2003 (File No. 001-12493).         |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *10.23 |   | Separation Agreement and Full Release of Claims between  the Company and James M. Hussey, dated as of June 17, 2004, incorporated  by reference from Exhibit 10.01 contained in the Company’s Quarterly  Report on Form 10-Q for the quarter ended June 30, 2004.                                                     |
| *10.24 |   | Form of Director and Executive Officer Indemnification  Agreement of NeoPharm, Inc., as adopted on September 20, 2004,  incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed September 30, 2004 (File  No. 001-12493).                                      |
| 10.25  |   | Settlement Agreement among NeoPharm, Inc., John  N. Kapoor, Ph.D., Erick E. Hanson, Gregory P. Young, and Dr. Kaveh T.  Safavi dated as of November 11, 2004, incorporated by reference from  Exhibit 10.01 to the Company’s Current Report on Form 8-K  filed November 17, 2004 (File No. 001-12493). |
| *10.26 |   | Separation Agreement by and between  NeoPharm, Inc. and Sander A. Flaum dated as of November 11, 2004,  incorporated by reference from Exhibit 10.02 the Company’s Current  Report on Form 8-K filed September 17, 2004 (File  No. 001-12493).                                                              |
| *10.27 |   | Separation Agreement by and between  NeoPharm, Inc. and Matthew P. Rogan dated as of November 11, 2004,  incorporated by reference from Exhibit 10.03 to the Company’s Report on  Form 8-K filed on November 17, 2004 (File No. 001-12493).                                                                 |
| 10.28  |   | Sublicense and License Agreement between Nippon  Kayaku Co., Ltd. and NeoPharm, Inc. dated as of December 28, 2004,  incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed January 4, 2005 (File No. 001-112493).                                                 |
| *10.29 |   | Separation Agreement and Full Release of Claims by  and between NeoPharm, Inc. and Gregory P. Young dated as of  March 11, 2005, incorporated by reference from Exhibit 10.02 to the  Company’s Current Report on Form 8-K filed on March 14, 2005  (File No. 001-12493).                                   |
| *10.30 |   | Amendment No. 1 to Separation Agreement and  Full Release of Claims by and between NeoPharm, Inc and James M. Hussey dated  March 10, 2005, incorporated by reference from Exhibit 10.03 to the  Company’s Current Report on Form 8-K filed on March 14, 2005  (File No. 001-12493).                        |
| *10.31 |   | Employment Agreement by and between  NeoPharm, Inc. and Ronald G. Eidell dated April 25, 2005,  incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed on April 28, 2005 (File No. 001-12493).                                                                     |
| *10.32 |   | Interim Engagement Resources Agreement by and  between NeoPharm, Inc. and Tatum CFO Partners, LLP. dated April 25,  2005, incorporated by reference from Exhibit 10.02 to the Company’s  Current Report on Form 8-K filed on April 28, 2005 (File  No. 001-12493).                                          |
| 10.33  |   | Note Repayment Agreement by and between  NeoPharm, Inc. and Akorn, Inc. dated May 16, 2005,  incorporated by reference from Exhibit 10.01 to the Company’s Current  Report on Form 8-K filed on May 20, 2005 (File No. 001-12493).                                                                     |
| *10.34 |   | Non-Employee Director Compensation dated  June 16, 2005, incorporated by reference from Exhibit 10.1  incorporate by reference from Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed on June 22, 2005 (File No. 001-12493).                                                                  |
| 10.35  |   | Modification to CRADA No. 26-97 by and  between the NeoPharm, Inc. and FDA dated July 25, 2005 incorporated  by reference from Exhibit 10.1 to the Company’s Current Report on  Form 8-K filed on August 11, 2005 (File No. 001-12493).                                                                |

55

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| *10.36 |   | Employment Agreement by and between NeoPharm, Inc.  and Guillermo A. Herrera dated October 28, 2005, incorporated by  reference from Exhibit 10.01 to the Company’s Current Report on  Form 8-K filed on November 1, 2005 (File No. 001-12493).                                                                                                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *10.37 |   | Terms of Employment by and between  NeoPharm, Inc. and Timothy P. Walbert dated January 17, 2006,  incorporated by reference from Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed on January 19, 2006 (File  No. 001-12493).                                                                                                                                             |
| 10.38  |   | License Amendment (L-226-1996/1) dated  May 30, 2006, between NeoPharm, Inc. and the National Institute of  Health, on behalf of the Public Health Service, amending License Agreement (L-226-1996/0),  incorporated by reference from Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed June 5, 2006 (File No. 001-12493).                                                |
| 10.39  |   | License Amendment (L-024-2006/0) dated  May 30, 2006, between NeoPharm, Inc. and the National Institute of  Health, on behalf of the Public Health Service, incorporated by reference  from Exhibit 10.3 to the Company’s Current Report on Form 8-K  filed June 5, 2006 (File No. 001-12493).                                                                                           |
| *10.40 |   | Separation Agreement and Full Release of All Claims,  dated June 13, 2006, by and between NeoPharm, Inc. and Lawrence A.  Kenyon, incorporated by reference from Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed June 13, 2006 (File  No. 001-12493).                                                                                                                    |
| *10.41 |   | The NeoPharm, Inc. 2006 Employee Stock Purchase  Plan, incorporated by reference from Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed June 21,2006 (File  No. 001-12493).                                                                                                                                                                                                     |
| *10.42 |   | The NeoPharm, Inc. 2006 Equity Incentive Plan,  incorporated by reference from Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed June 21,2006 (File No. 001-12493).                                                                                                                                                                                                             |
| *10.43 |   | Specimen Form of Award Agreement used to award  Stock Options under the NeoPharm, Inc. 2006 Equity Incentive Plan,  incorporated by reference from Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed June 21, 2006 (File No. 001-12493).                                                                                                                                   |
| *10.44 |   | Non-employee Director Compensation, incorporated by  reference from Exhibit 10.4 to the Company’s Current Report on  Form 8-K filed June 21, 2006 (File No. 001-12493).                                                                                                                                                                                                                            |
| *10.45 |   | Terms of Employment by and between  NeoPharm, Inc. and Ronald E. Pauli dated August 4, 2006,  incorporated by reference from Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed on August 9, 2006 (File No. 001-12493).                                                                                                                                                     |
| *10.46 |   | License Amendment (L-024-2006/1) dated  August 21, 2006, between NeoPharm, Inc. and the Natioanl Institutes  of Health, on behalf of the Public Health Service and the Department of  Health and Human Services, amending License Agreement L-024-2006/0,  incorporated by reference from Exhibit 10-1 to the Company Current  Report on Form 8-K filed on August 23, 2006 (File  No. 12493). |
| 10.47  |   | Amendment No. 5 to Cooperative Research and  Development Agreement No 26-97 incorporated by reference from  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed November 11, 2006 (File No. 001-12493).                                                                                                                                                                           |
| **23.1 |   | Consent of Independent Registered Public Accounting  Firm.                                                                                                                                                                                                                                                                                                                                                                  |
| **31.1 |   | Certification of Chief Executive Officer.                                                                                                                                                                                                                                                                                                                                                                                   |
| **31.2 |   | Certification of Chief Financial Officer.                                                                                                                                                                                                                                                                                                                                                                                   |
| **32.1 |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                      |
| **32.2 |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act.                                                                                                                                                                                                                                                                                                                                                      |

----

*                    Denotesmanagement contract or compensatory plan or arrangement.

**             Filedherewith

All schedules andexhibits, other than those listed above, are omitted as the information is notrequired or are furnished elsewhere in the financial statements or the notesthereto.

56

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**SIGNATURES**

PURSUANTTO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITSBEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED

|        |     |     | NEOPHARM, INC. |
|--------|----------|----------|---------------------|
|   |     |     | By:                 | /s/  GUILLERMO A. HERRERA |
|   |     |     |                | Guillermo A.  Herrera |
|   | * * | * * |                | *President  and Chief Executive Officer* |

 

PURSUANTTO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS ANNUAL REPORTHAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATESINDICATED.

|                          | **Signature** | ** **                                | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|-------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ JOHN N. KAPOOR       |          | Director, Chairman of  the Board          |       | March 15, 2007  |
| John N. Kapoor           |          |                                      |       |                 |
| /s/ GUILLERMO A. HERRERA |          | Director,  President, and Chief Executive |       | March 15,  2007 |
| Guillermo A. Herrera     |          | Officer (Principal  Executive Officer)    |       |                 |
| /s/ FRANK C. BECKER      |          | Director                                  |       | March 15,  2007 |
| Frank C. Becker          |          |                                      |       |                 |
| /s/ RONALD G. EIDELL     |          | Director                                  |       | March 15,  2007 |
| Ronald G. Eidell         |          |                                      |       |                 |
| /s/ BERNARD A. FOX       |          | Director                                  |       | March 15,  2007 |
| Bernard A. Fox           |          |                                      |       |                 |
| /s/ PAUL E. FREIMAN      |          | Director                                  |       | March 15,  2007 |
| Paul E. Freiman          |          |                                      |       |                 |
| /s/ ERICK E. HANSON      |          | Director                                  |       | March 15,  2007 |
| Erick E. Hanson          |          |                                      |       |                 |
| /s/ KAVEH T. SAFAVI      |          | Director                                  |       | March 15,  2007 |
| Kaveh T. Safavi          |          |                                      |       |                 |
| /s/ RONALD E. PAULI      |          | Chief Financial  Officer (Principal       |       | March 15,  2007 |
| Ronald E. Pauli          |          | Financial Officer and  Principal          |       |                 |
|                     |          | Accounting Officer)                       |       |                 |

 

57

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersNeoPharm, Inc.:

We have audited the accompanying consolidated balancesheets of NeoPharm, Inc. and subsidiary as of December 31, 2006 and2005, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2006. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of NeoPharm, Inc. and subsidiary as of December 31, 2006 and2005, and the results of their operations and their cash flows for each of theyears in the three-year period ended December 31, 2006, in conformity withU.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financialstatements, the Company adopted the provisions of Statement of FinancialAccounting Standards No. 123(R), *Share-Based Payment*,as of January 1, 2006.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of NeoPharm, Inc.’sinternal control over financial reporting as of December 31, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), and our report dated March 16, 2007 expressedan unqualified opinion on management’s assessment of, and the effectiveoperation of, internal control over financial reporting.

| /s/ KPMG LLP        |   |
|---------------------|--------|
| Chicago, Illinois   |
| March 16, 2007 |

 

58

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**NEOPHARM, INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                |       |                  |       |   |   |
| Current assets:                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                 |       | $                     | 1,852,000  |   | $ | 1,486,000 |   |
| Short-term investments                                                                                                                    |       | 36,735,000            |       | 28,776,000 |   |
| Trade accounts receivable, net                                                                                                            |       | —                |       | 1,000 |   |
| Inventories                                                                                                                               |       | —                |       | 6,000 |   |
| Prepaid expenses and other                                                                                                                |       | 627,000               |       | 728,000 |   |
| Total current assets                                                                                                                      |       | 39,214,000            |       | 30,997,000 |   |
| Fixed assets, net of accumulated depreciation                                                                                             |       | 1,266,000             |       | 2,157,000 |   |
| Other assets                                                                                                                              |       | 209,000               |       | 216,000 |   |
| Total assets                                                                                                                              |       | $                     | 40,689,000 |   | $ | 33,370,000 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                            |       |                  |       |   |   |
| Current  liabilities:                                                                                                                     |       |                  |       |   |   |
| Accounts payable                                                                                                                          |       | $                     | 5,085,000  |   | $ | 683,000 |   |
| Accrued clinical trial expenses                                                                                                           |       | 2,272,000             |       | 5,370,000 |   |
| Accrued compensation                                                                                                                      |       | 811,000               |       | 1,889,000 |   |
| Accrued legal expenses                                                                                                                    |       | 129,000               |       | 241,000 |   |
| Obligations under capital lease                                                                                                           |       | 30,000                |       | — |   |
| Other accrued expenses                                                                                                                    |       | 1,250,000             |       | 1,206,000 |   |
| Total current liabilities                                                                                                                 |       | 9,577,000             |       | 9,389,000 |   |
| Obligations under capital lease                                                                                                           |       | 105,000               |       | — |   |
| Deferred revenue                                                                                                                          |       | 2,000,000             |       | 2,000,000 |   |
| Deferred rent                                                                                                                             |       | 35,000                |       | 36,000 |   |
| Derivative financial instruments                                                                                                          |       | 101,000               |       | — |   |
| Stockholders’  equity:                                                                                                               |       |                  |       |   |   |
| Preferred stock, $0.01 par value; 15,000,000 shares  authorized: none issued and outstanding                                              |       | —                |       | — |   |
| Common stock, $0.0002145 par value; 50,000,000  shares authorized: 28,080,408 and 23,740,051 shares issued and outstanding,  respectively |       | 6,000                 |       | 5,000 |   |
| Additional paid-in capital                                                                                                                |       | 290,098,000           |       | 249,965,000 |   |
| Accumulated deficit                                                                                                                       |       | (261,233,000          | )          | (228,025,000 | ) |
| Total stockholders’ equity                                                                                                           |       | 28,871,000            |       | 21,945,000 |   |
| Total liabilities  and stockholders’ equity                                                                                          |       | $                     | 40,689,000 |   | $ | 33,370,000 |   |

 

The accompanying notes to consolidated financial statements  are an integral part of these financial statements.

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**NEOPHARM, INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                    | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                    | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Collaboration  revenue                                        |       | $                                                             | —      |   | $ | 500,000 |   | $ | — |   |
| Product revenue                                               |       | 11,000                                                        |        | 43,000 |   | 157,000 |   |
| Total revenue                                                 |       | 11,000                                                        |        | 543,000 |   | 157,000 |   |
| Expenses:                                                     |       |                                                          |        |   |   |   |   |
| Cost of product revenue                                       |       | 1,000                                                         |        | 2,000 |   | 5,000 |   |
| Research and development                                      |       | 21,199,000                                                    |        | 31,851,000 |   | 44,513,000 |   |
| Selling, general, and administrative                          |       | 14,136,000                                                    |        | 11,421,000 |   | 12,798,000 |   |
| Change in fair value of derivative financial   instruments    |       | (1,551,000                                                    | )           | — |   | — |   |
| Employee termination costs                                    |       | 1,528,000                                                     |        | — |   | 1,149,000 |   |
| Facility consolidation costs                                  |       | 433,000                                                       |        | — |   | — |   |
| Related party expenses                                        |       | —                                                        |        | — |   | 420,000 |   |
| Recovery of note receivable                                   |       | —                                                        |        | (2,500,000 | ) | — |   |
| Total expenses                                                |       | 35,746,000                                                    |        | 40,774,000 |   | 58,885,000 |   |
| Loss from  operations                                         |       | (35,735,000                                                   | )           | (40,231,000 | ) | (58,728,000 | ) |
| Interest income                                               |       | 2,527,000                                                     |        | 1,506,000 |   | 1,119,000 |   |
| Net loss                                                      |       | $                                                             | (33,208,000 | ) | $ | (38,725,000 | ) | $ | (57,609,000 | ) |
| Net loss per  share—  Basic and diluted                  |       | $                                                             | (1.20       | ) | $ | (1.64 | ) | $ | (2.51 | ) |
| Weighted average shares  outstanding—  Basic and diluted |       | 27,782,074                                                    |        | 23,601,643 |   | 22,941,668 |   |

 

The accompanying notes to consolidated financial statements  are an integral part of these financial statements.

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**NEOPHARM, INC. AND SUBSIDIARYSTATEMENT OF STOCKHOLDERS’ EQUITY**

| ** **                                                                                               | ** ** | **Shares of  Preferred  Stock** | ** ** | **Shares of  Common Stock** | ** ** | **Par Value** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------------|------------|--------------------|------------|----------------------------------|------------|--------------------------|------------|---------------------------------------|------------|
| Balance at December 31, 2003                                                                        |       |                                 | —     |                                  |       |               | 18,862,906 |                             |       |                     | $          | 4,000                                 |       |   | $ | 171,705,000 |   | $ | (131,691,000 | ) |   | $ | 40,018,000 |   |   |
| Issuance of common stock pursuant to public offering                                                     |       |                                 | —     |                                  |       |               | 4,312,500  |                             |       |                     | 1,000      |                                  |       | 73,472,000 |   | — |   |   | 73,473,000 |   |   |
| Issuance of common stock pursuant to exercise of  stock options                                          |       |                                 | —     |                                  |       |               | 172,367    |                             |       |                     | —     |                                  |       | 1,187,000 |   | — |   |   | 1,187,000 |   |   |
| Issuance of restricted common stock to non-employee  directors                                           |       |                                 | —     |                                  |       |               | 24,982     |                             |       |                     | —     |                                  |       | 381,000 |   | — |   |   | 381,000 |   |   |
| Employee common stock option compensation                                                                |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | 43,000 |   | — |   |   | 43,000 |   |   |
| Non-employee common stock option compensation                                                            |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | 737,000 |   | — |   |   | 737,000 |   |   |
| Net loss                                                                                                 |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | — |   | (57,609,000 | ) |   | (57,609,000 | ) |   |
| Balance at December 31, 2004                                                                        |       |                                 | —     |                                  |       |               | 23,372,755 |                             |       |                     | 5,000      |                                  |       | 247,525,000 |   | (189,300,000 | ) |   | 58,230,000 |   |   |
| Issuance of common stock pursuant to exercise of  stock options                                          |       |                                 | —     |                                  |       |               | 285,519    |                             |       |                     | —     |                                  |       | 1,494,000 |   | — |   |   | 1,494,000 |   |   |
| Issuance of restricted common stock to non-employee  directors                                           |       |                                 | —     |                                  |       |               | 36,010     |                             |       |                     | —     |                                  |       | 305,000 |   | — |   |   | 305,000 |   |   |
| Employee common stock-based compensation                                                                 |       |                                 | —     |                                  |       |               | 22,075     |                             |       |                     | —     |                                  |       | 217,000 |   | — |   |   | 217,000 |   |   |
| Non-employee common stock option compensation                                                            |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | 236,000 |   | — |   |   | 236,000 |   |   |
| Issuance of common stock in lieu of cash payment                                                         |       |                                 | —     |                                  |       |               | 23,692     |                             |       |                     | —     |                                  |       | 188,000 |   | — |   |   | 188,000 |   |   |
| Net loss                                                                                                 |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | — |   | (38,725,000 | ) |   | (38,725,000 | ) |   |
| Balance at December 31, 2005                                                                        |       |                                 | —     |                                  |       |               | 23,740,051 |                             |       |                     | 5,000      |                                  |       | 249,965,000 |   | (228,025,000 | ) |   | 21,945,000 |   |   |
| Issuance of common stock pursuant to public offering                                                     |       |                                 | —     |                                  |       |               | 4,025,000  |                             |       |                     | 1,000      |                                  |       | 38,738,000 |   | — |   |   | 38,739,000 |   |   |
| Issuance of common stock pursuant to exercise of  stock options                                          |       |                                 | —     |                                  |       |               | 217,950    |                             |       |                     | —     |                                  |       | 856,000 |   | — |   |   | 856,000 |   |   |
| Issuance and compensation associated with restricted  common stock issued to non-employee directors |       |                                 | —     |                                  |       |               | 58,083     |                             |       |                     | —     |                                  |       | 368,000 |   | — |   |   | 368,000 |   |   |
| Employee common stock-based compensation                                                                 |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | 1,633,000 |   | — |   |   | 1,633,000 |   |   |
| Issuance of common stock to employee stock purchase  plan                                                |       |                                 | —     |                                  |       |               | 39,324     |                             |       |                     | —     |                                  |       | 190,000 |   | — |   |   | 190,000 |   |   |
| Reclassification of derivative instrument                                                                |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | (1,652,000 | ) | — |   |   | (1,652,000 | ) |   |
| Net loss                                                                                                 |       |                                 | —     |                                  |       |               | —     |                             |       |                     | —     |                                  |       | — |   | (33,208,000 | ) |   | (33,208,000 | ) |   |
| Balance at  December 31, 2006                                                                       |       |                                 | —     |                                  |       |               | 28,080,408 |                             |       |                     | $          | 6,000                                 |       |   | $ | 290,098,000 |   | $ | (261,233,000 | ) |   | $ | 28,871,000 |   |   |

 

The accompanying notes to consolidated financial statements  are an integral part of these financial statements.

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**NEOPHARM, INC. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                   | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                   | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating  activities:                                       |       |                                                          |        |   |   |   |   |
| Net loss                                                                     |       | $                                                             | (33,208,000 | ) | $ | (38,725,000 | ) | $ | (57,609,000 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                                          |        |   |   |   |   |
| Depreciation                                                                 |       | 1,153,000                                                     |        | 1,300,000 |   | 1,329,000 |   |
| Stock-based compensation expense                                             |       | 2,059,000                                                     |        | 758,000 |   | 1,162,000 |   |
| Change in fair value of derivative financial  instruments                    |       | (1,551,000                                                    | )           | — |   | — |   |
| Loss on retirement of fixed assets                                           |       | 11,000                                                        |        | 25,000 |   | — |   |
| Non-cash reorganization charge                                               |       | 94,000                                                        |        | — |   | — |   |
| Provision for losses on accounts receivable                                  |       | —                                                        |        | 10,000 |   | — |   |
| Changes  in assets and liabilities:                                          |       |                                                          |        |   |   |   |   |
| (Increase) in interest receivable on short-term  investments                 |       | (9,000                                                        | )           | (55,000 | ) | (20,000 | ) |
| Decrease (increase) in trade accounts receivable                             |       | 1,000                                                         |        | (1,000 | ) | (11,000 | ) |
| Decrease (increase) in inventories                                           |       | 6,000                                                         |        | — |   | (6,000 | ) |
| (Increase) decrease in prepaid expenses and other                            |       | 101,000                                                       |        | 473,000 |   | (221,000 | ) |
| Increase (decrease) in accounts payable                                      |       | 4,402,000                                                     |        | 285,000 |   | (101,000 | ) |
| Increase (decrease) in accrued expenses                                      |       | (4,250,000                                                    | )           | 91,000 |   | 3,238,000 |   |
| Increase (decrease) in deferred revenue                                      |       | —                                                        |        | 1,997,000 |   | 3,000 |   |
| Increase in deferred rent                                                    |       | 9,000                                                         |        | 36,000 |   | — |   |
| Net cash and cash equivalents used in operating  activities                  |       | (31,182,000                                                   | )           | (33,806,000 | ) | (52,236,000 | ) |
| Cash flows from  investing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from sales and maturities of marketable  securities                 |       | 32,850,000                                                    |        | 59,100,000 |   | 22,266,000 |   |
| Purchase of marketable securities                                            |       | (40,800,000                                                   | )           | (77,450,000 | ) | (18,000,000 | ) |
| Purchase of equipment and furniture                                          |       | (204,000                                                      | )           | (588,000 | ) | (463,000 | ) |
| Net cash and cash equivalents (used in) provided by investing  activities    |       | (8,154,000                                                    | )           | (18,938,000 | ) | 3,803,000 |   |
| Cash flows from  financing activities:                                       |       |                                                          |        |   |   |   |   |
| Proceeds from issuance of common stock, net                                  |       | 38,739,000                                                    |        | — |   | 73,473,000 |   |
| Proceeds from exercise of stock options                                      |       | 856,000                                                       |        | 1,494,000 |   | 1,187,000 |   |
| Proceeds from employee stock purchase plan                                   |       | 133,000                                                       |        | — |   | — |   |
| Repayment of capital lease obligation                                        |       | (26,000                                                       | )           | — |   | — |   |
| Net cash and cash equivalents provided by financing  activities              |       | 39,702,000                                                    |        | 1,494,000 |   | 74,660,000 |   |
| Net increase/(decrease) in cash and cash equivalents                         |       | 366,000                                                       |        | (51,250,000 | ) | 26,227,000 |   |
| Cash and cash equivalents, beginning of period                               |       | 1,486,000                                                     |        | 52,736,000 |   | 26,509,000 |   |
| Cash and cash equivalents, end of period                                     |       | $                                                             | 1,852,000   |   | $ | 1,486,000 |   | $ | 52,736,000 |   |
|                                                                         |       | $                                                             | —      |   |   |   |   |   |
| Supplemental schedule of  non-cash financing activities:                     |       |                                                          |        |   |   |   |   |
| Issuance of common stock in satisfaction of liability                        |       | $                                                             | —      |   | $ | 188,000 |   | $ | — |   |
| Capital lease of office equipment                                            |       | $                                                             | 161,000     |   | $ | — |   | $ | — |   |
| Supplemental disclosure  of cash paid for:                                   |       |                                                          |        |   |   |   |   |
| Interest                                                                     |       | $                                                             | —      |   | $ | — |   | $ | — |   |
| Income taxes                                                                 |       | $                                                             | —      |   | $ | — |   | $ | — |   |

 

The accompanying notes to consolidated financial statements  are an integral part of these financial statements.

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**NEOPHARM, INC. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 NATUREOF OPERATIONS AND PRINCIPAL ACCOUNTING POLICIES

***Nature ofOperations—******NeoPharm,*** Inc.(“we”, “us, “our”, or the “Company”), a Delaware corporation, was incorporatedon June 15, 1990, under the name of OncoMed, Inc. In March 1995,we changed our name to NeoPharm, Inc. During 2004, we established awholly-owned subsidiary, NeoPharm EU Limited, to comply with regulatoryrequirements enacted for clinical trials conducted in the European Union. Allof our assets are located in the United States.

We are a biopharmaceutical company engaged in theresearch, development, and commercialization of drugs for the treatment ofvarious cancers. Our corporate strategy is to advance the research,development, and commercialization of new and innovative anti-cancertreatments. Our corporate office and research and development facility islocated in Waukegan, Illinois and we had 53 active employees as of December 31,2006.

Since we began business in June 1990, we haveprincipally devoted our resources to funding research and product developmentprograms. To date, we have not received United States Food and DrugAdministration, or FDA, approval of any of our drug product candidates. Weexpect to continue to incur losses for the foreseeable future as we continueour research and development activities, which include the sponsorship of humanclinical trials for our drug product candidates. If and until we are able toconsistently generate profitable revenue through the sale of drug or non-drugproducts, we anticipate that we will continue to be required to fund thedevelopment of our pre-clinical compounds and drug product candidatesprimarily by other means, including, but not limited to, selling stock in theCompany, licensing the development rights to some of our drug productcandidates to third parties, or collaborating with third parties to developformulations of their compounds using our technology.

One of the our drug product candidates has been licensedfrom the National Institutes of Health, or NIH, and is the subject of aCooperative Research and Development Agreement, or CRADA, with the FDA. We alsohave rights to drug product candidates developed under license and contractresearch agreements with Georgetown University, or Georgetown.

We are continuing to develop our drug productcandidates, which requires substantial capital for research, productdevelopment and market development activities. We have not yet initiatedmarketing of a commercial drug product. Future product development will requireclinical testing, regulatory approval, and substantial additional investmentprior to commercialization. Our future success is dependent on our ability tomake progress in the development of our drug product candidates and,ultimately, upon our ability to attain future profitable operations through thesuccessful manufacturing and marketing of those drug product candidates. Therecan be no assurance that we will be able to obtain the necessary financing orregulatory approvals to be able to successfully develop, manufacture, andmarket our drug product candidates, or attain successful future operations.Insufficient funds could require us to delay, scale back, or eliminate one ormore of our research and development programs or to license third parties tocommercialize drug product candidates or technologies that we would otherwiseseek to develop without relinquishing our rights thereto. Accordingly, thepredictability of our future success is uncertain.

Our rights to our drug product candidates are subjectto the terms of our agreements with NIH, FDA, and Georgetown. Termination ofany, or all, of these agreements could have a material adverse effect on ourbusiness, financial position and results of operations. In addition,uncertainty exists as to our ability to protect our rights to patents andproprietary information. There can also be no assurance that research anddiscoveries by others will not render some or all of our technology or drugproduct candidates 

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noncompetitive orobsolete. Nor can there be any assurance that unforeseen problems will notdevelop with our technologies or applications, or that we will be able tosuccessfully address technological challenges we encounter in our research anddevelopment programs. While we maintain insurance to cover the use of our drugproduct candidates in clinical trials, we do not yet maintain insurancecovering the potential sales of our products nor is there any assurance that wewill be able to obtain or maintain such insurance on acceptable terms or withadequate coverage against potential liabilities.

From our inception on June 15, 1990, through December 31,1998, the Company was classified as a development stage entity. We completedour development stage upon the out-licensing of our first major drug productcandidates to Pharmacia & Upjohn Company, or Pharmacia, in February of1999. Accordingly, the inception to date information is not presented in theseconsolidated financial statements.

***Basis ofPresentation—******The*********consolidated financial statementsinclude the accounts of NeoPharm, Inc. and its wholly-owned subsidiary,NeoPharm EU Limited. As of and through December 31, 2006, the subsidiaryhad nominal assets and had not conducted any business. All significantintercompany accounts and transactions have been eliminated in consolidation.

Amounts presented have been rounded to the nearestthousand.

***Use of Estimates—******The***preparationof financial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of revenue and expense during the reporting period. Actualresults could differ from those estimates.

***Cash and CashEquivalents—******We*** considerall highly liquid investments purchased with an original maturity of threemonths or less to be cash equivalents. Included with cash are cash equivalents of$593,000 and $104,000 as of December 31, 2006 and 2005, respectively. Thecarrying value of these investments approximates their fair market value due totheir short maturity and liquidity.

***Short-termInvestments—******Short-term*** investmentsconsist of auction rate certificates that have scheduled maturities greaterthan 90 days at the time of purchase. We believe the structural features of theauction rate certificates provide us with liquidity characteristics similar tocash equivalents. As provided by Statement of Financial Accounting Standards,or SFAS, No. 115, *Accounting for CertainInvestment in Debt and Equity Securities,* we have elected to treatall of our investments in marketable securities as “available-for-sale,” whichrequires that these investments be recorded at fair market value. However,given the interest rate reset features of our auction rate certificates, thecarrying value of our short-term investments represents their fair value.Dividend and interest income are recognized when earned. We had $36,735,000 and$28,776,000 of investments in marketable securities as of December 31,2006 and 2005, respectively. Included with the carrying value of theinvestments in marketable securities was accrued interest income receivable of$85,000 and $76,000 as of December 31, 2006 and 2005, respectively.Realized gains on investments sold in the periods presented were immaterial.

***Inventory—******We***had nocommercial inventory on hand as of December 31, 2006. Inventory of $6,000on hand at December 31, 2005 was comprised solely of NeoPhectin finishedgoods stated at the lower of cost or market using the first in, first outmethod, or FIFO method. Inventory cost consisted of direct material and directlabor costs.

***Fixed Assets—******Fixed***assetsare recorded at cost and depreciated using the straight-line method over theirestimated useful lives. Maintenance and repairs that do not extend the life ofassets are charged to expense when incurred. When properties are disposed of,the related costs and accumulated depreciation are removed from the accountsand any gain or loss is reported in the period the transaction takes place.Total depreciation expense for the years ended December 31, 2006, 2005 and2004, was $1,153,000, $1,300,000 and $1,329,000, respectively.

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Long-lived assets are reviewed for impairment wheneverevents or changes in circumstances indicate the carrying amount of an asset maynot be recoverable. Recoverability of assets to be held and used is measured bya comparison of the carrying amount of an asset to estimated undiscounted cashflows expected to be generated by the asset. If the carrying amount exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount exceeds the fair value of the asset.

***Other Assets—******Other*** assetsconsist of a lease security deposit of $27,000 and of $182,000 in cash held bya bank as collateral for a standby letter of credit issued by the bank in favorof the Company. The cash held by the bank is restricted as to use for the termof the standby letter of credit.

***Income Taxes—******We***accountfor**income taxes under the asset andliability method. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss and tax credit carryforwards. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. We provide valuation allowances against thedeferred tax assets for amounts which are not considered “more likely than not”to be realized.

***Revenue Recognition—******We***recognizerevenue when persuasive evidence of an arrangement exists, delivery hasoccurred or services have been rendered, the price is fixed or determinable,and collectibility is reasonably assured.

For product sales not subject to unconditional rightsof return, we recognize revenue upon shipment as title and risk of loss haspassed to the customer. For product sales subject to unconditional rights ofreturn, we recognize revenue upon shipment when we can reasonably estimate thelevel of returns at the time of shipment. Given the limited sales history of ourproducts, we are currently unable to reasonably estimate the level of returnsat the time of shipment. Accordingly, revenue related to shipments todistributors that have been granted an unconditional right of return iscurrently being recognized when the right of return has expired, which occursupon the earlier of shipment of the product by the distributor to an end useror expiration of the right of return, which is 60-180 days depending uponthe distributor. The Company warrants its products in a manner consistent withindustry standards and has not incurred any warranty costs related to the saleof NeoPhectin.

We enter into collaboration and technology licensingarrangements, which contain multiple deliverables. Under the provisions ofEmerging Issues Task Force (EITF) No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*, we evaluatewhether these deliverables constitute separate units of accounting to whichtotal arrangement consideration is allocated. A deliverable qualifies as aseparate unit of accounting when the item delivered to the customer hasstandalone value, there is objective and reliable evidence of fair value ofitems that have not been delivered to the customer, and, if there is a generalright of return for the items delivered to the customer, delivery orperformance of the undelivered items is considered probable and substantiallyin our control. Arrangement consideration is allocated to units of accountingon a relative fair-value basis or the residual method if we are unable todetermine the fair value of all deliverables in the arrangement. Considerationallocated to a unit of accounting is limited to the amount that is notcontingent upon our future performance. Upon determination of separate units ofaccounting and allocated consideration, the general criteria for revenue recognitionare applied to each unit of accounting.

We have entered into collaboration and licenseagreements with third parties. The terms of one of our collaboration agreementsprovided for an upfront nonrefundable payment to the Company of $150,000 as wellas an additional $350,000 upon delivery of a customized formulation forNeoPhectin to the customer. We delivered the customized formulation in June 2005at which time we recognized the full contract 

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amount as revenue. In January 2005,we entered into a license agreement with Nippon Kayaku Co., Ltd, or Nippon, inwhich Nippon licensed the rights to develop and commercialize CINTREDEKINBESUDOTOX in Japan. In exchange, we received a $2,000,000 upfront nonrefundablefee in January 2005 and are entitled to receive future additional fees,milestone payments and royalties. Nippon is responsible for all developmentcosts in Japan. We have agreed to provide or arrange for contract manufactureof a commercial supply of CINTREDEKIN BESUDOTOX upon receipt of marketingapproval by Nippon. The upfront nonrefundable fee received by the Company willbe recognized ratably as revenue once the general criteria for revenuerecognition has been met for the unit of accounting to which the fee has beenallocated, or if the agreement should be terminated.

***Research andDevelopment—******Research*** anddevelopment, or R&D, costs are expensed when incurred. These costs include,among other things, consulting fees and costs reimbursed to third parties underlicense and research agreements described in Note 10, Commitments. Paymentsrelated to the acquisition of technology rights, for which development work isin process, are expensed as incurred and are considered a component of R&Dcosts. We charge the indirect cost of administering R&D activities toR&D expense.

***Share-basedCompensation—******We***adoptedthe provisions of SFAS No. 123 (revised 2004), *Share-BasedPayment*, or SFAS 123(R), effective January 1, 2006. SFAS 123(R) requiresthe financial statement recognition of compensation expense related to the fairvalue of our share-based compensation awards. Prior to our adoption of SFAS123(R), we accounted for share-based awards to directors, officers, andemployees using the intrinsic value method in accordance with AccountingPrinciples Board Opinion No. 25, or APB No. 25, as allowed under SFASNo. 123, *Accounting for Share-based Compensation*,or SFAS 123. Under the intrinsic value method, compensation expense is measuredon the date of grant if the current market price of the underlying stock exceededthe exercise price or when the number of shares and exercise price are known,if both are not determinable at the date of grant. Compensation expense forfixed awards was recognized ratably over the vesting period. SFAS 123 alsoestablished accounting and disclosure requirements using a fair-value method ofaccounting for share-based employee compensation plans.

We adopted SFAS 123(R) using the modifiedprospective method. Under this transition method, compensation cost recognizedin the 2006 consolidated statement of operations includes: a) compensation costfor the fair value of the remaining portion of the requisite service period forall share-based awards granted prior to, but not vested, as of January 1,2006, and b) compensation cost for the fair value for all share-based awardsgranted or modified subsequent to January 1, 2006. We recognize suchcompensation cost on a straight-line basis. Under the pro forma disclosurerequirements of SFAS 123, in prior periods, we recognized costs on astraight-line basis and considered the effect of forfeitures as incurred.

***Leases—******With*********respect to our operating leases, weapply the provisions of FASB Technical Bulletin, or FTB, 85-3, *Accounting for Operating Leases with Scheduled Rent Increases*,to scheduled rent increase provisions contained in lease agreements byrecognizing rent expense on a straight-line basis over the lease term. Ourcapital lease is accounted for under the provision of SFAS No. 13, *Accounting for Leases*.

***Contingencies—******Liabilities*********for loss contingencies arising fromclaims, assessments, litigation, fines, and penalties and other sources arerecorded when it is probable that a liability has been incurred and the amountof the assessment can be reasonably estimated. Recoveries from other partiesare recorded when realized.

***Fair Value ofFinancial Instruments—******Financial*** instrumentsconsist of cash, cash equivalents, short-term investments, accounts receivable,accounts payable and derivative financial instruments, see Note 6. Thesefinancial instruments are marked to market, therefore their carrying value is areasonable estimate of fair value.

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***Recent AccountingPronouncements—******In***February 2007,the Financial Accounting Standards Board, or FASB, issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities—Includingan amendment of SFAS No. 115, or SFAS 159. SFAS 159 permits companies to electto measure many financial instruments and certain other items at fair value.Unrealized gains and losses on items for which the fair value option has beenelected will be recognized in earnings at each subsequent reporting date. SFAS159 is effective for fiscal years beginning after November 15, 2007. TheCompany is currently considering the impact of SFAS 159 on its consolidatedfinancial statements.

In June 2006, the FASB issued FinancialInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes, an interpretation of FASB Statement No. 109*,or FIN 48*.* This interpretation is effective forfiscal years beginning after December 15, 2006 and clarifies theaccounting for uncertainty in income taxes by prescribing a recognitionthreshold and measurement attribute for financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return aswell as provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition. Adoptionof FIN 48 is not expected to have a material impact on the Company’sconsolidated financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurement*, or SFAS 157.SFAS 157 defines fair value, establishes a framework for measuring fair valueunder U.S. GAAP, and expands disclosures about fair value measurements. SFAS157 is effective for fiscal years beginning after November 15, 2007. TheCompany is currently evaluating the impact of SFAS 157 on its consolidatedfinancial statements.

In September 2006, the United States Securitiesand Exchange Commission issued Staff Accounting Bulletin, or SAB, No. 108,*Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements.* SAB No. 108 requires analysis of misstatementsusing both an income statement, or rollover, approach and a balance sheet, oriron curtain, approach in assessing materiality and provides for a one-timecumulative effect transition adjustment. SAB No. 108 is effective forfiscal years ending after November 15, 2006. The adoption of SAB No. 108did not have a material impact on our consolidated financial position orresults of operations.

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**2.**                 NET LOSS PERSHARE

The following table setsforth the computation of the basic and diluted net loss per share for the yearsended December 31:

| ** **                             | ** ** | **For the Years Ended December 31,** | ** **  |
|----------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                             | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Numerator:                             |       |                                                          |        |   |   |   |   |
| Net loss                               |       | $                                                             | (33,208,000 | ) | $ | (38,725,000 | ) | $ | (57,609,000 | ) |
| Denominator:                           |       |                                                          |        |   |   |   |   |
| Weighted average shares outstanding    |       | 27,782,074                                                    |        | 23,601,643 |   | 22,941,668 |   |
| Loss per share—basic  and diluted |       | $                                                             | (1.20       | ) | $ | (1.64 | ) | $ | (2.51 | ) |
| Potential common  share equivalents    |       | 2,765,808                                                     |        | 3,805,157 |   | 3,713,376 |   |

 

As the Company hasincurred a net loss for all periods presented, basic and diluted per shareamounts are the same, since the effect of potential common share equivalents isanti-dilutive.

**3.**                 SHORT-TERMINVESTMENTS

Short-terminvestments, stated at market, include the following at December 31, 2006and 2005:

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| State government  agencies    |       | $        | 36,650,000 |     | $          | 28,700,000 |   |
| Total short-term  investments |       | $        | 36,650,000 |     | $          | 28,700,000 |   |

 

Included with the carrying value of the investments isaccrued interest income receivable of $85,000 and $76,000 as of December 31,2006 and 2005, respectively.

Short-term investments arestated at cost, which approximate fair value due to their variable interestrates, which typically reset every 7 to 35 days. As of December 31, 2006,the Company’s investments in auction rate certificates have contractualmaturities of greater than ten years. Despite the long-term nature of theirstated contractual maturities, the Company has demonstrated the ability toliquidate these securities as needed. Accordingly, as these securitiesrepresent the investment of cash, which is available for operations, they havebeen classified as a current asset on the accompanying Consolidated BalanceSheets.

**4.**                 FIXED ASSETS

Fixed assets are comprisedof the following as of December 31:

| ** **                     | ** ** | **Estimated**        | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|----------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | **Useful Life** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **(years)**          | ** ** | **2006**   | ** ** | **2005**   | ** ** |
| Computer  equipment            |       |                 | 3          |       |       | $          | 1,452,000  |   | $ | 1,447,000 |   |
| Scientific  equipment          |       |                 | 5          |       |       | 3,967,000  |       | 3,968,000 |   |
| Furniture                      |       |                 | 7          |       |       | 780,000    |       | 981,000 |   |
| Equipment under  capital lease |       |                 | 5          |       |       | 161,000    |       | — |   |
| Leasehold  improvements        |       |                 | *          |       |       | 908,000    |       | 868,000 |   |
| Less accumulated  depreciation |       |                 | **         |       |       | (6,002,000 | )          | (5,107,000 | ) |
| Fixed assets, net              |       |                 |       |       |       | $          | 1,266,000  |   | $ | 2,157,000 |   |

 

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*—The estimated useful life of leasehold improvementsis the lesser of the lease term or five years.

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**—Amortization expense related to assets undercapital lease in included in depreciation expense and accumulated depreciation.

**5.**                 STOCKHOLDERS’EQUITY

On January 10, 2006, we issued 4,025,000 sharesof our common stock in a public offering, which resulted in net proceeds of$39,002,000, after underwriting discounts and commissions of $2,053,000 andbefore expenses of $263,000.

On January 27, 2004, we issued 4,312,500 sharesof common stock in a public offering which resulted in net proceeds of$73,981,000 after underwriting discounts and commissions of $4,722,000 andbefore expenses of $508,000.

In June 2003, ourBoard of Directors adopted a stockholder rights plan that provided for theissuance of rights to purchase shares of Series A Participating PreferredStock, or Series A Preferred, of the Company. Under the plan, onepreferred share purchase right was distributed for each outstanding share ofcommon stock. Each purchase right entitles the holder to purchase from theCompany one one-thousandth (1/1000th) of a share of Series APreferred at a price of $112.00 per share, subject to adjustment. The rightsbecome exercisable, with certain exceptions, ten business days after any party,without prior approval of our Board of Directors, acquires, or announces anoffer to acquire, beneficial ownership of 15% or more of our common stock, weare acquired in a merger or other business combination, or 50% or more of ourassets are sold after the time that the rights become exercisable. The rightsprovide that each right holder will receive, upon exercise, shares of thecommon stock of the surviving or acquiring company, as applicable, having amarket value of twice the exercise price of the right. The rights expire on July 28,2013, unless they are earlier redeemed or exchanged by the Company. No rightshad been exercised as of December 31, 2006.

**6.**                 SHARE-BASEDCOMPENSATION

We currently sponsor thefollowing share-based payment plans:

*2006 Plan*

In June 2006, our stockholdersapproved the NEOPHARM, Inc. 2006 Equity Incentive Plan, or the 2006 Plan.The 2006 Plan provides for the issuance of stock options, non-vested stock,restricted stock, performance units or performance share awards to employees,directors and consultants convertible to up to 1,000,000 shares of our commonstock. Awards under the 2006 Plan generally consist of stock options having anexercise price equal to the average of the lowest and highest reported saleprices of our common stock on the date of grant; vest ratably over four years;have a 10 year term; and are subject to continuous employment. Stock awardsgranted to our non-employee directors under the 2006 Plan typically vest oneyear from the date of grant. Awards under the 2006 Plan vest immediately upon achange in control, as defined in the 2006 Plan. Although the 2006 Plan providesfor the issuance of performance units and performance shares, we have not madegrants of these types of awards. The 2006 Plan limits to 500,000 the shares ofcommon stock which may be issued pursuant to restricted stock or bonus stockawards. As of December 31, 2006, 299,917 shares were available forissuance under the 2006 Plan.

*2006 Employee StockPurchase Plan*

In June 2006, ourshareholders also approved the 2006 Employee Stock Purchase Plan, or thePurchase Plan, under which eligible employees may purchase shares of commonstock quarterly through payroll deductions. An aggregate of 100,000 shares ofcommon stock may be issued under the Purchase Plan. The price per share underthe Purchase Plan is 85% of the lower of the closing price of the common stockon (i) the first business day of the plan period or (ii) the purchasedate. The Purchase Plan imposes a 

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limitationupon a participant’s right to acquire common stock if immediately after orprior to purchase the employee owns 5% or more of the total combined votingpower or value of the our common stock. During 2006, 39,324 shares were issuedunder the Purchase Plan resulting in compensation expense of $54,000. At December 31,2006, 60,676 shares remained available for issuance.

*The 1998 Plan*

Our 1998 Equity Incentive Plan, or the 1998 Plan,provided for the grant of awards, primarily stock options, to employees,directors, and consultants to acquire up to 4,600,000 shares of our commonstock. Following the June 2006 shareholder approval of the 2006 Plan, nofurther awards have been or will be made under the 1998 Plan. Option awardsunder the 1998 Plan were generally granted with an exercise price equal to theclosing price of our common stock on the date of grant, but may have beengranted with an exercise price of not less than 85% of the fair market value ofour common stock. Option awards under the 1998 Plan typically had a 10-yearlife and vested ratably on the first four anniversaries of the grant, subjectto continuous employment. Stock awards granted to our non-employee directorsunder the 1998 Plan typically vested one year from the date of grant.Outstanding awards issued under the 1998 Plan vested immediately upon a changein control, as defined in the 1998 Plan.

Amountsrecognized in the consolidated statements of operations with respect to ourshare based compensation plans were as follows: 

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Research and  development                              |       | $                                          | 722,000    |   | $ | — |   | $ | — |   |
| Selling, general  and administrative                   |       | 1,337,000                                  |       | 758,000 |   | 1,162,000 |   |
| Total cost of  share-based payment plans during period |       | $                                          | 2,059,000  |   | $ | 758,000 |   | $ | 1,162,000 |   |

 

We have never capitalized, or recognized an income taxbenefit from, share-based compensation.

For fiscal periods prior to our January 2006adoption of SFAS 123(R), we used the APB 25 intrinsic-value method ofaccounting for share-based compensation. The following table illustrates theeffect on our net loss in prior periods as if the SFAS 123 fair-value method ofaccounting had been applied:

| ** **                                                                                                | ** ** | **2005**   | ** **  | **2004**    | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------|-------------|-------------|------------|
| Net loss as  reported                                                                                     |       | $          | (38,725,000 | )           | $          | (57,609,000 | ) |
| Add: stock-based compensation  expense included in reported net loss(1)                                   |       | 758,000    |        | 1,162,000   |       |
| Less: total  stock-based compensation expense determined under fair-value based method for  all awards(2) |       | (1,647,000 | )           | (14,161,000 | )          |
| Pro forma net loss                                                                                        |       | $          | (39,614,000 | )           | $          | (70,608,000 | ) |
| Basic and diluted loss per common share                                                                   |       |       |        |        |       |
| As reported                                                                                               |       | $          | (1.64       | )           | $          | (2.51 | ) |
| Pro forma                                                                                                 |       | $          | (1.68       | )           | $          | (3.08 | ) |

 

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(1)          Valueof restricted stock granted to non-employee directors in 2005 and 2004,compensation expense relating to options granted to an executive at 85% of fairvalue in 2005 and 2004 and the grant of common stock to an executive in 2005.

(2)          Includesacceleration of vesting period due to the triggering of a change in controlprovision under the 1998 Plan in 2004. In November 2004, the Companyentered into an agreement to end a shareholder consent solicitation. The termsof the agreement provided for expansion of the board of directors andreplacement of certain directors. These provisions constituted a “change incontrol” under the terms 

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of the 1998 Plan.Accordingly, substantially all outstanding unvested stock options wereimmediately vested pursuant to their original terms of grant upon the “changein control” event. Other than the then Chief Executive Officer, all employees’unvested stock options became vested, which resulted in the vesting of anadditional 1,221,203 stock options in 2004 that would have otherwise vested infuture years.

During 2004, the Company awarded its then newly-hiredCEO, Mr. Gregory P. Young, the right to receive up to 350,000 commonstock options, which would be granted at the then fair market value upon theCompany’s common stock reaching certain price levels for defined periods oftime.

In March 2005, Mr. Young resigned as CEO anda Director and became a consultant to the Company. Under the terms of theconsulting agreement, Mr. Young agreed to serve as a consultant to theCompany for a period of up to 12 months or until the termination of theSeparation Agreement, whichever was earlier, during which time all optionspreviously granted to Mr. Young continued to vest and remained exercisableuntil 90 days after termination as a consultant, resulting in the vesting of62,500 options. All other options granted to Mr. Young were forfeited. Forthe year ended December 31, 2005, the Company recorded compensationexpense of $236,000 related to the options granted to Mr. Young thatcontinued to vest during the term of the consulting agreement.

In June 2004, the Company’s then CEO, Mr. JamesHussey, resigned and became a consultant to the Company. Under the terms of theconsulting agreement, 473,625 unvested options previously granted to Mr. Husseycontinued to vest in accordance with their original terms. The vesting of theseoptions was accelerated upon the change of control event. Upon acceleration ofvesting of the options, the former CEO’s performance commitment was reached andthe Company measured the fair value of these options and recorded compensationexpense of $737,000 for the year ended December 31, 2004.

Thefollowing table summarizes employee stock option awards during the years ended December 31,2006, 2005 and 2004:

| ** **                             | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price /  Fair Value** | ** ** | **Weighted Average  Remaining  Contractual Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  December 31, 2003 |       | 3,246,725  |       |                                                                   | $          | 12.45/$9.71                                                 |       |                                |       |   |   |   |   |   |   |   |
| Granted                                |       | 821,500    |       |                                                                   | $          | 15.28/$12.47                                                |       |                                |       |   |   |   |   |   |   |   |
| Exercised                              |       | (172,367   | )          |                                                                   | $          | 6.89/$5.62                                                  |       |                                |       |   |   |   |   |   |   |   |
| Forfeited, expired and or cancelled    |       | (182,482   | )          |                                                                   | $          | 15.65/$12.37                                                |       |                                |       |   |   |   |   |   |   |   |
| Outstanding at December 31, 2004  |       | 3,713,376  |       |                                                                   | $          | 13.17/$9.38                                                 |       |                                |       |   |   |   |   |   |   |   |
| Granted                                |       | 960,875    |       |                                                                   | $          | 8.55/$5.56                                                  |       |                                |       |   |   |   |   |   |   |   |
| Exercised                              |       | (285,519   | )          |                                                                   | $          | 5.23/$2.30                                                  |       |                                |       |   |   |   |   |   |   |   |
| Forfeited, expired and or cancelled    |       | (583,575   | )          |                                                                   | $          | 13.02/$10.54                                                |       |                                |       |   |   |   |   |   |   |   |
| Outstanding at December 31, 2005  |       | 3,805,157  |       |                                                                   | $          | 12.99/$8.82                                                 |       |                                |       |   |   |   |   |   |   |   |
| Granted                                |       | 929,400    |       |                                                                   | $          | 8.42/$5.73                                                  |       |                                |       |   |   |   |   |   |   |   |
| Granted out of the money               |       | 30,000     |       |                                                                   | $          | 6.51/$3.46                                                  |       |                                |       |   |   |   |   |   |   |   |
| Exercised                              |       | (180,000   | )          |                                                                   | $          | 3.75/$3.22                                                  |       |                                |       |   |   |   |   | $ | 225,000 |   |   |
| Forfeited, expired and or cancelled    |       | (2,052,774 | )          |                                                                   | $          | 13.82/$10.43                                                |       |                                |       |   |   |   |   |   |   |   |
| Outstanding at December 31, 2006  |       | 2,531,783  |       |                                                                   | $          | 11.28/$8.29                                                 |       |                                |       | 7.33 |   |   |   | $ | — |   |   |
| Exercisable at  December 31, 2006 |       | 1,093,050  |       |                                                                   | $          | 15.00/$11.65                                                |       |                                |       | 5.19 |   |   |   | $ | — |   |   |

 

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We expect to recognize$6.0 million of unrecognized share-based compensation over a weighted averageperiod of 2.1 years.  The following tablesummarizes information about our stock options outstanding at December 31,2006:

| ** **               | ** ** | **Options Outstanding**  | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | ** **               | ** ** | **Weighted-Average**    | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| **Range of**        | ** ** | **Options**              | ** ** | **Remaining Life** | ** ** | **Average** | ** ** | **Options** | ** ** | **Average** | ** ** |
| **Exercise Prices** | ** ** | **Outstanding (1)** | ** ** | **(in years)**     | ** ** | **Exercise Price** | ** ** | **Exercisable** | ** ** | **Exercise Price** | ** ** |
| $5.17                    |       |                     | 75,000     |                    |       |   | 9.66 |   |   |   | $ | 5.17 |   |   | — |   |   | $ | — |   |   |
| $5.73 - $8.60            |       |                     | 825,887    |                    |       |   | 9.33 |   |   |   | $ | 7.31 |   |   | 128,629 |   |   | $ | 7.95 |   |   |
| $8.60 - $11.46           |       |                     | 614,078    |                    |       |   | 7.89 |   |   |   | $ | 9.10 |   |   | 237,728 |   |   | $ | 9.15 |   |   |
| $11.46 - 14.33           |       |                     | 343,333    |                    |       |   | 7.02 |   |   |   | $ | 12.78 |   |   | 167,883 |   |   | $ | 13.31 |   |   |
| $14.33 - $17.19          |       |                     | 94,520     |                    |       |   | 2.99 |   |   |   | $ | 15.78 |   |   | 94,520 |   |   | $ | 15.78 |   |   |
| $17.19 - $20.06          |       |                     | 300,945    |                    |       |   | 4.71 |   |   |   | $ | 19.22 |   |   | 300,945 |   |   | $ | 19.22 |   |   |
| $20.06 - $22.92          |       |                     | 157,653    |                    |       |   | 3.90 |   |   |   | $ | 22.56 |   |   | 157,653 |   |   | $ | 22.56 |   |   |
| $22.92 - $25.80          |       |                     | 5,692      |                    |       |   | 2.37 |   |   |   | $ | 23.21 |   |   | 5,692 |   |   | $ | 23.21 |   |   |
| Total Options            |       |                     | 2,417,108  |                    |       |   | 7.45 |   |   |   | $ | 11.32 |   |   | 1,093,050 |   |   | $ | 15.00 |   |   |

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(1)   Excludes114,675 of options held by a former employee and consultant.

In June 2006, wegranted 58,083 non-vested shares of common stock to non-employee directors witha weighted average fair value of $6.37 and one year vesting. In June 2005,we granted 36,010 shares of non-vested common stock to non-employee directorswith a weighted average fair value of $9.76, all shares of which vested on June 16,2006. As of December 31, 2006, there were 58,083 non-vested non-employeedirector shares outstanding, with $171,000 of unrecognized compensation expenseto be recognized over a weighted average period of six months. No stock optionswere granted to non-employee directors during fiscal 2006.

*Stock OptionValuation Information*

Wehave estimated the fair value of our share-based compensation using theBlack-Scholes option-pricing model. This model requires the use of subjectiveassumptions that have a significant impact on the fair value estimate. Theweighted-average estimated fair value of employee stock options granted ascalculated using the Black-Scholes model and the related weighted-averageassumptions follow:

| ** **                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  volatility                                                     |       | 67.9     | %          | 70.5     | %          | 72.0     | %          |
| Risk-free  interest rate                                                 |       | 4.5      | %          | 4.3      | %          | 3.7      | %          |
| Expected term (in  years)                                                |       | 6.25     |       | 6.25     |       | 10.00    |       |
| Expected dividend  yield                                                 |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |
| Weighted average  estimated fair value of employee stock options granted |       | $        | 5.56       |     | $          | 5.73     |       | $ | 12.47 |   |
|                                                                          |            |          |            |          |            |          |            |  |  |  |

 

We have based ourassumptions regarding expected volatility on the historic volatility of ourcommon stock, the risk-free interest rate on the U.S. Treasury yield curve ineffect at the time of grant, and the expected term of options using the “SimplifiedMethod” in accordance with SAB No. 107, *Share-BasedPayment*.

*DerivativeFinancial Instruments*

Prior to 2000, we granted common stock options tocertain non-employee consultants as compensation related to research anddevelopment activities. As of January 1, 2006, the effective date of 

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SFAS123(R), optionsgranted to certain non-employees to purchase 234,025 shares of our common stockwere vested and outstanding. Upon adoption of SFAS 123(R), these non-employeecommon stock options were accounted for as derivative instruments in accordancewith SFAS 133, *Accounting for Derivative Instruments andHedging Activities,* and recorded as a liability.

In August 2006, we entered into a separationagreement with Lawrence A. Kenyon, our former Chief Financial Officer, underwhich Mr. Kenyon’s employment status changed from employee to consultantreflecting his continued service to the Company. Under the agreement, at thattime 40,300 options were forfeited and 17,025 unvested employee stock optionswere reclassified to non-employee option grants which will vest through May 31,2007 and are exercisable until August 29, 2007. We have recognized theexpense for these non-employee grants accordingly.

We calculated the estimated fair value of theoutstanding options granted to non-employees as of January 1, 2006 to be$1,652,000 and reclassified this amount from additional paid-in-capital to aliability. The estimated fair value of the non-employee options is remeasuredeach reporting period with any change in estimated fair value recorded as acomponent of loss from operations in the accompanying Consolidated Statement ofOperations for the year ended December 31, 2006. As of December 31,2006, 175,150 non-employee options were outstanding. During 2006, we recordedthe benefit of the change in fair value of $1,551,000, which resulted primarilyfrom a decline in our stock price.

We use the Black-Scholesoption-pricing model to estimate the fair value of the non-employee optiongrants over the remaining contractual terms of the outstanding options, whichranged from 8 months to 37 months at December 31, 2006.

**7.**                 INCOME TAXES

From inception through October 1995, we operated as anS Corporation for income tax purposes. Losses incurred during this period werereported on the stockholders’ tax returns, and are not available to the Companyas a net operating loss carry forward. Since that time, losses incurred resultin net operating loss carry forwards which could be used to offset possiblefuture taxable income.

Thenet operating loss carry forwards will expire as follows:

| **Year of Expiration**        | ** ** | ** ** | ** **  | ** ** | ** ** |
|-----------------------------------------|------------|------------|-------------|------------|------------|
| 2011                                    |       | $          | 1,882,000   |       |
| 2012                                    |       | 1,969,000  |        |
| 2018                                    |       | 3,122,000  |        |
| 2020                                    |       | 3,296,000  |        |
| 2021                                    |       | 12,500,000 |        |
| 2022                                    |       | 35,488,000 |        |
| 2023                                    |       | 52,200,000 |        |
| 2024                                    |       | 57,597,000 |        |
| 2025                                    |       | 40,990,000 |        |
| 2026                                    |       | 33,038,000 |        |
| Total net operating loss  carryforwards |       | $          | 242,082,000 |       |

 

We have general business credit carry forwards ofapproximately $6,340,000 which expire in the period 2011-2026, and analternative minimum tax credit of approximately $40,000 which can be carriedforward for an indefinite period. At December 31, 2006, excess taxbenefits related to employee stock option deductions of $225,000 are not yetreflected in deferred tax assets, the related tax benefit of $88,000 would berecorded in Additional Paid in Capital when it reduces income taxes payable.

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Under Section 382 of the Internal Revenue Code,if an ownership change of more than 50% occurs there are annual limitations onthe amount of net operating loss and other deductions which would be availableto us. Accordingly, our ability to offset any future federal taxable income withnet operating loss carryforwards arising before any such ownership changes maybe limited.

Our federal statutory tax rate is 35% while oureffective tax rate is 0%. Differences between the federal statutory andeffective tax rates result from the establishment of a valuation allowance toreduce the carrying value of deferred tax assets to zero.

Significantcomponents of the Company’s deferred tax assets and (liabilities) as of December 31are as follows:

| ** **                                         | ** ** | **2006**     | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|----------------------------------------------------|------------|--------------|------------|-------------|------------|-------------|------------|
| Net operating loss carry  forwards                 |       | $            | 94,324,000 |        | $          | 81,540,000  |       | $ | 65,932,000 |   |
| General business credit  carry forwards            |       | 6,340,000    |       | 5,790,000   |       | 4,896,000   |       |
| Charitable contribution  carry forwards            |       | 375,000      |       | 418,000     |       | 378,000     |       |
| Alternative minimum tax  credit carry  forwards    |       | 40,000       |       | 40,000      |       | 40,000      |       |
| Deferred revenue                                   |       | 780,000      |       | 780,000     |       | —      |       |
| Depreciation                                       |       | (169,000     | )          | (292,000    | )          | (403,000    | )          |
| Non-deductible stock  compensation expense         |       | 744,000      |       | 233,000     |       | 476,000     |       |
| Expense not currently  deductible for tax purposes |       | 149,000      |       | 172,000     |       | 1,066,000   |       |
| Total deferred tax  assets                         |       | 102,583,000  |       | 88,681,000  |       | 72,385,000  |       |
| Valuation allowance                                |       | (102,583,000 | )          | (88,681,000 | )          | (72,385,000 | )          |
| Net deferred tax assets                            |       | $            | —     |        | $          | —      |       | $ | — |   |

 

The valuation allowanceincreased by $13,902,000, $16,296,000 and $24,113,000 in each of the yearsended December 31, 2006, 2005, and 2004, respectively. In assessing therealizability of deferred tax assets, we consider whether it is more likelythan not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. We also consider the scheduled reversal ofdeferred tax liabilities, projected future taxable income or losses, and taxplanning strategies in making this assessment. Based upon our history of taxlosses and projections for future taxable income over the periods in which thedeferred tax assets are deductible, we do not believe realization of these taxassets is more likely than not. As such, we have established full valuationallowances for the deferred tax assets.

**8.**                 TRANSACTIONS WITH RELATED PARTIES

Prior to 2005, we receivedmanagement consulting services from EJ Financial Enterprises, Inc., or EJ Financial,a healthcare consulting and investment firm in which John N. Kapoor, Ph.D.,Chairman of the Company’s Board of Directors, is the sole stockholder. Theconsulting agreement with EJ Financial expired on June 30, 2004 and wasnot renewed. In 2004, we paid EJ Financial $62,000 in consulting fees underthis arrangement. Additionally, in 2004, we paid $350,000 to EJ Financial toreimburse Dr. Kapoor for out-of-pocket costs incurred in aconsent solicitation under the terms of a settlement agreement between theCompany and Dr. Kapoor. We had also entered into a consulting agreement,which was terminated in 2004, with an individual who is also an employee ofAkorn, Inc., the Chairman of our Board of Directors is also the Chairmanof Akorn’s Board of Directors, under which we paid Akorn $6,000 in 2004.

In December 2001,NeoPharm entered into a transaction whereby NeoPharm loaned to Akorn, Inc.$3,250,000 to assist Akorn in the completion of its lyophilized productsmanufacturing facility in Decatur, Illinois. Dr. Kapoor, our currentChairman of the Board of Directors and at that time a member of the 

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Company’sBoard of Directors, is also Chairman of the Akorn Board of Directors and holdsa substantial stock position in both companies. In connection with the loantransaction, NeoPharm entered into the following agreements: Promissory Note,dated December 20, 2001, in the original principal amount of $3,250,000 byAkorn to NeoPharm; Processing Agreement, dated December 20, 2001, by andbetween Akorn and NeoPharm; Subordination and Intercreditor Agreement, dated December 20,2001, by and between John N. Kapoor, as Trustee under The John N. Kapoor Trust,dated September 20, 1989 and NeoPharm; and a Subordination, Standby andIntercreditor Agreement, dated December 20, 2001, by and among Akorn,Akorn (New Jersey), Inc., The Northern Trust Company and NeoPharm. ThePromissory Note issued by Akorn was due in December 2006, and accruedinterest at a rate equal to that received on the Company’s investments inmarketable securities, which is lower than the interest rate paid by Akorn onits other outstanding debt. The Processing Agreement granted NeoPharm access toat least 15% of the annual lyophilization manufacturing capacity at Akorn atmost favored customer pricing, upon completion of the facility. The ProcessingAgreement also provided that Akorn was to begin providing lyophilizationservices on or before June 30, 2003. At the time these transactions wereentered into, Akorn represented that the manufacturing facility would beoperational in 2003, approximately the time when NeoPharm originallyanticipated it would need to manufacture its lyophilized drug productcandidates for Phase 1/3 clinical trials. In 2001, NeoPharm recorded thePromissory Note net of a valuation allowance of $1,266,619 reflecting thedifference between the actual loan amount and the present value of the loan usingan estimated market interest rate of 10%. As of December 31, 2002, theCompany determined the Promissory Note was impaired and recorded a charge tofully reserve for the Promissory Note and related accrued interest. On August 18,2003, NeoPharm presented Akorn with a formal “Notice of Default” on thePromissory Note. Because the carrying value of the Promissory Note was zero,there was no financial statement impact as a result of any event of defaultunder, or non-payment of, the Promissory Note. In September 2003, Akornadvised NeoPharm that it wished to refinance its senior debt with a new seniorlender, which lender would require NeoPharm to subordinate its debt. In orderto preserve the possibility of collecting Akorn’s debt to NeoPharm, NeoPharmand Akorn entered into an Amended and Restated Promissory Note in considerationof a higher rate of interest (which would now equal that to be charged by thenew senior lender, which is the prime rate plus 175 basis points) and thepossibility of accelerated mandatory repayments once Akorn’s senior debt wasrepaid in full. NeoPharm also agreed to waive Akorn’s default, to allow Akornuntil October 2004 to provide the manufacturing rights and to subordinateAkorn’s indebtedness to NeoPharm to Akorn’s indebtedness to its new seniorlender. Akorn’s refinancing was completed on October 7, 2003. On October 6,2004, NeoPharm presented Akorn with a formal “Notice of Default” on the Amendedand Restated Promissory Note resulting from Akorn’s failure to meet itsobligations under the Processing Agreement. Because the carrying value of thePromissory Note was zero, there was no financial statement impact as a resultof any event of default under, or non-payment of, the Promissory Note. On May 16,2005, the Company and Akorn entered into a Note Repayment Agreement (“RepaymentAgreement”), whereby the Company agreed to accept $2,500,000 as payment in fullfor all outstanding principal and interest due and owing under the PromissoryNote, which was paid in 2005. In addition, the parties mutually agreed toterminate the Processing Agreement. As a result of the Repayment Agreement, theCompany recorded a $2,500,000 benefit which was recorded as “Recovery of NoteReceivable” in the Company’s Consolidated Statement of Operations for the yearended December 31, 2005.

**9.      EMPLOYEETERMINATION AND FACILITY CONSOLIDATION COSTS**

During the first ninemonths of 2006, we reduced our workforce by 26 associates under anorganizational restructuring initiative. In May 2006, Dr. Imran Ahmadresigned as the Company’s Executive Vice President and Chief Scientific Officerand, in accordance with the terms of his original offer letter, Dr. Ahmadis scheduled to receive a twelve-month salary continuation and he received aseparation payment of $20,000. Additionally, in June 2006, we entered intoa separation and consulting agreement with our former Chief Financial Officer,Mr. Larry Kenyon which became effective August 31, 

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2006.Under this agreement, Mr. Kenyon is scheduled to receive nine-month salarycontinuation, reimbursement of medical and dental coverage and his previouslygranted options continue to vest during the consulting period. InDecember 2006, we completed an additional organizational restructuringwhich resulted in a workforce reduction of 14 positions, or approximately 20%of the workforce at that time and recorded related expense of $230,000.Aggregate 2006 employee termination costs related to 2006 reorganization andseparation agreements were $1,528,000. Accrued but unpaid employee terminationcosts are included in other accrued expenses at December 31, 2006, totaled$415,000 and are expected to be paid in the first half of 2007.

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Also in 2006, we recorded a $339,000 charge forestimated lease exposure related to our former Lake Forest, Illinois officespace and wrote off $94,000 in related equipment and leasehold improvementswith $238,000 accrued for the remaining, estimated lease exposure atDecember 31, 2006.

In late 2004, we reducedour workforce by 30 employees, or 23%. Terminated employees were eligible toreceive salary continuation through December 31, 2004, severance, 2004earned bonus, Company paid insurance benefits and outplacement services. All$1,149,000 of employee termination costs were expensed in 2004 and amountsaccrued as of December 31, 2004 were paid out by February 28, 2005.

**10.**          COMMITMENTS

***Manufacturing Commitment—******To***secureaccess to manufacturing capacity for the potential manufacture, scale-up ofmanufacturing and regulatory advancement of CINTREDEKIN BESUDOTOX through early2008, we have entered into contractual commitments, under take or payagreements, with a contract manufacturing organization. Under the terms of theagreements, we are obligated to pay half of the committed processing costs, orapproximately $1.8 million, should we elect not to utilize such capacity.

***License andResearch Agreements—******From*********time to time we enter into licenseand research agreements with third parties. As of December 31, 2006, wehad significant agreements with three parties, as described below.

***GeorgetownUniversity—******We*** haveentered into three license agreements with Georgetown whereby we obtained anexclusive worldwide license to use certain technologies. In exchange for thegrant of these exclusive licenses, we agreed to pay Georgetown a royalty,ranging from 2.50% to 5.00% of any net sales from our products incorporatingsuch technologies. The royalty will be payable for the life of the relatedpatents. Additionally, we may be obligated to make milestone payments totaling$1,500,000 upon achievement of certain development objectives.

In addition, in 2004 we paid Georgetown $500,000 undertwo annually renewable contract research agreements that expired in February 2005under which we were obligated to reimburse Georgetown for all direct andindirect costs associated with research on specific projects. In return, withrespect to any project for which a New Drug Application, or NDA, is ultimatelyapproved, we retained all rights to all inventions, developments, discoveriesand other proprietary ideas which are first conceived, discovered or developedduring the conduct of the research upon making a one time payment of up to $175,000to Georgetown.

***National Institutesof Health—******We***enteredinto an exclusive worldwide licensing agreement with the NIH to develop andcommercialize IL13-PE38QQR (CINTREDEKIN BESUDOTOX). The agreement requiresus to pay NIH a $75,000 non-refundable license issue payment and requires minimumannual royalty payments of $10,000, which increase to $25,000 after the firstcommercial sale. The agreement further provides for us to make milestonepayments to NIH of up to $585,000 and royalties of up to 4.00% based on anyfuture product sales. We made the first milestone payment of $25,000 to NIH in November 1999after the filing of the U.S. Investigational New Drug IND application for IL13-PE38QQR.We are required to pay the costs of filing and maintaining product patents onthe licensed products. The agreement extends to the expiration of the last toexpire of the patents on the licensed products, if not terminated earlier. Theagreement may be terminated by mutual consent of NIH and us. Either party mayterminate if the other party breaches a material term or condition and suchbreach is not cured within a certain period of time. Also, either party mayunilaterally terminate by giving advanced notice.

On May 30, 2006, we entered into a non-exclusivePatent License Agreement with the United States Public Health Service, or PHS,providing us with a non-exclusive license to utilize a patented process ownedby the U.S. government relating to convection enhanced delivery, or CED, for usto 

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use with drugs, including CINTREDEKINBESUDOTOX in the treatment of gliomas, in the U.S., its territories andpossessions. Under the terms of this Patent License Agreement, we have paid PHSa noncreditable, nonrefundable license issue royalty of $5,000 and have agreedto pay a nonrefundable, minimum annual royalty of $2,000, which will becredited against earned royalties, which are fixed at one-half of one percent(0.5%) on aggregate future product sales over $100 million. An additionalbenchmark royalty of $20,000 is payable within thirty (30) days of receivingapproval from the U.S. FDA of approval to use the licensed CED process inadministrating a drug for the treatment of gliomas. Pursuant to an amendment tothis Patent License Agreement entered into in August 2006, we expanded thefield of use to cover the treatment of cancer, were given the right tosublicense our rights and extended the time for us to reach certain benchmarks.In return for these additional rights, we agreed to pay additional sublicensingroyalties of one and one-half percent (1.5%), to a maximum of $200,000, on thefair market value of any upfront consideration received for granting asublicense.

***U.S. Food and DrugAdministration—******In*** 1997, theCompany entered into a CRADA with the FDA. Pursuant to the CRADA, we committedto work to commercialize the IL13-PE38QQR chimeric protein which welicensed from NIH. The FDA agreed to collaborate on the clinical developmentand commercialization of IL13-PE38QQR. In January 2001, the partiesagreed to expand the scope of the CRADA and increase our funding requirement to$400,000 per year and extend the term of the agreement through December 31,2003. In 2004, the parties agreed to reduce the funding under the CRADA for2004 to $230,000. Funding for the CRADA expired on December 31, 2004. On August 8,2005, we and the FDA agreed to extend the term and funding of the CRADA throughApril 30, 2006 for $130,000.

***Lease Commitments—******We***havenoncancelable operating leases, for office space and a research and developmentfacility, which expire in 2008 and require us to pay all executory costs suchas maintenance and insurance. Rental payments include minimum rentals pluscontingent rentals based on common area maintenance expenses and propertytaxes.

Rentalexpense for the three most recent fiscal years consisted of the following:

| ** **          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Minimum rentals     |       | $        | 395,000    |     | $          | 541,000  |       | $ | 532,000 |   |
| Contingent  rentals |       | 244,000  |       | 194,000  |       | 195,000  |       |
| Rental Expense      |       | $        | 639,000    |     | $          | 735,000  |       | $ | 727,000 |   |

 

Futureminimum lease payments under noncancelable operating leases (with initial orremaining terms in excess of one year) as of December 31, 2006 are:

| Year ending December 31:      |   |    |    |
|-------------------------------|--------|---------|---------|
| 2007                          |   | $       | 434,000 |   |
| 2008                          |   | 117,000 |    |
| 2009                          |   | 2,000   |    |
| 2010                          |   | 1,000   |    |
| 2011                          |   | —  |    |
| Later years                   |   | —  |    |
| Total minimum  lease payments |   | $       | 554,000 |   |

 

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Minimumfuture lease payments under a capital lease as of December 31, 2006 are asfollows:

| For the year  ending December 31, 2007 |   | $       | 38,000  |   |
|---------------------------------------------|--------|---------|---------|--------|
| For the year  ending December 31, 2008 |   | 38,000  |    |
| For the year ending  December 31, 2009 |   | 38,000  |    |
| For the year  ending December 31, 2010 |   | 38,000  |    |
| Subsequent to  2010                         |   | 3,000   |    |
| Total minimum lease payments                |   | 155,000 |    |
| Less amount  representing interest          |   | (20,000 | )       |
| Present value of minimum  lease payments    |   | $       | 135,000 |   |

*** ***

***Termination andEmployment Agreements—******On*****April 25, 2005, the Company andRonald G. Eidell, a director of the Company, finalized an Employment Agreementunder which Mr. Eidell was employed, on an interim basis, as the Company’sPresident and CEO. Mr. Eidell had been serving as President and CEO since March 8,2005 under a principal terms employment agreement (“PTA”) executed between theCompany and Mr. Eidell on March 10, 2005, in which Mr. Eidellhad agreed to a base salary of $325,000, which was superseded by the EmploymentAgreement. Additionally, the Company entered into a separate agreement withTatum LLC (“Tatum”), of which Mr. Eidell continues to be a partner,providing for up to 20% of Mr. Eidell’s base salary and bonus, if any, tobe remitted to Tatum. Under the terms of an agreement entered into with Tatum,an annualized amount of $65,000, prorated for the period of Mr. Eidell’semployment by the Company, was to be paid to Tatum. Under the EmploymentAgreement, Mr. Eidell received a base salary of $260,000, as well as Mr. Eidellwas entitled to an annual performance-based milestone bonus payment, of which20% would be payable to Tatum, as per the Tatum agreement, and a monthlytransportation allowance of $1,500. On March 10, 2005, Mr. Eidellreceived a stock option grant of 80,000 shares at an exercise price equal tothe closing price of the Company’s stock on that date. The stock options wereto vest at the earlier of the termination of the Employment Agreement as aresult of Mr. Eidell’s resignation to allow a new permanent CEO to takeoffice or one year from the date of grant. On October 28, 2005, Mr. Eidellresigned as interim President and CEO to allow his successor to take office asPresident and CEO. In accordance with the terms of the Employment Agreement, a$96,000 performance based bonus was paid to him. In addition under the terms ofan agreement between the Company and Tatum, of which Mr. Eidell is apartner, the Company paid $24,000 to Tatum upon making the bonus payment to Mr. Eidell.Additionally, the 80,000 options granted earlier to Mr. Eidell vestedpursuant to the original terms of the option grant.**

**On October 28,2005, NeoPharm entered into an employment agreement with Guillermo A. Herrera(the “Herrera Agreement”) to serve as its President and CEO and member of theBoard of Directors. Under the terms of the Herrera Agreement, Mr. Herrera receivedan initial annual base salary of $425,000 and a grant of shares of the Company’scommon stock, at the time of hire, equal to a total fair market of $200,000based upon the closing price as of October 28, 2005. Mr. Herrera isalso eligible for an annual performance-based bonus payment and receives amonthly car allowance of $1,000. Additionally, Mr. Herrera received acommon stock option grant of 500,000 options with a grant price equal to thefair market value on the date of grant. The options vest in four equal annualinstallments on the anniversary of the option grant date.**

In May 2006, Dr. Imran Ahmad resigned as theCompany’s Executive Vice President and Chief Scientific Officer and, inaccordance with the terms of his original offer letter, Dr. Ahmad isscheduled to receive a twelve-month salary continuation and he received aseparation payment of $20,000. Additionally, in June 2006, we entered intoa separation and consulting agreement with our former Chief Financial Officer, Mr. LarryKenyon which became effective August 31, 2006. Under this agreement, Mr. Kenyonis 

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scheduled to receivenine-month salary continuation, reimbursement of medical and dental coverageand his previously granted options continue to vest during the consultingperiod.

***Defined Contribution Retirement Plan (401(k) Plan)—******We***sponsor a401(k) Plan covering all full-time employees. Participants may contributeup to legal limitations. The 401(k) Plan provides for us to matchcontributions of 50% of employee contributions up to 3% of the employee’seligible compensation. Our matching contributions were $252,000, $288,000 and$306,000 for the years ended December 31, 2006, 2005 and 2004,respectively.

**11.**          CONTINGENCIES

In December 2006, we suffered a significantsetback with the results of our Phase 3 clinical trial of CINTREDEKINBESUDOTOX, the PRECISE trial. Patients in the PRECISE trial received treatmenteither with CINTREDEKIN BESUDOTOX or with Gliadel® Wafers, a product currentlyapproved to treat this disease. The primary endpoint of the study was todetermine if there was a statistically significant overall patient survivaldifference between patients treated with CINTREDEKIN BESUDOTOX and patientstreated with Gliadel® Wafers. The Phase 3 PRECISE Clinical trial did not meetthe primary endpoint at 215 deaths.

Since the announcement of the PRECISE trial results,the Company has been working with its Scientific Advisory Board to identify apotential regulatory path forward based on the totality of the clinical datagathered to date. We plan to meet with the FDA in late March 2007 to discussthe possibility of approval on the strength of our data and analysis. We cannotpredict the outcome of that meeting. The FDA could evaluate the data in adifferent way, for example using different statistical methods, and could reachdifferent conclusions about the PRECISE trial altogether. The FDA could agreewith our conclusions about the PRECISE trial, but still reject the argumentthat these conclusions may support product approval. Even if the FDA agreedthat these conclusions may support product approval, it could requirestatistically significant results from a second Phase 3 trial. There is noassurance that we would or could generate these additional data. The agencycould also reject the data from the PRECISE trial for other reasons, includinghuman errors in the conduct of the trial.

In December 2006, we were advised by the staff ofthe U.S. Securities and Exchange Commission, the SEC, that the SEC’sinvestigation of the Company, which the Company believe concerned the Company’sdisclosures regarding the development of its LEP and LED drug productcandidates, had been terminated and no enforcement action had been recommended.The decision by the SEC to terminate its investigation is not a finding orjudgment regarding the matters investigated.

NeoPharm, Inc. and certain of our former officershave been named in a consolidated amended complaint, which alleges variousviolations of the federal securities laws in connection with our publicstatements regarding our LEP drug product candidate during the period from October 31,2001 through April 19, 2002. On November 4, 2002, we moved to havethe complaint dismissed. Our motion to dismiss was granted in part and deniedin part in February 2003. In November 2004, the plaintiffs filed amotion to amend and a motion for summary adjudication. The motion to amendseeks to include certain pre-class period statements in the complaint. Themotion for summary adjudication asks the Court to rule that certainstatements made in an arbitration award regarding the LEP drug productcandidate be deemed facts established in this proceeding. On February 23,2007, the Court entered an order denying both the plaintiffs’ motion to amendand the plaintiffs’ motion for summary adjudication. The Court has set a factdiscovery cut-off date of August 24, 2007. No trial date has yet been set.We intend to vigorously defend each and every claim in the complaint.Management is unable to estimate the potential outcome or range ofpossibilities, if any. In addition, we maintain insurance coverage to mitigatethe financial impact of any potential loss.

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We are from time to timesubject to claims and litigation arising in the ordinary course of business. Weintend to defend vigorously any such litigation that may arise under alldefenses that would be available to us. In the opinion of management, theultimate outcome of those proceedings of which management is aware, even ifadverse to us, will not have a material adverse effect on our consolidatedfinancial position or results of operations. While we maintain insurance tocover the use of our drug product candidates in clinical trials, we do notpresently maintain insurance covering the potential commercial use of our drugproduct candidates and there is no assurance that we will be able to obtain ormaintain such insurance on acceptable terms.

**12.**          SUBSEQUENTEVENTS

On March 2, 2007, Mr. RonaldE. Pauli, our Chief Financial Officer, advised the Company of his intention toresign his position in order to pursue other opportunities in the privatesector. His resignation will take effect March 21, 2007. The Company iscommencing a search for a replacement for Mr. Pauli.

**13.**          QUARTERLYFINANCIAL DATA (unaudited)

Thefollowing table summarizes the quarterly financial data for the years ended December 31,2006 and 2005.

| ** **                                     | ** ** | **2006**  | ** ** |
|------------------------------------------------|------------|-----------|------------|
| ** **                                     | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| Revenue                                        |       | $         | 2,000      |   | $ | 8,000 |   | $ | 1,000 |   | $ | — |   |
| Research and  development expenses             |       | $         | 5,844,000  |   | $ | 6,037,000 |   | $ | 4,319,000 |   | $ | 4,999,000 |   |
| Selling, general,  and administrative expenses |       | $         | 3,046,000  |   | $ | 4,496,000 |   | $ | 3,266,000 |   | $ | 3,328,000 |   |
| Reorganization  costs                          |       | $         | —     |   | $ | 570,000 |   | $ | 1,156,000 |   | $ | 235,000 |   |
| Net loss                                       |       | $         | (7,679,000 | ) | $ | (9,791,000 | ) | $ | (8,004,000 | ) | $ | (7,734,000 | ) |
| Net loss per basic and  diluted share          |       | $         | (0.28      | ) | $ | (0.35 | ) | $ | (0.29 | ) | $ | (0.28 | ) |

 

| ** **                                     | ** ** | **2005**  | ** **  |
|------------------------------------------------|------------|-----------|-------------|
| ** **                                     | ** ** | **First** | ** **  | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| Revenue                                        |       | $         | 72,000      |   | $ | 455,000 |   | $ | 9,000 |   | $ | 7,000 |   |
| Research and  development expenses             |       | $         | 8,074,000   |   | $ | 7,961,000 |   | $ | 8,538,000 |   | $ | 7,278,000 |   |
| Selling, general,  and administrative expenses |       | $         | 3,233,000   |   | $ | 3,051,000 |   | $ | 2,388,000 |   | $ | 2,749,000 |   |
| Recovery of note  receivable                   |       | $         | —      |   | $ | 2,500,000 |   | $ | — |   | $ | — |   |
| Net loss                                       |       | $         | (10,864,000 | ) | $ | (7,658,000 | ) | $ | (10,533,000 | ) | $ | (9,670,000 | ) |
| Net loss per basic and  diluted share          |       | $         | (0.46       | ) | $ | (0.32 | ) | $ | (0.45 | ) | $ | (0.41 | ) |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersNeoPharm, Inc.:

Under the date of March 16, 2007, we reported onthe consolidated balance sheets of NeoPharm, Inc. and subsidiary (theCompany) as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of theyears in the three-year period ended December 31, 2006. In connection withour audits of the aforementioned consolidated financial statements, we alsoaudited the related financial statement schedule. This financial statementschedule is the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statement schedule based on ouraudits.

In ouropinion, such financial statement schedule, when considered in relation to thebasic consolidated financial statements taken as a whole, presents fairly, inall material respects, the information set forth therein.

| /s/ KPMG LLP        |   |
|---------------------|--------|
| Chicago, Illinois   |
| March 16, 2007 |

 

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**NEOPHARM, INC. AND SUBSIDIARY**

**Schedule II—Valuation and Qualifying Accountsfor the Years Ended December 31, 2006, 2005, and 2004**

| ** **                         | ** ** | **Valuation allowance  for note receivable** | ** **                                                                                              |
|------------------------------------|------------|-------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| Balance at  December 31, 2004 |       |                                                        | $                                                                                                       | 2,189,281 |   |   |
| Charged to  operations             |       |                                                        | (2,189,281                                                                                              | ) |   |
| Balance at  December 31, 2005 |       |                                                        |                  — |   |   |
| Charged to operations              |       |                                                        | —                                                                                                  |   |   |
| Balance at  December 31, 2006 |       |                                                        | $                                                                                                       | — |   |   |

 

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