##### Table of Contents

---

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



---

FORM 10-Q



---

(Mark One)

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

For the Quarterly Period Ended June 30, 2006.

or



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

For the Transition Period from  to
.

Commission File No. 0-19651



---

GENAERA CORPORATION

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 13-3445668                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification Number)
|                                                               | 
|5110 Campus Drive Plymouth Meeting, Pennsylvania               |  | 19462                               
|(Address of principal executive offices)                       |  | (Zip Code)                          

610-941-4020

(Registrants telephone number, including area code)



---

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

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



|                         |  |                      |  |                       
|------------------------ |  | -------------------- |  | ----------------------
|Large accelerated filer ̈ |  | Accelerated filer  x |  | Non-accelerated filer ̈

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

The number of outstanding shares of the registrants Common Stock, par value $.002 per share, on August 9, 2006 was 104,553,789.



---



---

##### Table of Contents

GENAERA CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED June 30, 2006

TABLE OF CONTENTS



|                                                                                                           |  |     
|---------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                           |  | Page
|PART I - FINANCIAL INFORMATION                                                                             |  |     
|                                                                                                           | 
|Item 1.Financial Statements:                                                                               |  |     
|                                                                                                           | 
|Balance Sheets as of June 30, 2006, unaudited and December 31, 2005                                        |  | 2   
|                                                                                                           | 
|Statements of Operations for the three-month and six-month periods ended June 30, 2006 and 2005, unaudited |  | 3   
|                                                                                                           | 
|Statements of Cash Flows for the six-month periods ended June 30, 2006 and 2005, unaudited                 |  | 4   
|                                                                                                           | 
|Notes to Financial Statements                                                                              |  | 5   
|                                                                                                           | 
|Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations              |  | 12  
|                                                                                                           | 
|Item 3. Quantitative and Qualitative Disclosures about Market Risk                                         |  | 17  
|                                                                                                           | 
|Item 4. Controls and Procedures                                                                            |  | 17  
|                                                                                                           | 
|PART II - OTHER INFORMATION                                                                                |  |     
|                                                                                                           | 
|Item 1. Legal Proceedings                                                                                  |  | 18  
|                                                                                                           | 
|Item 1A. Risk Factors                                                                                      |  | 18  
|                                                                                                           | 
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                        |  | 27  
|                                                                                                           | 
|Item 3. Defaults Upon Senior Securities                                                                    |  | 27  
|                                                                                                           | 
|Item 4. Submission of Matters to a Vote of Security Holders                                                |  | 28  
|                                                                                                           | 
|Item 5. Other Information                                                                                  |  | 28  
|                                                                                                           | 
|Item 6. Exhibits                                                                                           |  | 29  
|                                                                                                           | 
|SIGNATURES                                                                                                 |  | 30  



---

##### Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

GENAERA CORPORATION

BALANCE SHEETS

(In thousands, except per share data)



|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                                       |  | June 30, 2006 |          |   | December 31, 2005 |  
|                                                                                                                                                                                       |  | (Unaudited)   |          |   |                   |  
|ASSETS                                                                                                                                                                                 |  |               |          |   |                   |   |          |  
|Current assets:                                                                                                                                                                        |  |               |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                              |  | $             | 32,702   |   |                   | $ | 16,418   |  
|Short-term investments                                                                                                                                                                 |  |               | 11,840   |   |                   |   | 15,797   |  
|Prepaid expenses and other current assets                                                                                                                                              |  |               | 922      |   |                   |   | 892      |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total current assets                                                                                                                                                                   |  |               | 45,464   |   |                   |   | 33,107   |  
|Fixed assets, net                                                                                                                                                                      |  |               | 933      |   |                   |   | 848      |  
|Other assets                                                                                                                                                                           |  |               | 56       |   |                   |   | 56       |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total assets                                                                                                                                                                           |  | $             | 46,453   |   |                   | $ | 34,011   |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                   |  |               |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                                   |  |               |          |   |                   |   |          |  
|Accounts payable and accrued expenses                                                                                                                                                  |  | $             | 6,639    |   |                   | $ | 5,946    |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                              |  |               | 6,639    |   |                   |   | 5,946    |  
|Other liabilities                                                                                                                                                                      |  |               | 1,762    |   |                   |   | 1,781    |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                                      |  |               | 8,401    |   |                   |   | 7,727    |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Commitments and contingencies (NOTE 7)                                                                                                                                                 |  |               |          |   |                   |   |          |  
|                                                                                                                                                                                       |  |              
|Stockholders equity (NOTE 2):                                                                                                                                                         |  |               |          |   |                   |   |          |  
|Preferred stock - $.001 par value per share, 9,211 shares authorized, none issued and outstanding at June 30, 2006 and December 31,
2005                                               |  |               |         |   |                   |   |         |  
|Common stock - $.002 par value per share; 150,000 and 100,000 shares authorized; 104,554 and 68,704 shares issued and outstanding at
June 30, 2006 and December 31, 2005, respectively |  |               | 209      |   |                   |   | 137      |  
|Additional paid-in capital                                                                                                                                                             |  |               | 290,509  |   |                   |   | 265,756  |  
|Accumulated other comprehensive loss                                                                                                                                                   |  |               | (13      | ) |                   |   | (77      | )
|Accumulated deficit                                                                                                                                                                    |  |               | (252,653 | ) |                   |   | (239,532 | )
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                             |  |               | 38,052   |   |                   |   | 26,284   |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                             |  | $             | 46,453   |   |                   | $ | 34,011   |  
|                                                                                                                                                                                       |  |               |          |   |                   |   |          |  

See accompanying notes to financial statements.



2



---

##### Table of Contents

GENAERA CORPORATION

STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)



|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                        |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                        |  | 2006                       |        |   | 2005                     |   |        | 2006 |  |   | 2005    |  
|Collaborative research agreement and grant revenues     |  | $                          | 85     |   |                          | $ | 244    |      |  | $ | 245     |   |  | $ | 390     |  
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Costs and expenses:                                     |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Research and development                                |  |                            | 4,590  |   |                          |   | 4,939  |      |  |   | 10,750  |   |  |   | 9,213   |  
|General and administrative                              |  |                            | 1,495  |   |                          |   | 1,146  |      |  |   | 3,102   |   |  |   | 2,465   |  
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                                        |  |                            | 6,085  |   |                          |   | 6,085  |      |  |   | 13,852  |   |  |   | 11,678  |  
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Loss from operations                                    |  |                            | (6,000 | ) |                          |   | (5,841 | )    |  |   | (13,607 | ) |  |   | (11,288 | )
|Interest income                                         |  |                            | 246    |   |                          |   | 149    |      |  |   | 486     |   |  |   | 302     |  
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                |  | $                          | (5,754 | ) |                          | $ | (5,692 | )    |  | $ | (13,121 | ) |  | $ | (10,986 | )
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share  basic and diluted                  |  | $                          | (0.08  | ) |                          | $ | (0.10  | )    |  | $ | (0.19   | ) |  | $ | (0.19   | )
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Weighted average shares outstanding  basic and diluted |  |                            | 69,334 |   |                          |   | 57,191 |      |  |   | 69,068  |   |  |   | 57,161  |  
|                                                        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  

See accompanying notes to financial statements.



3



---

##### Table of Contents

GENAERA CORPORATION

STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                            |  |                           |         |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | ------- | -
|                                                                            |  | Six Months Ended June 30, |        
|                                                                            |  | 2006                      |         |   | 2005 |  
|Cash Flows From Operating Activities:                                       |  |                           |         |   |      |   |         |  
|Net loss                                                                    |  | $                         | (13,121 | ) |      | $ | (10,986 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                           |         |   |      |   |         |  
|Depreciation and amortization                                               |  |                           | 203     |   |      |   | 162     |  
|Amortization of investment premiums (discounts)                             |  |                           | 21      |   |      |   | (14     | )
|Compensation expense on option grants and equity awards                     |  |                           | 1,579   |   |      |   | 335     |  
|Changes in operating assets and liabilities:                                |  |                           |         |   |      |   |         |  
|Prepaid expenses and other assets                                           |  |                           | (30     | ) |      |   | (367    | )
|Accounts payable and accrued expenses                                       |  |                           | (1,151  | ) |      |   | (345    | )
|Accrued development expenses                                                |  |                           |        |   |      |   | (563    | )
|Other liabilities                                                           |  |                           | (19     | ) |      |   | 709     |  
|                                                                            |  |                           |         |   |      |   |         |  
|Net cash used in operating activities                                       |  |                           | (12,518 | ) |      |   | (11,069 | )
|                                                                            |  |                           |         |   |      |   |         |  
|Cash Flows From Investing Activities:                                       |  |                           |         |   |      |   |         |  
|Purchase of investments                                                     |  |                           | (8,000  | ) |      |   | (13,000 | )
|Proceeds from maturities of investments                                     |  |                           | 12,000  |   |      |   | 22,000  |  
|Capital expenditures                                                        |  |                           | (288    | ) |      |   | (267    | )
|                                                                            |  |                           |         |   |      |   |         |  
|Net cash provided by investing activities                                   |  |                           | 3,712   |   |      |   | 8,733   |  
|                                                                            |  |                           |         |   |      |   |         |  
|Cash Flows From Financing Activities:                                       |  |                           |         |   |      |   |         |  
|Gross proceeds from issuance of common stock and warrants                   |  |                           | 25,050  |   |      |   |        |  
|Proceeds from exercise of stock options                                     |  |                           | 40      |   |      |   | 9       |  
|                                                                            |  |                           |         |   |      |   |         |  
|Net cash provided by financing activities                                   |  |                           | 25,090  |   |      |   | 9       |  
|                                                                            |  |                           |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                        |  |                           | 16,284  |   |      |   | (2,327  | )
|Cash and cash equivalents at beginning of period                            |  |                           | 16,418  |   |      |   | 14,217  |  
|                                                                            |  |                           |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                  |  | $                         | 32,702  |   |      | $ | 11,890  |  
|                                                                            |  |                           |         |   |      |   |         |  

See accompanying notes to financial statements.



4



---

##### Table of Contents

NOTE 1. Basis of Presentation

The accompanying financial statements of Genaera Corporation
(Genaera or the Company) are unaudited and have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC) for interim financial statements. The
December 31, 2005 balance sheet was derived from audited financial statements, however, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting
principles have been condensed or omitted pursuant to SEC rules and regulations. The Company believes that the financial statements include all adjustments (consisting of a normal and recurring nature) necessary to present fairly the results of
operations, financial position and cash flows for the periods presented. Results of operations for interim periods are not necessarily indicative of those to be achieved for full fiscal years. These financial statements should be read in conjunction
with the financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial
statements and related notes. Actual results could differ from those estimates.

On December 16, 2004, the Financial Accounting
Standards Board published SFAS No. 123 (Revised 2004), Share-Based Payment(SFAS 123R). SFAS 123R requires that compensation cost related to share-based payment transactions be accounted for using a fair-value-based method
and recognized in the financial statements. Share-based payment transactions within the scope of SFAS 123R include stock options, restricted stock plans, performance-based awards, stock appreciation rights and employee share purchase plans. The
Company implemented the revised standard using the modified prospective method which requires the application of the accounting standard as of January 1, 2006. In accordance with the modified prospective method, the financial statements for
prior periods have not been restated for, and do not include, the impact of SFAS 123R (see NOTE 5. Stock-Based Compensation for further details).

NOTE 2. Stockholders Equity

The changes in stockholders equity from December 31, 2005 to June 30,
2006 are summarized as follows (in thousands):



|                                                                                        |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   |         |  
|--------------------------------------------------------------------------------------- |  | --------------- |  | ---------- | --- | ---------------- | - | ------------------- |  | - | ------------------ | ----- |  | ------------------- | -------- | - |  | - | ------- | -
|                                                                                        |  | Common Stock    |  | Additional |     | AccumulatedOther |   |                     |  |   |                    | Total | 
|                                                                                        |  | Numberof Shares |  | Amount     |     | Paid-inCapital   |   | ComprehensiveIncome |  |   | AccumulatedDeficit |       |  | StockholdersEquity |         
|Balance at December 31, 2005                                                            |  | 68,704          |  | $          | 137 |                  | $ | 265,756             |  | $ | (77                | )     |  | $                   | (239,532 | ) |  | $ | 26,284  |  
|Exercise of stock options and compensation expense under option grants and stock awards |  | 260             |  |            | 1   |                  |   | 1,662               |  |   |                   |       |  |                     |         |   |  |   | 1,663   |  
|Common stock issued pursuant to private placement                                       |  | 35,590          |  |            | 71  |                  |   | 23,091              |  |   |                   |       |  |                     |         |   |  |   | 23,162  |  
|Comprehensive loss:                                                                     |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   |         |  
|Net loss                                                                                |  |                |  |            |    |                  |   |                    |  |   |                   |       |  |                     | (13,121  | ) |  |   | (13,121 | )
|Unrealized gain on investments                                                          |  |                |  |            |    |                  |   |                    |  |   | 64                 |       |  |                     |         |   |  |   | 64      |  
|                                                                                        |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   |         |  
|Total comprehensive loss                                                                |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   | (13,057 | )
|                                                                                        |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   |         |  
|Balance at June 30, 2006                                                                |  | 104,554         |  | $          | 209 |                  | $ | 290,509             |  | $ | (13                | )     |  | $                   | (252,653 | ) |  | $ | 38,052  |  
|                                                                                        |  |                 |  |            |     |                  |   |                     |  |   |                    |       |  |                     |          |   |  |   |         |  

NOTE 3. Common Stock

On June 30, 2006, the Company completed the sale of 35,589,972 shares of its common stock to unaffiliated institutional investors in a registered direct offering, at a purchase price of $0.6101 per share, for
aggregate net proceeds of approximately $23,162,000 after offering expenses ($385,000) and placement agency fees ($1,503,000). The shares were offered through a prospectus supplement pursuant to the Companys effective shelf registration
statement. In addition, warrants to purchase 26,692,477



5



---

##### Table of Contents

shares of the Companys common stock were issued to the institutional investors at a purchase price of $0.125. On June 30, 2006, the Company
received payment for all of the shares sold in the registered direct offering. Of the 35,589,972 shares sold, 21,819,423 shares were not delivered to the institutional investors until after the end of the second quarter.

On September 15, 2005, the Company completed the sale of 11,400,000 shares of its common stock to unaffiliated institutional investors in a
registered direct offering, at a purchase price of $2.15 per share, for aggregate net proceeds of approximately $22,942,000 after offering expenses ($97,000) and placement agency fees ($1,471,000). The shares were offered through a prospectus
supplement pursuant to the Companys effective shelf registration statement. The share price represented an 18% discount to the closing price on the Nasdaq Capital Market on September 9, 2005. In addition, warrants to purchase 3,420,000
shares of the Companys common stock were issued to the institutional investors.

NOTE 4. Common Stock Warrants

In June 2006, in connection with a registered direct offering of our common stock, we issued to institutional investors warrants to purchase 26,692,477
shares of our common stock at an exercise price of $0.6101 per share. The warrants are exercisable beginning on December 30, 2006 and expire on December 30, 2011. The exercise price and the number of shares that may be purchased upon
exercise of the warrants may be adjusted from time to time as a result of a stock dividend, split or subdivision of shares, as well as a combination of shares or merger or consolidation. The Company determined that the securities purchase agreement
does not expressly provide that the shares issued upon the exercise of the warrants must be registered and there are no express or implied remedies to the warrant holders that would indicate that the Company is required to net-cash settle the
warrants in the event of delivery of unregistered shares in settlement of the contract. In accordance with the guidance in EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Companys Own Stock, the Company has accounted for the warrants issued in this transaction as part of permanent equity. As of June 30, 2006, all of the warrants were outstanding.

In connection with its September 2005 registered direct offering, the Company issued warrants to purchase 3,420,000 shares of its common stock. The
warrants have an exercise price of $3.15 per share and expire on March 13, 2011. The exercise price and the number of shares that may be purchased upon exercise of the warrants may be adjusted from time to time as a result of a stock dividend,
split or subdivision of shares, as well as a combination of shares or merger or consolidation. All of the warrants issued in connection with the September 2005 offering are currently outstanding and exercisable.

The table below sets forth outstanding warrants issued prior to 2005:



|              |  |         |  |                |      |     |                 |            |        |            
|------------- |  | ------- |  | -------------- | ---- | --- | --------------- | ---------- | ------ | -----------
|Grant Date    |  | Amount  |  | Exercise Price |      |     | Expiration Date |            | Status
|January 2004  |  | 990,100 |  | $              | 5.38 | (1) |                 | 1/23/2009  |        | Exercisable
|April 2002    |  | 100,000 |  | $              | 2.75 |     |                 | (2)        |        | (2)        
|December 2001 |  | 50,000  |  | $              | 3.79 |     |                 | 12/12/2006 |        | Exercisable
|August 2000   |  | 167,166 |  | $              | 3.22 | (3) |                 | 8/17/2007  |        | Exercisable

---

|(1) | The exercise price and the number of shares that may be purchased upon exercise of warrants
may be adjusted from time to time as a result of a stock dividend, split or subdivision of shares, as well as a combination of shares or a merger or consolidation.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | In connection with its April 2002 private placement, the Company granted to the placement
agent warrants to purchase 100,000 shares of the Companys common stock at an exercise price of $2.75 per share. When issued, these warrants will be fully exercisable and have a term of five years from the date of the transaction.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | The warrants are subject to adjustment under certain circumstances, including the issuance of
shares of common stock by the Company for a consideration per share less than the market price of the common stock at the time of said issuance and the issuance by the Company of securities convertible into shares of common stock for which the
exercise or conversion price, when added to the purchase price of such convertible securities, is less than the exercise price of the warrants.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



6



---

##### Table of Contents

NOTE 5. Stock-Based Compensation

In May 1998, the stockholders approved the 1998 Equity Compensation Plan (the 1998 Plan), which provides for the granting of options and stock awards of up to 1,500,000 shares of common stock. In May 2001,
the stockholders approved an amendment to the 1998 Plan to increase the number of shares of common stock issuable thereunder to 3,500,000 shares. In May 2004, the stockholders approved the 2004 Stock-Based Incentive Compensation Plan (the 2004
Plan), which provides for the granting of options and stock awards of up to 4,500,000 shares of common stock. In May 2006, the stockholders approved an amendment of the 2004 Plan to increase the number of shares of the Companys common
stock issuable thereunder to 7,500,000 shares of common stock.

The plans provide for the granting of incentive stock options and
nonqualified stock options and are administered by a committee of the Companys board of directors. The committee has the authority to determine the term during which an option may be exercised (provided that no option may have a term of more
than ten years), the exercise price of an option and the rate at which options vest. Stock options generally vest ratably over four years. Incentive stock options may be granted only to employees of the Company. Nonqualified stock options may be
granted to employees, directors or consultants of the Company. The exercise price of options under the 1998 Plan and the 2004 Plan cannot be less than the fair market value of the underlying common stock on the date of the grant. The Company issues
new shares to satisfy stock option exercises under the 1998 Plan and the 2004 Plan.

Adoption of SFAS 123R

Prior to January 1, 2006, the Company accounted for employee stock-based compensation using the intrinsic value method in accordance with Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). Under the intrinsic value method, compensation expense was recorded for the excess of the stocks quoted market price at the time of
grant over the amount an employee had to pay to acquire the stock. As the Companys equity compensation plans require stock options to be granted at prices equal to or above the fair market value of the Companys common stock on the grant
dates, no compensation expense related to employee options was recorded prior to January 1, 2006 under the intrinsic value method.

The Company has adopted SFAS 123R using the modified prospective method as of January 1, 2006. SFAS 123R requires the measurement of compensation expense for all stock-based awards at fair value on the date of grant and recognition of
compensation expense over the requisite service period for awards expected to vest. The fair value of stock option grants is determined using the Black-Scholes valuation model, which is consistent with the Companys valuation techniques
previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure(SFAS 148). Such fair values will be recognized as compensation expense over the requisite service period, net of estimated forfeitures, using the accelerated method under SFAS 123R. Total stock-based
compensation expense included in the statement of operations for the three- and six-month periods ended June 30, 2006 is as follows (in thousands, except per share amounts):



|                                       |  |                                 |       |   |                               |   |       |  
|-------------------------------------- |  | ------------------------------- | ----- | - | ----------------------------- | - | ----- | -
|                                       |  | Three Months EndedJune 30, 2006 |       |   | Six Months EndedJune 30, 2006 |  
|Stock-based compensation included in:  |  |                                 |       |   |                               |   |       |  
|Research and development expense       |  | $                               | 323   |   |                               | $ | 745   |  
|General and administrative expense     |  |                                 | 376   |   |                               |   | 834   |  
|                                       |  |                                 |       |   |                               |   |       |  
|Net loss                               |  | $                               | 699   |   |                               | $ | 1,579 |  
|                                       |  |                                 |       |   |                               |   |       |  
|Net loss per share  basic and diluted |  | $                               | (0.01 | ) |                               | $ | (0.02 | )
|                                       |  |                                 |       |   |                               |   |       |  



7



---

##### Table of Contents

The fair value of each option grant is estimated on the date of grant using the Black-Scholes method and
the following assumptions:



|                                                                 |  |                             |  |                           |  |             |  |            
|---------------------------------------------------------------- |  | --------------------------- |  | ------------------------- |  | ----------- |  | -----------
|                                                                 |  | Three Months Ended June 30, |  | Six Months Ended June 30,
|                                                                 |  | 2006                        |  | 2005                      |  | 2006        |  | 2005       
|Range of risk free interest rates                                |  | 5.50%-5.52%                 |  | 3.82%-4.17%               |  | 4.55%-5.52% |  | 3.70%-4.17%
|Dividend yield                                                   |  | 0%                          |  | 0%                        |  | 0%          |  | 0%         
|Volatility factor                                                |  | 95.9%-96.0%                 |  | 125%                      |  | 95.9%-98.3% |  | 125%       
|Weighted average expected life of options (in years)             |  | 4.94                        |  | 5.00                      |  | 5.00        |  | 5.00       
|Weighted average fair value of options granted during the period |  | $ 0.80                      |  | $ 1.82                    |  | $ 0.92      |  | $ 1.95     

The computations of expected volatility for the three and six months ended June 30, 2006 are
based on the historical volatility of the Companys stock price. The computation of expected life for the three and six months ended June 30, 2006 was determined based on historical experience of similar awards. The risk-free interest rate
is based on the yield of U.S. Treasury constant maturities with a term consistent with the expected life of the options.

SFAS 123R
requires the periodic review of estimated number of options for which the requisite service is expected to be rendered. Based on this review, the Company determined that actual forfeiture rates were higher than initially expected. As a result, the
Company has recorded a decrease in share-based payment expense of approximately $122,000.

A summary of the status of the Companys
stock options as of June 30, 2006 and changes during the six-month period then ended is presented below (in thousands, except years and per share data):



|                                             |  |                 |   |  |                               |      |                                                  |     |                          |   |   
|-------------------------------------------- |  | --------------- | - |  | ----------------------------- | ---- | ------------------------------------------------ | --- | ------------------------ | - | --
|                                             |  | Number ofShares |   |  | WeightedAverage ExercisePrice |      | Weighted AverageRemainingContractual Term(years) |     | AggregateIntrinsic Value
|Outstanding at January 1, 2006               |  | 5,577           |   |  | $                             | 2.90 |                                                  |     |                          |   |   
|Granted                                      |  | 273             |   |  |                               | 1.22 |                                                  |     |                          |   |   
|Exercised                                    |  | (101            | ) |  |                               | 0.40 |                                                  |     |                          |   |   
|Forfeited                                    |  | (215            | ) |  |                               | 4.76 |                                                  |     |                          |   |   
|Expired                                      |  | (33             | ) |  |                               | 8.43 |                                                  |     |                          |   |   
|                                             |  |                 |   |  |                               |      |                                                  |     |                          |   |   
|Outstanding at June 30, 2006                 |  | 5,501           |   |  | $                             | 2.76 |                                                  | 7.4 |                          | $ | 16
|                                             |  |                 |   |  |                               |      |                                                  |     |                          |   |   
|Vested at June 30, 2006 and expected to vest |  | 5,297           |   |  | $                             | 2.78 |                                                  | 7.4 |                          | $ | 16
|                                             |  |                 |   |  |                               |      |                                                  |     |                          |   |   
|Exercisable at June 30, 2006                 |  | 2,242           |   |  | $                             | 3.55 |                                                  | 5.4 |                          | $ | 12
|                                             |  |                 |   |  |                               |      |                                                  |     |                          |   |   

Aggregate intrinsic value is calculated as the difference between the exercise price of the
underlying stock options and the quoted price of our common stock for the options that were in-the-money at June 30, 2006. The total intrinsic value of stock options exercised during the six-month periods ended June 30, 2006 and 2005 was
$94,000 and $35,000, respectively, determined as of the date of exercise.

As of June 30, 2006, there was approximately $3,270,000 of
total unrecognized compensation expense related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 2.9 years.

The 1998 Plan provides for the issuance of common stock awards, up to a maximum of 375,000 shares. The 2004 Plan provides for the issuance of common stock awards with no restriction as to the percentage of shares
issued as stock awards in relation to the maximum shares allowable under the plan. Such awards shall be made subject to such performance requirements, vesting provisions, transfer restrictions or other restrictions and conditions as a committee of
the Companys board of directors may



8



---

##### Table of Contents

determine. Under the 1998 and 2004 Plans, common stock awards canceled are reissuable. As of June 30, 2006, 574,125 and 251,875 shares have been awarded
under the 1998 Plan and 2004 Plan, respectively. The fair value of these awards is determined based on the number of shares granted and the quoted price of the Companys stock on the grant date. The resulting compensation cost of these awards
will be recognized as expense over the vesting periods, which range from two to four years. The Company has not assumed any expected forfeitures for the stock awards as those awards have been granted to a small number of individuals. A summary of
the status of the Companys nonvested stock awards as of June 30, 2006 and the changes during the six-month period then ended is presented below:



|                             |  |                 |   |  |                                      |     
|---------------------------- |  | --------------- | - |  | ------------------------------------ | ----
|                             |  | Number ofShares |   |  | Weighted AverageGrant Date FairValue
|Nonvested at January 1, 2006 |  | 186,666         |   |  | $                                    | 3.84
|Granted                      |  | 150,000         |   |  |                                      | 1.44
|Vested                       |  | (108,334        | ) |  |                                      | 3.64
|Forfeited                    |  |                |   |  |                                      |    
|                             |  |                 |   |  |                                      |     
|Nonvested at June 30, 2006   |  | 228,332         |   |  | $                                    | 2.36
|                             |  |                 |   |  |                                      |     

As of June 30, 2006, there was approximately $402,000 of total unrecognized compensation
expense related to nonvested stock awards. That cost is expected to be recognized over a weighted average period of 1.2 years. The total fair value of stock awards vested during the three- and six-month periods ended June 30, 2006 was
approximately $132,000 and $394,000, respectively. Compensation expense related to these stock awards for the three- and six-month periods ended June 30, 2006 and 2005 was $91,000 and $168,000 and $149,000 and $280,000, respectively.

Prior to the adoption of SFAS 123R, the Company provided the disclosures required under SFAS 123, as amended by SFAS 148. Employee
stock-based compensation was not reflected in the Companys results of operations for the three- and six-month periods ended June 30, 2005 for employee stock options as all options were granted with an exercise price equal to the market
value of the underlying common stock on the date of grant.

The following table provides the information disclosed for the three- and
six-month periods ended June 30, 2005 in accordance with SFAS 123, as amended by SFAS 148 (in thousands, except per share amounts):



|                                                                                                                            |  |                                  |        |   |                                |   |         |  
|--------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------ | - | ------- | -
|                                                                                                                            |  | Three Months Ended June 30, 2005 |        |   | Six Months Ended June 30, 2005 |  
|Net loss, as reported                                                                                                       |  | $                                | (5,692 | ) |                                | $ | (10,986 | )
|Add: Stock-based employee compensation expense included in reported net loss                                                |  |                                  | 149    |   |                                |   | 280     |  
|Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all stock-based awards |  |                                  | (612   | ) |                                |   | (1,102  | )
|                                                                                                                            |  |                                  |        |   |                                |   |         |  
|Pro forma net loss                                                                                                          |  | $                                | (6,155 | ) |                                | $ | (11,808 | )
|                                                                                                                            |  |                                  |        |   |                                |   |         |  
|Net loss per share  basic and diluted:                                                                                     |  |                                  |        |   |                                |   |         |  
|As reported                                                                                                                 |  | $                                | (0.10  | ) |                                | $ | (0.19   | )
|                                                                                                                            |  |                                  |        |   |                                |   |         |  
|Pro forma                                                                                                                   |  | $                                | (0.11  | ) |                                | $ | (0.21   | )
|                                                                                                                            |  |                                  |        |   |                                |   |         |  

NOTE 6. Collaboration Agreements

In April 2001, the Company entered into a research collaboration and licensing agreement with MedImmune, Inc. (MedImmune) to develop and
commercialize therapies related to the Companys IL9 program. MedImmune provided funding of $2,500,000 to the Company for research and development



9



---

##### Table of Contents

activities at the Company over a two-year period from April 2001 to April 2003 (the R&D Funding). By the end of that two-year period,
licensed technology had been transferred to MedImmune and MedImmune assumed responsibility for development and commercialization efforts on the IL9 program. In addition to the R&D Funding, MedImmune agreed to reimburse the Company for certain
external costs incurred by the Company in connection with the IL9 research plan, which will be recognized by the Company as revenues when the related expenses are incurred. For the three- and six-month periods ended June 30, 2006, the Company
recognized $85,000 and $130,000, respectively, as revenue related to external cost reimbursements. For the three- and six-month periods ended June 30, 2005, the Company recognized $242,000 and $291,000, respectively, as revenue related to
external cost reimbursements. The Company could also receive up to $54,500,000 in additional funding based on successful completion of future milestones. The Company is also entitled to royalties on sales of commercial products resulting from the
collaboration. Receipt of future milestones and royalties is dependent upon favorable results in the future from clinical trials being conducted by MedImmune, MedImmune continuing to conduct the research and development activities required to
commercialize the product and the commercial success of the product if and when it is approved for marketing by the United States Food and Drug Administration (FDA).

In September 2001, the Company received a contingent award of up to $1,700,000 from Cystic Fibrosis Foundation Therapeutics (CFFT), an
affiliate of the Cystic Fibrosis Foundation, to support early clinical evaluation of LOMUCIN involving patients with cystic fibrosis. In April 2005, the award was increased to $2,863,000, consisting of $513,000 previously received in connection with
the Companys initial Phase II trial of LOMUCIN and up to $2,350,000 in milestone-driven, matching funds from CFFT to support a multi-center, randomized, double-blind, placebo-controlled Phase II clinical trial of LOMUCIN. After consultation
with CFFT, the protocol for this trial has been amended to decrease the number of patients in the trial from 200 to 80. Of a total grant of $2,863,000, $1,713,000 of grant support relating to the Phase II clinical evaluation of LOMUCIN has been
received by the Company and was recorded as a long-term liability as of June 30, 2006. The Company did not recognize this amount as revenue as it is refundable to CFFT upon marketing approval by the FDA or if the Company elects not to enter
Phase III clinical trials or to commercialize the product within two years of the satisfaction of development milestones, assuming the achievement of statistically significant results. The Company is currently in discussion with CFFT regarding
appropriate amendments to the grant in light of the revised protocol. There can be no assurance that CFFT will not decrease the amount of the grant or amend the terms thereof. CFFT is also due a royalty of up to 1.6% on net sales of any resultant
product, based upon the amount of funding ultimately provided by CFFT.

In February 2002, the Company received a Phase II Small Business
Innovative Research (SBIR) program grant from the National Institutes of Health (NIH) in the amount of $800,000 to support its aminosterol research program. The grant extended over a two-year period, which ended in February
2004. In February 2004, the Company notified the NIH of a no-cost extension to the original budget period by twelve months. As a result of the notification, the grant was extended to February 2005. The Company recognized $96,000 of revenue related
to this grant in the six-month period ended June 30, 2005.

In April 2004, the Company received a Phase I SBIR program grant from the
National Institute of Diabetes and Digestive and Kidney Diseases of the NIH in the amount of $100,000 to support its trodusquemine (formerly trodulamine) program. The grant extended over a one-year period which ended in March 2005. In March 2005,
the Company notified the NIH of a no-cost extension to the original budget period by twelve months. As a result of the notification, the grant was extended to March 2006. The Company recognized $100,000 of revenue related to this grant during the
six-month period ended June 30, 2006. The Company recognized no revenue related to this grant in the six-month period ended June 30, 2005.

In September 2004, the Company received a Phase I SBIR program grant from the National Eye Institute of the NIH in the amount of $100,000 to support its aminosterols for age-related macular



10



---

##### Table of Contents

degeneration program. The grant extended over a one-year period, which ended in August 2005. In August 2005, the Company notified the NIH of a no-cost
extension to the original budget period by twelve months. As a result of the notification, the grant was extended to August 2006. The Company recognized no revenue related to this grant during the six-month periods ended June 30, 2006 and 2005.

In February 2006, the Company entered into an agreement to provide pexiganan cream to a research facility for its conduct of a research
study. As a result of this agreement, the Company recognized $15,000 as revenue in the six-month period ended June 30, 2006.

NOTE 7. Commitments,
Contingencies and Liquidity

Employment Agreements

The Company has employment agreements with certain officers and employees. Employees covered under employment agreements who are terminated without cause are entitled to receive from the Company
continuation of base pay for periods ranging from six months to twelve months. Continuation of pay for officers will cease upon the attainment of full time employment elsewhere.

Manufacturing Agreement

In January 1999 and prior, the Company entered into several agreements with
Abbott Laboratories (Abbott) providing for the purchase of approximately $10,000,000 of bulk drug substance to be used in the manufacturing process for LOCILEX cream. The Company renegotiated this agreement with Abbott in September 1999
after the FDA did not approve LOCILEX cream, paying Abbott $4,200,000 at that time and receiving partial delivery of material under the renegotiated agreement. An additional $3,400,000 was due to Abbott and payable if the Company received in excess
of $10,000,000 of additional funds (as defined in the agreement) in any year beginning in 2000, in which case the Company must pay 15% of such excess over $10,000,000 to Abbott. The Company recorded this conditional obligation as a liability in 1999
at its then estimated present value. As a result of the Companys financing activities during 2000 and 2001 and other cash inflows, $1,391,000 and $480,000 of this liability was payable and paid to Abbott on March 1, 2001 and 2002,
respectively. No portion of the liability was payable to Abbott on March 1, 2003, as the Company did not receive in excess of $10,000,000 of cash inflows during 2002. As a result of the Companys financing activities during 2003 and other
cash inflows, $966,000 of the liability was payable and paid to Abbott on March 1, 2004. The remaining amount of $563,000 was payable and paid to Abbott on March 1, 2005 as a result of the Companys financing activities during the
year ended December 31, 2004.

Liquidity

The Company has not generated any revenues from product sales and has funded operations primarily from the proceeds of public and private placements of its securities. Substantial additional financing will be required by the Company to fund
its continuing research and development activities. No assurance can be given that any such financing will be available when needed or that the Companys research and development efforts will be successful.

The Company regularly explores alternative means of financing its operations and seeks funding through various sources, including public and private
securities offerings and collaborative arrangements with third parties. The Company currently does not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. If
the Company cannot obtain funding, it will need to delay, scale back or eliminate research and development programs or enter into collaborations with third parties to commercialize potential products or technologies that it might otherwise seek to
develop or commercialize independently, or seek other arrangements. If the Company engages in collaborations, it may receive lower consideration upon commercialization of such products than if it had not entered into such arrangements or if it
entered into such arrangements at later stages in the product development process.

The Company believes that its current cash, cash
equivalents and investments as of June 30, 2006 are sufficient to meet its research and development goals for all programs and sustain operations into 2008, based on our intention to license EVIZON to a suitable partner prior to commencing new
Phase III trials. Our strategy also includes seeking dedicated funding for our squalamine for oncology program.



11



---

##### Table of Contents

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking
Statements

Our disclosure and analysis in this Quarterly Report on Form 10-Q contains some forward-looking statements.
Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Such statements may include words such as
anticipate, estimate, expect, project, intend, plan, believe, hope and other words and terms of similar meaning. In particular, these include, among
others, statements relating to present or anticipated scientific progress, development of potential pharmaceutical products, future revenues, capital expenditures, research and development expenditures, future financing and collaborations,
personnel, manufacturing requirements and capabilities, the impact of new accounting pronouncements, and other statements regarding matters that are not historical facts or statements of current condition.

There are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements,
including those addressed below in Part II, Item 1A. under Risk Factors.

We undertake no obligation (and expressly
disclaim any such obligation) to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. You are advised, however, to consult any further disclosures we make on
related subjects in our filings with the United States Securities and Exchange Commission, all of which are available in the SEC EDGAR database at www.sec.gov and from us.

Financial Condition, Liquidity and Capital Resources

Cash, cash equivalents and short-term
investments were $44.5 million at June 30, 2006 as compared to $32.2 million at December 31, 2005. The increase in cash, cash equivalents and short-term investments during the six-month period ended June 30, 2006 was a result of the
net proceeds from our June 2006 sale of 35,589,972 shares of the Companys common stock and 26,692,477 warrants to purchase shares of the Companys common stock in a registered direct offering, offset by cash used to finance our research
and development operations.

Current liabilities were $6.6 million and $5.9 million at June 30, 2006 and December 31, 2005,
respectively. Long-term liabilities include $1.7 million received as a contingent award from Cystic Fibrosis Foundation Therapeutics.

Our
capital expenditure requirements will depend upon numerous factors, including the progress of our research and development programs, the time and cost required to obtain regulatory approvals, our ability to enter into additional collaborative
arrangements, the demand for products based on our technology, if and when such products are approved and possible acquisitions of products, technologies and companies. We had no significant commitments for capital expenditures as of June 30,
2006.

We regularly explore alternative means of financing our operations and seek funding through various sources, including public and
private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. We currently do not have any commitments to obtain additional funds and may be unable to obtain sufficient funding
in the future on acceptable terms, if at all. If we cannot obtain funding, we will need to delay, scale back or eliminate research and development programs or enter into collaborations with third parties to commercialize potential products or
technologies that we might otherwise seek to develop or commercialize ourselves, or seek other arrangements. If we engage in collaborations, we may receive lower consideration upon commercialization of such products than if we had not entered into
such arrangements, or if we entered into such arrangements at later stages in the product development process. Additional factors that may impact our ability to raise capital are described in Part II, Item 1A. under Risk Factors.



12



---

##### Table of Contents

Critical Accounting Policies and Estimates

A discussion of our critical accounting policies and estimates is included in Item 7. Managements Discussion and Analysis of Financial
Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2005. Except as described below, there have not been any changes or additions to our critical accounting policies during the six months
ended June 30, 2006.

Stock-Based Compensation

Prior to January 1, 2006, we accounted for employee stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25). Under the intrinsic value method, compensation expense was recorded for the excess of the stocks quoted market price at the time of grant over the amount an employee had to pay to acquire the stock. As our
equity compensation plans require stock options to be granted at prices equal to or above the fair market value of our common stock on the grant dates, no compensation expense was recorded prior to January 1, 2006 under the intrinsic value
method.

We have adopted SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS 123R), using the modified
prospective method as of January 1, 2006. SFAS 123R requires the measurement of compensation expense for all employee stock-based awards at fair value on the date of grant and recognition of compensation expense over the requisite service
period for awards expected to vest. The fair value of stock option grants is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under
SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure(SFAS 148). The fair value of
restricted stock awards is determined based on the number of shares granted and the quoted price of our common stock on the grant date. Such fair values will be recognized as compensation expense over the requisite service period, net of estimated
forfeitures, using the accelerated method under SFAS 123R.

Stock or other equity-based compensation for non-employees is accounted for
under the fair-value-based method as required by SFAS 123R and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services, and other related interpretations. Under this method, the equity-based instrument is valued at the fair value of either the consideration received or the equity instrument issued on the date of grant. The resulting
compensation cost is recognized and charged to operations over the service period, which is usually the vesting period. Estimating the fair value of equity securities involves a number of judgments and variables that are subject to significant
change.

Results of Operations

Revenues

We have received no revenues to date from product sales. Revenues recorded to date have consisted principally of revenues recognized
under collaborations with third parties. In April 2001, we entered into a research collaboration and licensing agreement with MedImmune, Inc. to develop and commercialize therapies related to our IL9 program. MedImmune provided funding of $2.5
million, payable in eight equal quarterly installments through April 2003 (the R&D Funding), plus it funds external cost reimbursements for our research and development activities. We could also receive up to $54.5 million in
additional funding based on successful completion of future milestones. In August 2004, we received the first of such milestone payments as a result of the initiation of Phase I clinical trials. For the three- and six-month periods ended
June 30, 2006, we recognized $85,000 and $130,000, respectively as revenue related to external cost reimbursements. For the three- and six-month periods ended June 30, 2005, we recognized $242,000 and $291,000, respectively as revenue
related to external cost reimbursements.



13



---

##### Table of Contents

In February 2002, we received a Phase II Small Business Innovative Research (SBIR) program
grant from the National Institutes of Health (NIH) in the amount of $800,000 to support our aminosterol research program. The grant extended over a two-year period, which ended in February 2004. In February 2004, we notified the NIH of a
no-cost extension of the original budget period by twelve months. As a result of the notification, the grant was extended through February 2005. No revenue related to this grant was recognized during the six-month period ended June 30, 2006. We
recognized $96,000 of revenue related to this grant during the six-month period ended June 30, 2005.

In April 2004, we received a
Phase I SBIR program grant from the National Institute of Diabetes and Digestive and Kidney Diseases of the NIH in the amount of $100,000 to support our trodusquemine (formerly trodulamine) program. The grant extended over a one-year period, which
ended in March 2005. In March 2005, we notified the NIH of a no-cost extension to the original budget period by twelve months. As a result of the notification, the grant was extended to March 2006. We recognized $100,000 of revenue related to this
grant during the six-month period ended June 30, 2006. No revenue related to this grant was recognized in the six-month period ended June 30, 2005.

In September 2004, we received a Phase I SBIR program grant from the National Eye Institute of the NIH in the amount of $100,000 to support its aminosterols for age-related macular degeneration (AMD)
program. The grant extended over a one-year period, which ended in August 2005. In August 2005, the Company notified the NIH of a no-cost extension to the original budget period by twelve months. As a result of the notification, the grant was
extended to August 2006. We recognized no revenue related to this grant during the six-month periods ended June 30, 2006 and 2005.

In
February 2006, we entered into an agreement to provide pexiganan cream to a research facility for its conduct of a research study. As a result of this agreement, we recognized $15,000 as revenue in the six-month period ended June 30, 2006.

Research and Development Expenses

Our
current research and development programs include squalamine (squalamine lactate), which consists of EVIZON (squalamine lactate) for the treatment of wet AMD and squalamine for the treatment of cancer, LOMUCIN, IL9, trodusquemine (MSI-1436)
for the treatment of obesity and other programs, which consist of other aminosterols for the treatment of inflammatory disorders and LOCILEX cream for the treatment of infectious disease. The following table illustrates our research and development
projects and the stage to which each has been developed:



|                   |  |                      |  |              
|------------------ |  | -------------------- |  | -------------
|                   |  | Development Stage    |  | Status       
|Squalamine:        |  |                      |  |              
|EVIZON            |  | Phase II/III(1)      |  | Active       
|Squalamine         |  | Phase II             |  | Active       
|LOMUCIN            |  | Phase II             |  | Active       
|IL9                |  | Phase I              |  | Active(2)    
|Trodusquemine      |  | Research/Preclinical |  | Active/Active
|Other programs:    |  |                      |  |              
|Other aminosterols |  | Research             |  | Active       
|LOCILEX cream      |  | Phase III            |  | Inactive     

---

|(1) | In June 2005, we began a Phase III trial of EVIZON for the treatment of wet age-related macular degeneration.
|--- | -------------------------------------------------------------------------------------------------------------

|(2) | In April 2001, we entered into a collaborative agreement with MedImmune to develop and commercialize therapies related to our IL9 program.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------



14



---

##### Table of Contents

Research and development expenses for each of our projects consist of both direct and indirect expenses.
Direct expenses include salaries and other costs of personnel, raw materials and supplies for each project. We also may incur third-party costs related to these projects, such as contract research, clinical development and manufacturing costs and
consulting costs. Indirect expenses include depreciation expense and the costs of operating and maintaining our facilities and property and equipment to the extent used for our research and development projects, as well as the costs of general
management of our research and development projects.

We recognized research and development expenses of $4.6 million and
$4.9 million in the three-month periods ended June 30, 2006 and 2005, respectively. We recognized research and development expenses of $10.8 million and $9.2 million in the six-month periods ended June 30, 2006 and 2005,
respectively. The following table sets forth research and development expenses (in thousands) incurred during the three- and six-month periods ended June 30, 2006 and 2005 for our significant groups of research and development projects.



|                               |  |                             |       |                           |   |       |  |      |        |  |   |      
|------------------------------ |  | --------------------------- | ----- | ------------------------- | - | ----- |  | ---- | ------ |  | - | -----
|                               |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                               |  | 2006                        |       | 2005                      |   | 2006  |  | 2005
|Squalamine program expenses    |  | $                           | 3,058 |                           | $ | 3,770 |  | $    | 7,218  |  | $ | 7,047
|LOMUCIN program expenses       |  |                             | 226   |                           |   | 351   |  |      | 626    |  |   | 461  
|IL9 program expenses           |  |                             | 1     |                           |   | 62    |  |      | 25     |  |   | 118  
|Trodusquemine program expenses |  |                             | 165   |                           |   | 10    |  |      | 398    |  |   | 20   
|Other program expenses         |  |                             | 12    |                           |   | 13    |  |      | 25     |  |   | 26   
|Indirect expenses              |  |                             | 1,128 |                           |   | 733   |  |      | 2,458  |  |   | 1,541
|                               |  |                             |       |                           |   |       |  |      |        |  |   |      
|                               |  | $                           | 4,590 |                           | $ | 4,939 |  | $    | 10,750 |  | $ | 9,213
|                               |  |                             |       |                           |   |       |  |      |        |  |   |      

Research and development expenses decreased during the three-month period ended June 30,
2006, as compared to the same period in 2005, due primarily to decreases in clinical trial expenses ($0.5 million), manufacturing costs ($0.1 million) and research and development supplies expense ($0.1 million) related to our squalamine program for
the treatment of age-related macular degeneration, decreases in clinical trial expenses ($0.1 million) related to our LOMUCIN program for the treatment of cystic fibrosis and decreases in third-party contract research costs ($0.1 million) related to
our IL9 program for the treatment of asthma and related disorders. These decreases were partially offset by increases in third-party contract research costs and consulting expenses ($0.2 million) related to our trodusquemine program for the
treatment of obesity and increased indirect expenses as a result of increased salary expenses ($0.1 million) and stock-based compensation expense relating to the adoption of SFAS 123R ($0.3 million).

Research and development expenses increased during the six-month period ended June 30, 2006, as compared to the same period in 2005, due primarily
to increases in clinical trial expenses ($1.0 million) related to our squalamine program for the treatment of age-related macular degeneration. This increase was also due to increased personnel costs ($0.1 million) and manufacturing costs ($0.1
million) for our LOMUCIN program for the treatment of cystic fibrosis and increased personnel ($0.2 million), third-party contract research ($0.1 million) and consulting expenses ($0.1 million) related to our trodusquemine program for the treatment
of obesity. Research and development expenses also increased due to increased indirect expenses as a result of stock-based compensation expense relating to the adoption of SFAS 123R ($0.7 million) and an increase in temporary labor ($0.1 million).
These increases were partially offset by decreases in personnel costs ($0.1 million), manufacturing costs ($0.3 million), third-party contract research ($0.3 million) and research and development supplies expense ($0.1 million) related to our
squalamine program for the treatment of age-related macular degeneration as well as decreases in third-party contract research costs ($0.1 million) related to our IL9 program for the treatment of asthma and related disorders.

The costs incurred to date on each of our development projects are not reasonably estimable because work on one program often supports or enhances
another program. For example, it is not possible to separate the time and resources spent in development of squalamine lactate as a product candidate to treat



15



---

##### Table of Contents

wet AMD and as a product candidate to treat cancer because: (i) early research and development efforts devoted to cancer research led to development of
our product candidate squalamine lactate (trade name EVIZONTM) for AMD; (ii) clinical trial work pursuant to
our Investigational New Drug (IND) application for cancer forms part of the safety data base for the IND we filed with the FDA for wet AMD; (iii) our manufacturing development for squalamine lactate supports both the AMD and cancer
programs; and (iv) nonclinical testing conducted supports all regulatory filings and proposed indications for squalamine.

The level
of research and development expenses in future periods will depend principally upon the progress of our research and development programs and our capital resources. Due to the significant risks and uncertainties inherent in the preclinical and
clinical studies associated with each of our research and development programs, the cost to complete such programs, as well as the period in which net cash inflows from significant programs are expected to commence, are not reasonably estimable.
Preclinical and clinical studies may yield varying results that could delay, limit or prevent a programs advancement through the various stages of product development and significantly impact the costs to be incurred and the time involved in
bringing a program to completion. Such delays, limitations or prevention of a programs advancement could harm our financial condition and operating results and inhibit our ability to raise additional funds to support ongoing operations.

The nature of costs incurred in the future will also vary depending upon the stage of the product candidates development. Product
candidates in the research stage often require significant laboratory work to develop and prepare the product candidate for preclinical testing and for testing in humans. Costs for such work typically include our staff, our facilities, lab supplies
and equipment and fees to contract research facilities supervised by our personnel. All products to be tested in humans require preclinical testing and often require additional nonclinical testing while clinical trials are in process to fulfill
regulatory requirements. Preclinical and nonclinical work requires expenditures for staffing and facilities. Costs will also be incurred for work done by contract research facilities under our supervision. Early stage products require development of
manufacturing methods, supporting analytical and research work and qualifying vendors, including contract manufacturers. Products in human testing, particularly later stage trials, require manufacturing more significant quantities of product. The
costs of conducting clinical trials include fees to contract research organizations to conduct the trials, payments to physicians and research centers, and payments for a wide range of services to prepare for clinical trials, support the trials and
manage data gathered in the trials. Internal costs for clinical trials include staffing and infrastructure to design, adapt and manage the trials as well as managing vendors providing supporting services. Smaller but continuing costs throughout the
clinical trials process also include quality control and regulatory compliance activities conducted by our staff and through contractors under our supervision.

General and Administrative Expenses

We recognized general and administrative expenses of $1.5 million and
$1.1 million in the three-month periods ended June 30, 2006 and 2005, respectively. General and administrative expenses consist principally of personnel costs, professional fees and public company expenses. General and administrative costs
increased in the three-month period ended June 30, 2006, as compared to the same period in 2005, due to an increase in stock-based compensation expense relating to the adoption of SFAS 123R ($0.3 million) and an increase in patent professional
fee expenses ($0.1 million).

We recognized general and administrative expenses of $3.1 million and $2.5 million in the six-month
periods ended June 30, 2006 and 2005, respectively. General and administrative costs increased in the six-month period ended June 30, 2006, as compared to the same period in 2005, due to an increase in stock-based compensation expense
relating to the adoption of SFAS 123R ($0.7 million) offset by a decrease in restricted stock expense ($0.1 million).



16



---

##### Table of Contents

Interest Income

We recognized interest income of $246,000 and $149,000 for the three-month periods ended June 30, 2006 and 2005, respectively. We recognized interest income of $486,000 and $302,000 for the six-month periods ended
June 30, 2006 and 2005, respectively. Interest income increased during the three- and six-month periods ended June 30, 2006, as compared to the same periods in 2005, due to higher investment interest yields.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to risks associated
with interest rate changes. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We only invest in U.S. government, government agency, corporate and bank or institutional money market funds with
investment standards comparable to our investment policy. Our investment policy limits the amount of credit exposure we may have to any one issue, issuer or type of investment other than U.S. government debt.

As of June 30, 2006, our portfolio investments consisted of $32.7 million in cash and cash equivalents and $11.8 million in U.S. Treasury or U.S.
Government agency debt instruments having a maturity of less than one year. Due to the nature of our investment portfolio, management believes that a sudden change in interest rates would not have a material effect on the value of the portfolio.
Management estimates that if the average annualized yield of our investments had decreased by 100 basis points, our interest income for the six-month period ended June 30, 2006 would have decreased by approximately $139,000. Correspondingly, if
the average annualized yield of our investments had increased by 100 basis points, our interest income for the six-month period ended June 30, 2006 would have increased by $139,000. These estimates assume that the change occurred on the first
day of 2006 and changed the annualized yield of each investment instrument by 100 basis points. The impact on our future interest income will depend largely on the gross amount of our investment portfolio.

We do not currently have any significant direct foreign currency exchange rate risk.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures:

For the quarterly period ended June 30, 2006, we carried out an evaluation, under the supervision and with the participation of our management,
including our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer (the principal financial and accounting officer), of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end of the period covered by this report. Based upon this evaluation, our President and Chief Executive
Officer and our Executive Vice President and Chief Financial Officer concluded that, as of June 30, 2006, our disclosure controls and procedures were effective.

Our management, including our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer, does not expect that our disclosure controls and procedures will prevent all errors or
fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met and our disclosure controls and procedures are designed to provide this
reasonable assurance. Based upon the evaluation discussed above, our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer concluded that, as of June 30, 2006, our disclosure controls and procedures
were effective at providing such reasonable assurance. Because of inherent limitations in all control systems, no evaluation of control can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have
been detected.

Internal control over financial reporting:

There were no changes in our internal control over financial reporting during the fiscal quarter ended June 30, 2006 that have materially affected,
or are reasonably likely to materially affect, our internal control over financial reporting.



17



---

##### Table of Contents

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A. RISK FACTORS

Our performance and financial results, and any investment in shares of our common
stock, are subject to risks and uncertainties, including, but not limited to, the following specific risks:

Risks Related to Our Business

If we do not raise additional capital, we may not be able to continue our research and development programs. We may never commercialize any
products.

We maintained cash, cash equivalents and short-term investments of $44.5 million at June 30, 2006. We believe these
resources are sufficient to sustain operations and meet our research and development goals into 2008, based on our intention to license EVIZON to a suitable partner prior to commencing new Phase III trials. Our strategy also includes seeking
dedicated funding for our squalamine for oncology program. However, we will need to raise substantial additional funds in the future to continue our research and development programs and to commercialize our potential products. If we are unable to
raise additional funds, we may be unable to complete our development activities for any of our proposed products.

We regularly explore
alternative means of financing our operations and seek funding through various sources, including public and private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. We
currently do not have any commitments from other parties to provide us additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. If we cannot obtain funding, we will need to delay, scale back or
eliminate research and development programs or enter into collaborations with third parties to commercialize potential products or technologies that we might otherwise seek to develop or commercialize ourselves, or seek other arrangements.

Our capital raising efforts may dilute stockholder interests.

If we raise additional capital by issuing equity securities or securities convertible into equity, the issuance would result in ownership dilution to our stockholders and our share price may decline. The extent of
such dilution will vary based upon the amount of capital raised.

Capital raising efforts through collaborations may eventually negatively impact our
financial interests.

If we raise additional capital through collaborations and licensing, we may give up valuable rights in
intellectual property and the value of our interest in the licensed products could be negatively impacted by competing strategic and financial interests of our collaborators or licensees. If we engage in collaborations, we may receive lower
consideration upon commercialization of such products than if we had not entered into such arrangements, or if we had entered into such arrangements at later stages in the product development process.



18



---

##### Table of Contents

We expect to continue to incur substantial losses in the foreseeable future. We do not now have, nor have we ever had,
products available for commercial sale and we may never generate revenues or become profitable.

To date, we have engaged primarily in
the research and development of drug candidates. We have not generated any revenues from product sales and have incurred losses in each year since our inception. As of June 30, 2006, we had an accumulated deficit of $252.7 million.

Our proposed products are in a relatively early developmental stage and will require significant research, development and testing. We must obtain
regulatory approvals for any proposed product prior to commercialization of the product. Our operations are also subject to various competitive and regulatory risks. As a result, we are unable to predict when or if we will achieve any product
revenues or become profitable. We expect to experience substantial losses in the foreseeable future as we continue our research, development and testing efforts.

Risks Related to Our Industry

Development and commercial introduction of our products will take several more years and may not be
successful.

We are dedicating substantially all of our resources to research and development, do not have any marketed products and
have not generated any product revenue. Because substantially all of our potential products currently are in research, preclinical development or the early and middle stages of clinical testing, revenues from sales of any products will not occur for
at least the next several years, if at all. Our technologies are relatively new fields and may not lead to commercially viable pharmaceutical products. Before we can commercially introduce any products, we will likely incur substantial expense for,
and devote a significant amount of time to, preclinical testing and clinical trials. We cannot apply for regulatory approval of our potential products until we have performed additional research and development testing and demonstrated in
preclinical testing and clinical trials that our product candidates are safe and effective for use in humans. Some of our product candidates are in the early stages of research and development and we may abandon further development efforts on these
product candidates before they reach clinical trials. Conducting clinical trials is a lengthy, time-consuming and expensive process. Our clinical trials may not demonstrate the safety and efficacy of our potential products, and we may encounter
unacceptable side effects or other problems in the clinical trials. Should this occur, we may have to delay or discontinue development of the potential products. Further, even if we believe that any product is safe or effective, we may not obtain
the required regulatory approvals, be able to manufacture our products in commercial quantities or be able to market any product successfully.

Preclinical testing and clinical development are long, expensive and uncertain processes. It may take us several years to complete our testing and failure can occur at any stage of testing. Success in preclinical testing and early clinical
trials does not ensure that later clinical trials will be successful. We may suffer significant setbacks in advanced clinical trials, even after promising results in earlier trials. We may not be able to enroll a sufficient number of patients to
complete our clinical trials in a timely manner. Based on results at any stage of clinical trials, we may decide to discontinue development of our product candidates.

Failure to recruit patients could delay or prevent clinical trials of our potential products, which could delay or prevent the development of potential products.

Identifying and qualifying patients to participate in clinical trials of our potential products is critically important to our success. The timing of our
clinical trials depends on the speed at which we can recruit patients to participate in testing our product candidates. We have experienced delays in some of our clinical trials and we may experience similar delays in the future. If patients are
unwilling to participate in our trials because of competitive clinical trials for similar patient populations, the timeline for recruiting



19



---

##### Table of Contents

patients, conducting trials and obtaining regulatory approval of potential products will be delayed. These delays could result in increased costs, delays in
advancing our product development, delays in testing the effectiveness of our technology or termination of the clinical trials altogether.

Compliance
with extensive government regulations to which we are subject is expensive and time consuming, and may result in the delay, cessation or cancellation of product sales, introductions or modifications.

Extensive industry regulation has, and will continue to have, a significant impact on our business. Biopharmaceutical companies, are subject to extensive,
complex, costly and evolving regulation by the federal government, principally the U.S. Food and Drug Administration (FDA) and to a lesser extent by the U.S. Drug Enforcement Administration (DEA) and foreign and state
government agencies. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other domestic and foreign statutes and regulations govern or influence the testing, manufacturing, packing, labeling, storing, record keeping, safety,
approval, advertising, promotion, sale and distribution of our products. Under certain of these regulations, we and our contract suppliers and manufacturers could be subject to periodic inspection of our or their respective facilities, procedures
and operations and/or the testing of our products by the FDA, the DEA and other authorities, which conduct periodic inspections to confirm that we and our contract suppliers and manufacturers are in compliance with all applicable regulations. The
FDA also conducts pre-approval and post-approval reviews and plant inspections to determine whether our systems, or our contract suppliers and manufacturers processes, are in compliance with current Good Manufacturing Practices
(cGMP) and other FDA regulations.

We are dependent on receiving and maintaining FDA and other governmental approvals in order
to produce and conduct clinical trials on our products. There is always a risk that the FDA or other applicable governmental authorities will not approve our products, or will take postapproval action limiting, modifying or revoking our
ability to manufacture or sell our products or that the rate, timing and cost of such approvals will adversely affect our product introduction plans or results of operations.

Governmental authorities may delay or deny the approval of any of our drug candidates. In addition, governmental authorities may enact new legislation or
regulations that could limit or restrict our efforts. A delay or denial of regulatory approval for any of our drug candidates will have a material adverse effect on our business. Even if we receive approval of a product candidate, approval may be
conditioned upon certain limitations and restrictions as to the drugs used and may be subject to continuous review. If we fail to comply with any applicable regulatory requirements, we could be subject to penalties, including warning letters, fines,
withdrawal of regulatory approval, product recalls, operating restrictions, injunctions and criminal prosecution.

We expect to rely on third parties to
market any products we develop and expect to rely on third parties in connection with the development of our products; if these parties do not perform as expected, we may never successfully commercialize our products.

We do not have our own sales and marketing staff. In order to successfully develop and market our future products, we must develop this infrastructure
with inherent risks or enter into marketing and distribution arrangements with third parties. We also expect to delegate the responsibility for all, or a significant portion, of the development and regulatory approval for certain products to third
parties. If these parties do not develop an approvable or marketable product or do not market a product successfully, we may never generate revenue or become profitable. Additionally, we may be unable to enter into successful arrangements with other
parties for such products.

We currently have collaborative agreements with three primary collaborators: MedImmune, Inc., Ludwig Institute
of Cancer Research (LICR), and Laboratorios Bago SA. We do not have control over the amount and timing of resources to be devoted to our products by our collaborative partners. Our collaborators may not place a high priority on their
contractual arrangements with us. Collaborators may develop products independently or through third parties that could compete with our proposed products. In addition, a collaborator may decide to end a relationship with us.



20



---

##### Table of Contents

We also may decide to establish our own sales force to market and sell certain products. Although some
members of our management have limited experience in marketing pharmaceutical products, we have no experience with respect to marketing our products. If we choose to pursue this alternative, we will need to spend significant additional funds and
devote significant management resources and time to establish a successful sales force. This effort may not be successful. Moreover, because our financial resources are limited, our sales and marketing expenditures in this area would likely be
modest compared to that of our competitors.

We face formidable competition with respect to the products we are seeking to develop.

The pharmaceutical industry is characterized by intense competition. Many companies, research institutions and universities are conducting research and
development activities in our fields of interest. Most of these competitors have substantially greater financial, technical, manufacturing, marketing, distribution and other resources than we have. We may also face competition from companies using
different or advanced techniques that could render our future products obsolete. Accordingly, we must continue to devote substantial resources and efforts to research and development activities in order to maintain a competitive position in our
fields. Our efforts may not be successful.

Many companies are working to develop and market products intended for additional disease areas
being targeted by us, including AMD, cancer and respiratory diseases. A number of major pharmaceutical companies have significant franchises in these disease areas and can be expected to invest heavily to protect their interests. With respect to
AMD, anti-angiogenic agents are under development at a number of biopharmaceutical companies, including Alcon, Inc., Bausch & Lomb, Inc., Genentech, Inc., Miravant Medical Technologies, OSI Pharmaceuticals, Inc. and QLT, Inc., as well as
other large pharmaceutical companies. For cancer, anti-angiogenic agents are under development at a number of biopharmaceutical companies, including EntreMed, Inc., Genentech, Inc., and Imclone Systems, Inc., as well as other large pharmaceutical
companies. In the respiratory field, other biopharmaceutical companies also have reported the discovery of genes relating to asthma and other respiratory diseases, including Genentech, Inc., Amgen, Inc. and Vertex Pharmaceuticals, Inc., as well as
other large pharmaceutical companies. Many of the companies developing or marketing competing products have significantly more experience than we do in undertaking preclinical testing and human clinical trials of new or improved therapeutic products
and obtaining regulatory approvals of such products. Some of these companies may be in advanced phases of clinical testing of various drugs that may be competitive with our proposed products.

We expect technological developments in the biopharmaceutical field to occur at a rapid rate and expect competition to intensify as advances in this
field are made. Some of these companies are currently involved in research and development activities focused on the pathogenesis of disease and the competition among companies attempting to find genes responsible for disease is intense. In
addition, we are aware that others are conducting research on compounds derived from animal host-defense systems.

Colleges, universities,
governmental agencies and other public and private research organizations are becoming more active in seeking patent protection and licensing arrangements to collect royalties for use of technology that they have developed, some of which may be
directly competitive with our technology.

If we are unable to recruit and retain skilled employees, we may not be able to achieve our objectives.

Retaining our current employees and recruiting qualified scientific personnel to perform future research and development work will be
critical to our success. In addition to pharmaceutical and specialized biotechnology companies, colleges, universities, governmental agencies and other public and private research organizations can be expected to compete with us in recruiting highly
qualified scientific personnel. Competition is intense for experienced scientists, and we may not be able to retain or recruit sufficient skilled personnel to allow us to pursue collaborations and develop our products and core technologies to the
extent otherwise possible.



21



---

##### Table of Contents

If we do not develop and maintain relationships with contract manufacturers, we may not successfully commercialize our
products.

We currently do not have the resources, facilities or technical capabilities to manufacture any of our proposed products in
the quantities and quality required for commercial sale. We have no plans to establish a manufacturing facility. We expect to depend upon contract manufacturers for commercial scale manufacturing of our proposed products in accordance with
regulatory standards. For example, we are currently working with outside contractors for the chemical production of squalamine. This dependence on contract manufacturers may restrict our ability to develop and deliver products on a timely,
profitable and competitive basis especially because the number of companies capable of producing our proposed products is limited. These contract manufacturers generally have multiple projects and they may give ours a lower priority. As a result of
contract manufacturing mishaps, our product could be lost or delivered late, delaying our clinical and preclinical programs, or may not be produced in accordance with all current applicable regulatory standards. Product not produced in accordance
with all current applicable regulatory standards may lead to adverse outcomes for patients and/or product recalls. Furthermore, the development of a robust, low-cost manufacturing process for the commercial production of squalamine and other
proposed products will require significant time and expenditure by us. We may be unable to maintain arrangements with qualified outside contractors to manufacture materials at costs that are affordable to us, if at all.

Contract manufacturers may utilize their own technology, our technology, or technology acquired or licensed from third parties in developing a
manufacturing process. In order to engage another manufacturer, we may need to obtain a license or other technology transfer from the original contract manufacturer. Even if a license is available from the original contract manufacturer on
acceptable terms, we may be unable to successfully effect the transfer of the technology to the new contract manufacturer. Any such technology transfer may also require the transfer of requisite data for regulatory purposes, including information
contained in a proprietary drug master file held by a contract manufacturer. If we rely on a contract manufacturer that owns the drug master file, our ability to change contract manufacturers may be more limited.

We depend on our intellectual property. If we are unable to protect our intellectual property, our business may be harmed.

Patents

Our success depends, in part, on our ability
to develop and maintain a strong patent position for our products and technologies, both in the United States and other countries. As with most biotechnology and pharmaceutical companies, our patent position is highly uncertain and involves complex
legal and factual questions. Without patent and other protections, other companies could offer substantially identical products for sale without incurring the sizeable development and testing costs that we have incurred. As a result, our ability to
recover these expenditures and realize profits upon commercialization would likely be diminished.

The process of obtaining patents can be
time consuming and expensive. Even after significant expenditure, a patent may not issue. We can never be certain that we were the first to develop the technology or that we were the first to file a patent application for the particular technology.
U.S. patent applications are maintained in secrecy by the U.S. Patent and Trademark Office until a patent issues and publications in the scientific or patent literature concerning new technologies occur some time after actual discoveries of the
technologies are made.



22



---

##### Table of Contents

We cannot be certain that:



| |  |  | patents will issue from any of our patent applications;
| | - |  | -------------------------------------------------------



| |  |  | our patent rights will be sufficient to protect our technology;
| | - |  | ---------------------------------------------------------------



| |  |  | others may not file patents ahead of us in time and prevent the issuing of our patent claims;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | others will not design around the patented aspects of our technology; or
| | - |  | ------------------------------------------------------------------------



| |  |  | our patents will not be successfully challenged or circumvented by our competitors.
| | - |  | -----------------------------------------------------------------------------------

The cost of litigation related to patents can be substantial, regardless of the outcome.

We own several
patents and patent applications for the use of squalamine as an anti-angiogenic, including methods for the treatment of cancer and neovascularization in the eye. One of these patents is to the compounds combination therapy with other
anti-cancer agents and will expire in 2017, while another patent covers the treatment of age-related macular degeneration, retinopathy of prematurity and diabetic retinopathy and will expire in 2015. We also own patents covering methods and
intermediates in the manufacturing process of squalamine and trodusquemine that expire in 2017, 2018 and 2021. We own a composition of matter patent for the trodusquemine compound, which expires in 2014. We also own a patent for the use of
trodusquemine as an anti-obesity agent and other indications that expires in 2015. We own two patents for the use of anti-IL9 or anti-IL9 receptor antibodies for the treatment of asthma and related disorders that expire in 2016. We also have U.S.
patents covering the composition of matter for a mucoregulator target and another patent covering methods for screening for mucoregulator compounds that both expire in 2019. We own a patent on the use of talniflumate and related mucoregulator
compounds for treating various conditions where mucous is overproduced, which expires in 2021.

The expiration date of each of these
patents is subject to extension depending upon the future research and development program timelines. We have filed several other applications across our research and development programs and intend to file additional applications, as appropriate,
for patents on new compounds, products or processes discovered or developed through the application of our technology.

We have rights to
several patents and patent applications under certain license agreements pursuant to which we expect to owe royalties on sales of products that incorporate issued valid patent claims. In particular, we have licensed from the Ludwig Institute of
Cancer Research specific technologies related to our IL9 program, the earliest of which expires in 2009. We have licensed from the Childrens Hospital of Philadelphia the composition of matter patent for the squalamine compound, which expires
in 2012. These patents are subject to extensions by their owners depending upon the future research and development program timelines. Additionally, certain of these agreements also provide that if we elect not to pursue the commercial development
of any licensed technology, or do not adhere to an acceptable schedule of commercialization, our exclusive rights to such technology may terminate.

Third Party Intellectual Property Rights

We cannot be sure that our products do not infringe on the intellectual property
rights of others and we may have infringement claims asserted against us. These claims may harm our reputation, cost us money and prevent us from offering some products. Any claims or litigation in this area may be costly and could result in large
awards against us and, whether we ultimately win or lose, could be time-consuming, may injure our reputation, may result in costly delays or may require us to enter into royalty or licensing arrangements. If there is a successful claim of
infringement against us or if we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our ability to use certain technologies, products, services and brand names may be limited and our business may be
harmed.



23



---

##### Table of Contents

Other Intellectual Property

We have trademark protection for the product candidate names EVIZON and LOMUCIN and are currently seeking U.S. registration of these trademarks. In order to protect our proprietary technology and
processes, we also rely on trade secrets and confidentiality agreements with our employees, consultants, outside scientific collaborators, and other advisors. We may find that these agreements have been breached or that our trade secrets have
otherwise become known or independently developed or discovered by our competitors.

Certain of our exclusive rights to patents and patent
applications are governed by contract. Generally, these contracts require that we undertake certain obligations including the payment of royalties on sales of any products that are covered by patent claims. If we do not meet those obligations, we
may lose our rights. Additionally, some of these agreements also require that we develop the licensed technology or meet certain milestones within a given timeframe. If we do not adhere to an acceptable schedule of commercialization, we may lose our
rights.

Potential Ownership Disputes

Disputes may arise as to the ownership of our technology. Most of our research and development personnel have previously worked at other biotechnology companies, pharmaceutical companies, universities or research institutions. These
entities may raise questions as to when technology was developed and assert rights to the technology. These kinds of disputes have occurred in the past at our company and were resolved. However, we may not prevail in any such disputes in the future.

Similar technology ownership disputes may arise in the context of consultants, vendors or third parties, such as contract manufacturers.
For example, our consultants are employed by or have consulting agreements with third parties. There may be disputes as to the capacity in which consultants are operating when they make certain discoveries. We may not prevail in any such disputes.

If we cannot recruit and retain qualified management, we may not be able to successfully develop and commercialize our products.

We depend to a considerable degree on a limited number of key personnel. Most significant responsibilities have been assigned to a relatively small number
of individuals. In particular, it would be difficult to replace our President and Chief Executive Officer, John L. Armstrong, Jr. We entered into an evergreen employment agreement with Mr. Armstrong, dated October 21, 2003, that is
terminable by either party. This employment agreement contains non-competition and non-solicitation clauses. All of our executive officers have executed individual employment agreements with us. We do not maintain key man insurance on
any of our employees. The loss of certain management and technical personnel could adversely affect our ability to develop and commercialize products.

We are subject to potential product liability claims that could result in significant costs.

We are subject to significant
potential product liability risks inherent in the testing, manufacturing and marketing of human therapeutic products, including the risk that:



| |  |  | our proposed products cause some undesirable side effects or injury during clinical trials;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | our products cause undesirable side effects or injury in the market; or
| | - |  | -----------------------------------------------------------------------



| |  |  | third parties that we have agreed to indemnify incur a related liability.
| | - |  | -------------------------------------------------------------------------

We currently maintain primary products and completed operations liability insurance with per occurrence and aggregate coverage limits of $8.0 million. The coverage limits of our insurance policies may be inadequate to
protect us from any liabilities we might incur in connection with clinical trials, manufacturing and marketing of our products. Product liability insurance is expensive and in the future may not be available on commercially acceptable terms, or at
all. A successful claim or claims brought against us in excess of our insurance coverage could materially harm our business and financial condition.



24



---

##### Table of Contents

If we do not receive adequate third-party reimbursement for any of our drug candidates, some patients may be unable to
afford our products and sales could suffer.

In both the United States and elsewhere, the availability of reimbursement from third-party
payers, such as government health administration authorities, private health insurers and other organizations, can impact prescription pharmaceutical sales. These organizations are increasingly challenging the prices charged for medical products and
services, particularly where they believe that there is only an incremental therapeutic benefit that does not justify the additional cost. If any of our products ever obtain marketing approval, coverage and reimbursement may not be available for
these products or, if available, may not be adequate. Without insurance coverage, many patients may be unable to afford our products, in which case sales of the products would be adversely affected.

There also has been a trend toward government reforms intended to contain or reduce the cost of health care. In certain foreign markets, pricing or
profitability of prescription pharmaceuticals is subject to government control. In the United States, there have been a number of federal and state proposals to implement similar government control. We expect this trend to continue, but we cannot
predict the nature or extent of any reform that results. These reforms could adversely affect our ability to obtain financing for the continued development of our proposed products or market any of our products that are successfully developed.
Furthermore, reforms could have a broader impact by limiting overall growth of health care spending, such as Medicare and Medicaid spending, which could also adversely affect our business.

Risks Related to Our Stock

Our stock price is extremely
volatile and your investment in our stock could decline in value. We may become involved in securities class action litigation.

The
market prices and trading volumes for securities of biopharmaceutical and biotechnology companies, including ours, have historically been, and will likely continue to be, highly volatile. Future events affecting our business, or that of our
competitors, may have a significant impact on our stock price. Among these events are the following:



| |  |  | product testing results from us or our competitors;
| | - |  | ---------------------------------------------------



| |  |  | technological innovations by us or our competitors;
| | - |  | ---------------------------------------------------



| |  |  | new commercial products from us or our competitors;
| | - |  | ---------------------------------------------------



| |  |  | whether and when we achieve specified development or commercialization milestones;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | regulatory developments in the United States and foreign countries;
| | - |  | -------------------------------------------------------------------



| |  |  | developments concerning proprietary rights, including patents;
| | - |  | --------------------------------------------------------------



| |  |  | regulatory actions;
| | - |  | -------------------



| |  |  | litigation;
| | - |  | -----------



| |  |  | economic and other external factors or other disasters or crises;
| | - |  | -----------------------------------------------------------------



| |  |  | period-to-period fluctuations in our financial results; and
| | - |  | -----------------------------------------------------------



| |  |  | the general performance of the equity markets and, in particular, the biotechnology sector of the equity markets.
| | - |  | -----------------------------------------------------------------------------------------------------------------

In 2005, our stock price on the Nasdaq Capital Market fluctuated from a low of $1.28 per share to a high of $3.50 per share. During the six-month period
ended June 30, 2006, our stock price fluctuated from $0.55 to $1.74 per share, with an average price of approximately $1.22. The volatility in our stock price is due to the volatility of our industry in general and does not appear to be
connected to any event specific to us.



25



---

##### Table of Contents

In the past, following periods of volatility in the market price of a particular companys
securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often extremely expensive and diverts managements attention
and resources.

We may be unable to maintain the standards for listing on the Nasdaq Capital Market, which could adversely affect the liquidity of our
common stock and could subject our common stock to the penny stock rules.

Our common stock is currently listed on the
Nasdaq Capital Market. There are several requirements that we must satisfy in order for our common stock to continue to be listed on the Nasdaq Capital Market. These requirements include, but are not limited to, maintaining a minimum per share price
of our common stock of $1.00 and a minimum level of stockholders equity of $2.5 million. On June 26, 2006, we received notification from the National Association of Securities Dealers Automated Quotations (NASDAQ) that the bid
price of our common stock had closed below the minimum $1.00 per share requirement under NASDAQ Marketplace Rule 4310(c)(4) for 30 consecutive trading days. In accordance with NASDAQ rules, we have been afforded 180 calendar days, or until
December 26, 2006, to regain compliance with the minimum bid price requirements. Compliance would be achieved by the bid price of our common stock closing at $1.00 per share or more for a minimum of 10 consecutive trading days during the 180
day period. If we are unable to regain compliance prior to December 26, 2006, NASDAQ will determine whether we meet the NASDAQ initial listing criteria, as set forth in Marketplace Rule 4310(c), except for the bid price requirement. Should we
meet the initial listing criteria, NASDAQ will notify us that we have been granted an additional 180 calendar day compliance period. Delisting from the Nasdaq Capital Market could adversely affect the liquidity and the price of our common stock and
could have a long-term adverse impact on our ability to raise future capital through a sale of our common stock.

If our common stock were
delisted, our common stock would be traded on an electronic bulletin board established for securities that are not included on NASDAQ, traded on a national securities exchange or traded in quotations published by the National Quotation Bureau, Inc.,
commonly referred to as the pink sheets. If this occurs, it could be difficult to sell our securities or obtain the same level of market information as to the price of our common stock as is currently available.

In addition, if our common stock were delisted, it would be subject to the so-called penny stock rules. The SEC has adopted regulations that
define a penny stock to be any equity security that has a market price per share of less than $5.00, subject to certain exceptions, such as any securities listed on a national securities exchange or quoted on NASDAQ. For any transaction
involving a penny stock, unless exempt, the rules impose additional sales practice requirements on broker-dealers, subject to certain exceptions.

For transactions covered by the penny stock rules, a broker-dealer must make a special suitability determination for the purchaser and must have received the purchasers written consent to the
transaction prior to the transaction. The penny stock rules also require broker-dealers to deliver monthly statements to penny stock investors disclosing recent price information for the penny stock held in the
account and information on the limited market in penny stocks. Prior to the transaction, a broker-dealer must provide a disclosure schedule relating to the penny stock market. In addition, the broker-dealer must disclose the
following:



| |  |  | commissions payable to the broker-dealer and the registered representative; and
| | - |  | -------------------------------------------------------------------------------



| |  |  | current quotations for the security as mandated by the applicable regulations.
| | - |  | ------------------------------------------------------------------------------

If our common stock were delisted and determined to be a penny stock, a broker-dealer may find it more difficult to trade our common stock and an investor may find it more difficult to acquire or dispose
of our common stock in the secondary market.



26



---

##### Table of Contents

The exercise of options and warrants and other issuances of shares will likely have a dilutive effect on our stock
price.

As of June 30, 2006, there were outstanding options to purchase an aggregate of 5,501,250 shares of our common stock at
prices ranging from $0.40 per share to $11.63 per share, of which options to purchase 2,242,125 shares were exercisable as of such date. As of June 30, 2006, there were outstanding warrants to purchase 31,319,743 shares of our common stock. Of
this total, warrants to purchase 167,166 shares of our common stock are currently exercisable at $3.22 per share, subject to adjustment under the anti-dilution provisions of the warrants. Warrants to purchase 50,000, 990,100 and 3,420,000 shares are
currently exercisable at $3.79, $5.38 and $3.15 per share, respectively. In June 2006, in connection with a registered direct offering of our common stock, we issued to institutional investors warrants to purchase 26,692,477 shares of our common
stock at an exercise price of $0.6101 per share, which are exercisable beginning on December 30, 2006. In connection with an April 2002 private placement of our common stock, we granted to the placement agent warrants to purchase 100,000 shares
of our common stock at an exercise price of $2.75 per share. As of June 30, 2006, these warrants have not yet been issued.

The
exercise of options and warrants at prices below the market price of our common stock could adversely affect the price of our common stock. Additional dilution may result from the issuance of shares of our capital stock in connection with
collaborations or manufacturing arrangements or in connection with other financing efforts.

Our certificate of incorporation and Delaware law contain
provisions that could discourage a takeover and entrench management.

Our certificate of incorporation provides our board of directors
the power to issue shares of preferred stock without stockholder approval. This preferred stock could have voting rights, including voting rights that could be superior to that of our common stock. In addition, Section 203 of the Delaware
General Corporation Law contains provisions that impose restrictions on stockholder action to acquire control of us. The effect of these provisions of our certificate of incorporation and Delaware law make it more difficult to remove management and
could discourage third parties from seeking to obtain control, even though the price at which such third parties seek to acquire our common stock is in excess of the market price for our stock.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.



27



---

##### Table of Contents

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 11, 2006, we held our Annual
Meeting of Shareholders. Proxies were solicited for the Annual Meeting pursuant to Regulation 14 of the Exchange Act. At the Annual Meeting, the shareholders elected seven directors for one-year terms, approved an amendment to our Fourth Amended and
Restated Certificate of Incorporation, approved an amendment to our 2004 Stock-Based Incentive Compensation Plan, and ratified the appointment of our independent registered public accounting firm.



| | (a) | In the election of directors, the number of shares voted was as follows:
| | --- | ------------------------------------------------------------------------



|                          |  |            |  |               
|------------------------- |  | ---------- |  | --------------
|                          |  | Votes For  |  | Votes Withheld
|John L. Armstrong, Jr.    |  | 59,881,744 |  | 1,170,298     
|R. Frank Ecock            |  | 59,746,616 |  | 1,305,426     
|Zola P. Horovitz, Ph.D.   |  | 59,317,499 |  | 1,734,543     
|Osagie O. Imasogie        |  | 60,034,347 |  | 1,017,695     
|Peter J. Savino, M.D.     |  | 59,829,120 |  | 1,222,922     
|Robert F. Shapiro         |  | 59,621,929 |  | 1,430,113     
|James B. Wyngaarden, M.D. |  | 59,497,464 |  | 1,554,578     



| | (b) | In the approval of an amendment to the Companys Fourth Amended and Restated Certificate of Incorporation to increase the number of authorized shares of the Companys
Common Stock, the number of shares voted was as follows:
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|           |  |           |  |         
|---------- |  | --------- |  | --------
|For        |  | Against   |  | Withheld
|56,045,416 |  | 4,737,324 |  | 269,302 



| | (c) | In the approval of an amendment to the Companys 2004 Stock-Based Incentive Compensation Plan to provide for an increased number of shares issuable thereunder, the number of
shares voted was as follows:
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|           |  |           |  |         
|---------- |  | --------- |  | --------
|For        |  | Against   |  | Withheld
|13,430,832 |  | 4,105,876 |  | 243,840 



| | (d) | In the ratification of the appointment of KPMG LLP as the Companys independent registered public accounting firm for the fiscal year ending December 31, 2006, the number
of shares voted was as follows:
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|           |  |         |  |         
|---------- |  | ------- |  | --------
|For        |  | Against |  | Withheld
|60,237,472 |  | 375,063 |  | 439,506 

ITEM 5. OTHER INFORMATION

None.



28



---

##### Table of Contents

ITEM 6. EXHIBITS



|     |  |                                                                                                                                                                                                                            
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Fifth Amended and Restated Certificate of Incorporation of Genaera Corporation.                                                                                                                                            
|     | 
|10.1 |  | Amended 2004 Stock-Based Incentive Compensation Plan.                                                                                                                                                                      
|     | 
|31.1 |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
|     | 
|31.2 |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
|     | 
|32.1 |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.                                                                         
|     | 
|32.2 |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.                                                                         



29



---

##### Table of Contents

SIGNATURES

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



|                     |  |                     |  |                                                     
|-------------------- |  | ------------------- |  | ----------------------------------------------------
|                     |  | GENAERA CORPORATION
|                     |  |                    
|Date: August 9, 2006 |  | By:                 |  | /s/ John A. Skolas                                  
|                     |  |                     |  | John A. Skolas                                      
|                     |  |                     |  | Executive Vice President and Chief Financial Officer
|                     |  |                     |  | (Principal Financial and Accounting Officer)        



30



---

##### Table of Contents

EXHIBIT INDEX



|            |  |                                                                                                                                                                                                                            
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                
|            | 
|3.1         |  | Fifth Amended and Restated Certificate of Incorporation of Genaera Corporation.                                                                                                                                            
|            | 
|10.1        |  | Amended 2004 Stock-Based Incentive Compensation Plan.                                                                                                                                                                      
|            | 
|31.1        |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
|            | 
|31.2        |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
|            | 
|32.1        |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.                                                                         
|            | 
|32.2        |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.