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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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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 March 31, 2003.



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



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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)



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



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 ̈



The number of outstanding shares of the Registrants
Common Stock, par value $.002 per share, on May 6, 2003 was 35,666,491.



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##### Table of Contents



GENAERA
CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2003



TABLE OF CONTENTS



|                             |  |                                                                                       |  | Page
|---------------------------- |  | ------------------------------------------------------------------------------------- |  | ----
|PART IFINANCIAL INFORMATION
|                            
|Item 1.                      |  | Financial Statements (unaudited):                                                     |  |     
|                            
|                             |  | Balance Sheets as of March 31, 2003 and December 31, 2002                             |  | 3   
|                            
|                             |  | Statements of Operations for the three-months ended March 31, 2003 and 2002           |  | 4   
|                            
|                             |  | Statements of Cash Flows for the three-months ended March 31, 2003 and 2002           |  | 5   
|                            
|                             |  | Notes to Financial Statements                                                         |  | 6   
|                            
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 11  
|                            
|Item 3.                      |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 22  
|                            
|Item 4.                      |  | Controls and Procedures                                                               |  | 23  
|                            
|PART IIOTHER INFORMATION   
|                            
|Item 1.                      |  | Legal Proceedings                                                                     |  | 24  
|                            
|Item 2.                      |  | Changes in Securities and Use of Proceeds                                             |  | 24  
|                            
|Item 3.                      |  | Defaults Upon Senior Securities                                                       |  | 24  
|                            
|Item 4.                      |  | Submission of Matters to a Vote of Security Holders                                   |  | 24  
|                            
|Item 5.                      |  | Other Information                                                                     |  | 24  
|                            
|Item 6.                      |  | Exhibits and Reports on Form 8-K                                                      |  | 24  
|                            
|SIGNATURES                   |  | 25                                                                                   
|                            
|CERTIFICATIONS               |  | 26                                                                                   



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##### Table of Contents



PART
IFINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



GENAERA CORPORATION



BALANCE SHEETS

(Amounts in thousands, except per share data)



|                                                                                                                                                                                                                                                                                                                                                      |  | March 31, 2003 |          |   | December 31, 2002 |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | -------- | - | ----------------- | -
|                                                                                                                                                                                                                                                                                                                                                      |  | (Unaudited)    |          |   |                   |  
|ASSETS                                                                                                                                                                                                                                                                                                                                                |  |                |          |   |                   |  
|Current assets:                                                                                                                                                                                                                                                                                                                                       |  |                |          |   |                   |  
|Cash and cash equivalents                                                                                                                                                                                                                                                                                                                             |  | $              | 498      |   |                   | $
|Short-term investments (NOTE 2)                                                                                                                                                                                                                                                                                                                       |  |                | 7,286    |   |                   |  
|Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                             |  |                | 364      |   |                   |  
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|Total current assets                                                                                                                                                                                                                                                                                                                                  |  |                | 8,148    |   |                   |  
|Fixed assets, net                                                                                                                                                                                                                                                                                                                                     |  |                | 1,451    |   |                   |  
|Other assets                                                                                                                                                                                                                                                                                                                                          |  |                | 64       |   |                   |  
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|Total assets                                                                                                                                                                                                                                                                                                                                          |  | $              | 9,663    |   |                   | $
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                                                                                                                                  |  |                |          |   |                   |  
|Current liabilities:                                                                                                                                                                                                                                                                                                                                  |  |                |          |   |                   |  
|Accounts payable and accrued expenses                                                                                                                                                                                                                                                                                                                 |  | $              | 1,330    |   |                   | $
|Note payable (NOTE 2)                                                                                                                                                                                                                                                                                                                                 |  |                | 2,500    |   |                   |  
|Other current liabilities                                                                                                                                                                                                                                                                                                                             |  |                | 62       |   |                   |  
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|Total current liabilities                                                                                                                                                                                                                                                                                                                             |  |                | 3,892    |   |                   |  
|Accrued development expenselong-term (NOTE 6)                                                                                                                                                                                                                                                                                                        |  |                | 1,529    |   |                   |  
|Other liabilities                                                                                                                                                                                                                                                                                                                                     |  |                | 178      |   |                   |  
|Series A redeemable convertible preferred stock (liquidation value of $1,134 and $1,117
at March 31, 2003 and December 31, 2002, respectively) (NOTE 4)                                                                                                                                                                                               |  |                | 1,134    |   |                   |  
|Commitments, contingencies and other matters (NOTE 6)                                                                                                                                                                                                                                                                                                 |  |                |          |   |                   |  
|Stockholders equity (NOTE 3):                                                                                                                                                                                                                                                                                                                        |  |                |          |   |                   |  
|Preferred stock$.001 par value per share; 9,211 shares authorized; 0.888 shares
issued and outstanding as Series A redeemable convertible preferred stock at March 31, 2003 and December 31, 2002; 10.0 shares issued and outstanding as Series B convertible preferred stock at March 31, 2003 and December 31, 2002 (liquidation value
of $10,000) |  |                |         |   |                   |  
|Common stock$.002 par value per share; 75,000 shares authorized; 35,666 shares
issued and outstanding at March 31, 2003 and December 31, 2002                                                                                                                                                                                                        |  |                | 71       |   |                   |  
|Additional paid-in capital                                                                                                                                                                                                                                                                                                                            |  |                | 187,280  |   |                   |  
|Accumulated other comprehensive incomeunrealized gain on
investments                                                                                                                                                                                                                                                                                 |  |                |         |   |                   |  
|Accumulated deficit                                                                                                                                                                                                                                                                                                                                   |  |                | (184,421 | ) |                   |  
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|Total stockholders equity                                                                                                                                                                                                                                                                                                                            |  |                | 2,930    |   |                   |  
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  
|Total liabilities and stockholders equity                                                                                                                                                                                                                                                                                                            |  | $              | 9,663    |   |                   | $
|                                                                                                                                                                                                                                                                                                                                                      |  |                |          |   |                   |  



See
accompanying notes to financial statements.



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##### Table of Contents



GENAERA CORPORATION



STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands, except per share data)



|                                                                       |  | Three Months Ended March 31, |       
|---------------------------------------------------------------------- |  | ---------------------------- | ------
|                                                                       |  | 2003                         |       
|Collaborative research agreement revenues                              |  | $                            | 487   
|Costs and expenses:                                                    |  |                              |       
|Research and development                                               |  |                              | 1,734 
|General and administrative                                             |  |                              | 327   
|                                                                       |  |                              |       
|                                                                       |  |                              | 2,061 
|                                                                       |  |                              |       
|Loss from operations                                                   |  |                              | (1,574
|Interest income                                                        |  |                              | 24    
|Interest expense                                                       |  |                              | (34   
|                                                                       |  |                              |       
|Net loss                                                               |  |                              | (1,584
|Dividends on preferred stock                                           |  |                              | 18    
|                                                                       |  |                              |       
|Net loss applicable to common stockholders                             |  | $                            | (1,602
|                                                                       |  |                              |       
|Net loss applicable to common stockholders per sharebasic and
diluted |  | $                            | (0.04 
|                                                                       |  |                              |       
|Weighted average shares outstandingbasic and diluted                  |  |                              | 35,666
|                                                                       |  |                              |       



See
accompanying notes to financial statements.



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##### Table of Contents



GENAERA CORPORATION



STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)



|                                                                            |  | Three Months Ended March 31, |       
|--------------------------------------------------------------------------- |  | ---------------------------- | ------
|                                                                            |  | 2003                         |       
|Cash Flows From Operating Activities:                                       |  |                              |       
|Net loss                                                                    |  | $                            | (1,584
|Adjustments to reconcile net loss to net cash used in operating
activities: |  |                              |       
|Depreciation and amortization                                               |  |                              | 112   
|Amortization of investment discounts/premiums                               |  |                              | (21   
|Compensation expense on option grants and equity awards                     |  |                              | 21    
|Gain on sale of fixed assets                                                |  |                              | (130  
|Changes in operating assets and liabilities:                                |  |                              |       
|Increase in prepaid expenses and other                                      |  |                              | (178  
|Increase in accounts payable and accrued expenses                           |  |                              | 28    
|Decrease in accrued development expenses                                    |  |                              |      
|Increase in other liabilities                                               |  |                              | 8     
|                                                                            |  |                              |       
|Net cash used in operating activities                                       |  |                              | (1,744
|                                                                            |  |                              |       
|Cash Flows From Investing Activities:                                       |  |                              |       
|Purchase of investments                                                     |  |                              | (5,785
|Proceeds from maturities of investments                                     |  |                              | 6,550 
|Proceeds from sale of fixed assets                                          |  |                              | 130   
|Capital expenditures                                                        |  |                              | (21   
|                                                                            |  |                              |       
|Net cash provided by investing activities                                   |  |                              | 874   
|                                                                            |  |                              |       
|Cash Flows From Financing Activities:                                       |  |                              |       
|Proceeds from exercise of stock options                                     |  |                              |      
|                                                                            |  |                              |       
|Net cash provided by financing activities                                   |  |                              |      
|                                                                            |  |                              |       
|Net decrease in cash and cash equivalents                                   |  |                              | (870  
|Cash and cash equivalents at beginning of period                            |  |                              | 1,368 
|                                                                            |  |                              |       
|Cash and cash equivalents at end of period                                  |  | $                            | 498   
|                                                                            |  |                              |       
|Supplemental Cash Flow Information:                                         |  |                              |       
|Cash paid during the period for interest                                    |  | $                            | 34    
|                                                                            |  |                              |       



See
accompanying notes to financial statements.



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##### Table of Contents

GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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NOTE 1. Basis of Presentation and Stock-Based Compensation



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, 2002 balance sheet was derived from audited financial statements, however, certain information and footnote disclosures normally
included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to SEC rules and regulations. The Company believes that the
financial statements include all adjustments of a normal and recurring nature necessary to present fairly the results of operations, financial position, changes in stockholders equity 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, 2002. There have been no material changes in accounting policies from those stated in the Companys Annual Report on Form 10-K for the year ended December 31, 2002.



The Company accounts for its fixed-plan stock options under
the intrinsic-value-based method set forth by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, (APB 25), and related interpretations including Financial Accounting Standards Board
(FASB) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB No. 25, issued in March 2000. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation, (SFAS 123) established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation. As allowed by SFAS 123, the Company has elected to continue to
apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS 123. The following table illustrates the effect on net loss applicable to common stockholders if the fair-value-based
method had been applied to all outstanding and unvested stock-based awards for the periods ended March 31, 2003 and 2002.



|                                                                                                                                                        |  | 2003 |        |   | 2002 |  
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | -
|Net loss applicable to common stockholders, as reported                                                                                                 |  | $    | (1,602 | ) |      | $
|Add: Stock-based employee compensation expense included in reported net loss applicable
to common stockholders, net of related tax effects              |  |      | 21     |   |      |  
|Deduct: Total stock-based employee compensation expense determined under
fair-value-based method for all stock-based awards, net of related tax effects |  |      | (335   | ) |      |  
|                                                                                                                                                        |  |      |        |   |      |  
|Pro forma net loss applicable to common stockholders                                                                                                    |  | $    | (1,916 | ) |      | $
|                                                                                                                                                        |  |      |        |   |      |  
|Net loss applicable to common stockholders per sharebasic and
diluted:                                                                                 |  |      |        |   |      |  
|As reported                                                                                                                                             |  | $    | (0.04  | ) |      | $
|                                                                                                                                                        |  |      |        |   |      |  
|Pro forma                                                                                                                                               |  | $    | (0.05  | ) |      | $
|                                                                                                                                                        |  |      |        |   |      |  



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##### Table of Contents

GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



---



The resulting effect on pro forma net loss applicable to common stockholders and pro
forma net loss applicable to common stockholders per share disclosed above may not be representative of the effects on a pro forma basis in future years. There were no grants made during the three month period ended March 31, 2003. The fair value of
each option grant for 2002 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:



|                                                                 |  | 2002         
|---------------------------------------------------------------- |  | -------------
|Range of risk free interest rates                                |  | 4.69%  4.71%
|Dividend yield                                                   |  | 0%           
|Volatility factor                                                |  | 110%         
|Weighted average expected life of options (in years)             |  | 7.8          
|Weighted average fair value of options granted during the period |  | $2.59        



On April
22, 2003, the FASB determined that stock-based compensation should be recognized as a cost in the financial statements and that such cost be measured according to the fair value of the stock options. The FASB has not as yet determined the
methodology for calculating fair value and plans to issue an exposure draft later this year that could become effective in 2004. The Company will continue to monitor communications on this subject from the FASB in order to determine the impact on
the Companys financial statements.



NOTE 2. Note Payable



Under the terms of its note payable, the
Company makes monthly interest-only payments at an annual rate of 5.346%, with principal due in June 2003. The Company maintained investments in debt securities with an approximate market value of $2,800,000 at the bank as collateral for the note
payable as of March 31, 2003.



NOTE 3. Stockholders
Equity



The changes in stockholders
equity from December 31, 2002 to March 31, 2003 are summarized as follows (in thousands):



|                                                       |  | Common Stock     |  | Additional |    | Accumulated Other Compre- |   |                |  |   |                     | Total Stock- | 
|------------------------------------------------------ |  | ---------------- |  | ---------- | -- | ------------------------- | - | -------------- |  | - | ------------------- | ------------ | 
|                                                       |  | Number of Shares |  | Amount     |    | Paid-in Capita            |   | hensive Income |  |   | Accumulated Deficit |              | 
|Balance at December 31, 2002                           |  | 35,666           |  | $          | 71 |                           | $ | 187,258        |  | $ | 1                   |              | 
|Compensation expense on option grants and stock awards |  |                 |  |            |   |                           |   | 22             |  |   |                    |              | 
|Dividends on preferred stock                           |  |                 |  |            |   |                           |   |               |  |   |                    |              | 
|Comprehensive loss:                                    |  |                  |  |            |    |                           |   |                |  |   |                     |              | 
|Net loss                                               |  |                 |  |            |   |                           |   |               |  |   |                    |              | 
|Carrying value adjustment                              |  |                 |  |            |   |                           |   |               |  |   | (1                  | )            | 
|                                                       |  |                  |  |            |    |                           |   |                |  |   |                     |              | 
|Total comprehensive loss                               |  |                 |  |            |   |                           |   |               |  |   |                    |              | 
|                                                       |  |                  |  |            |    |                           |   |                |  |   |                     |              | 
|Balance at March 31, 2003                              |  | 35,666           |  | $          | 71 |                           | $ | 187,280        |  | $ |                    |              | 
|                                                       |  |                  |  |            |    |                           |   |                |  |   |                     |              | 



NOTE 4. Preferred
Stock



The Companys certificate of
incorporation provides the 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 the Companys
common stock, and the board of directors has the power to determine these voting rights. As of March 31, 2003, the Companys board of directors has designated 80,000 shares of preferred stock as Series A redeemable convertible preferred stock
(the Series A Preferred Stock) and 10,000 shares of preferred stock as Series B convertible preferred stock (the Series B Preferred Stock).



In connection with an agreement with Genentech, Inc., 1,188 shares of Series A Preferred Stock were issued
during 2000 and 888 shares are outstanding as of March 31, 2003. Preferred dividends of $246,000 have been accrued as of March 31, 2003 on the Series A Preferred Stock.



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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In
connection with an agreement with MedImmune, Inc. (as described in NOTE 5. Collaboration Agreements), 10,000 shares of Series B Preferred Stock were issued in April 2001 and are outstanding as of March 31, 2003.



NOTE 5. Collaboration Agreements



In April 2001, the Company entered into a research
collaboration and licensing agreement with MedImmune to develop and commercialize therapies related to the Companys IL9 program. MedImmune is expected to fund at least $2,500,000 for research and development activities at the Company through
April 2003 (the R&D Funding), which will be recognized by the Company as revenues on a straight-line basis over the two-year period. In addition to the R&D Funding, MedImmune also will 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-month period ended March 31, 2003, the Company recognized $487,000 as
revenue related to the R&D Funding ($308,000) and external cost reimbursements ($179,000). For the three-month period ended March 31, 2002, the Company recognized $436,000 as revenue related to the R&D Funding ($308,000) and external cost
reimbursements ($128,000).



In September 2001,
the Company received a contingent award of up to $1,700,000 from an affiliate of the Cystic Fibrosis Foundation (CFF) to support early clinical evaluation of LOMUCINinvolving patients with cystic fibrosis. This award has been granted and shall be paid to the Company from time to time upon the achievement of
certain development milestones. Of this grant, $125,000 was received as of March 31, 2003 and was recorded as a long-term liability. The Company did not recognize this amount as revenue because it is refundable to the CFF upon marketing approval by
the FDA or if the Company elects not to enter Phase 3 clinical trials or to commercialize the product within two years of the satisfaction of development milestones. The CFF is also due a royalty on net sales of any resultant product up to 1% based
upon the amount of funding ultimately provided by the CFF.



NOTE 6. Commitments, Contingencies and Liquidity



Manufacturing Agreement



In January 1999 and prior, the Company entered into several agreements with Abbott Laboratories providing for the purchase of approximately $10,000,000 of bulk drug substance to be used in the manufacturing process for LOCILEXCream. As FDA approval of LOCILEXCream did not occur, the Company renegotiated this agreement with Abbott in September 1999 (the Abbott Settlement), paying Abbott
$4,200,000 at that time and receiving partial delivery of material. An additional $3,400,000 is due to Abbott and payable if the Company receives 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 present value. As a result of the Companys financing activities during
2000 and other cash inflows, $1,392,000 of this liability was payable and paid to Abbott on March 1, 2001. As a result of the Companys financing activities during 2001 and other cash inflows, $480,000 of this liability was payable and paid to
Abbott on March 1, 2002. The remaining amount of $1,529,000 due to Abbott is included in long-term liabilities as of March 31, 2003, as the Company did not receive in excess of $10.0 million of cash inflows during 2002 or the three-month period
ended March 31, 2003.



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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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 in the near-term 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. In the absence of raising additional funds or significantly reducing expenses, the Company believes it has sufficient resources
to sustain operations into 2004.



The
Companys common stock is currently listed on the Nasdaq SmallCap Market. There are several requirements that we must satisfy in order for its common stock to continue to be listed on the Nasdaq SmallCap Market. These requirements include, but
are not limited to, maintaining a minimum per share price on its common stock of one dollar. The per share price of the Companys common stock does not currently satisfy requirements to remain listed on the Nasdaq SmallCap Market. The Company
has received notification from The Nasdaq Stock Market, Inc. that its common stock will be delisted from the Nasdaq SmallCap Market unless the stock closes at or above one dollar per share for at least ten consecutive days by September 18, 2003. In
addition, in the future the Company may not comply with other listing requirements, which might result in the delisting of its common stock. Delisting from the Nasdaq SmallCap Market could also adversely affect the liquidity and the price of the
Companys common stock and could have a long-term adverse impact on its ability to raise future capital through a sale of its common stock.



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 will 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.



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GENAERA CORPORATION

NOTES TO FINANCIAL STATEMENTS



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NOTE 7. Realignments of Operations



On August 14, 2002, the Company announced that it implemented
a realignment of operations intended to focus resources on its most advanced product development programs and reduce expenses. Under the realignment plan, the Company reduced its headcount by approximately 35%, or 23 employees, primarily impacting
unsupported preclinical research programs. All of the employees affected by the workforce reduction were offered severance and outplacement support. The Company recorded a nonrecurring charge of $506,000 in 2002, of which $498,000 and $8,000 were
recorded in Research and Development Expense and General and Administrative Expense, respectively. As of March 31, 2003, the Company has paid $477,000 in cash severance and outplacement support against this accrual, leaving a remaining accrual of
$29,000 at March 31, 2003.



On November 7, 2002,
the Company announced a further realignment of operations in order to continue its cost containment efforts. Under this realignment plan, the Company reduced its headcount by approximately 32%, or 11 employees. All of the employees affected by the
workforce reduction were offered severance and outplacement support. The Company recorded a nonrecurring charge of $317,000 in 2002, of which $183,000 and $134,000 were recorded in Research and Development Expense and General and Administrative
Expense, respectively. As of March 31, 2003, the Company has paid the entire $317,000 accrued for cash severance and outplacement support.



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##### 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 under Risk Factors Related to Our Business.



We undertake no 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 U.S. Securities and Exchange Commission.



Critical Accounting Policies and Estimates



The preparation of our financial statements in conformity
with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from
those estimates. The following are critical accounting policies important to our financial condition and results of operations presented in our financial statements and require management to make judgments, assumptions and estimates that are
inherently uncertain:



Revenue Recognition



Contract revenue for research and development is recorded as
earned based on the performance requirements of the contract. Non-refundable contract fees for which no further performance obligations exist, and for which there is no continuing involvement by us, are recognized on the earlier of when the payments
are received or when collection is assured. Revenue from non-refundable upfront license fees and certain guaranteed payments where we continue involvement through development collaboration is recognized on a straight-line basis over the development
period. Revenue associated with performance milestones is recognized based upon the achievement of the milestones, as defined in the respective agreements. Revenue under R&D cost reimbursement contracts or government grants is recognized as the
related costs are incurred. Advance payments received in excess of amounts earned are classified as liabilities until earned. Payments received that are refundable also are classified as liabilities until the refund provision expires. We make an
estimate as to the appropriate deferral period for recognition of revenue on any collaborative fees received. Changes in these estimates, due to the evolution of the development program, can have a significant effect on the timing of revenue
recorded.



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Research and Development Expenses



Research and development expenses include related salaries, contractor fees, and facility costs. R&D
expenses consist of independent R&D contract costs, contract manufacturing costs and costs associated with collaborative R&D arrangements. In addition, we fund R&D at other research institutions under agreements that are generally
cancelable. R&D expenses also include external activities such as investigator-sponsored trials. All such costs are charged to R&D expense systematically as incurred, which may be measured by percentage of completion, contract milestones,
patient enrollment or the passage of time. At the initiation of certain contracts, we must make an estimate as to the duration and expected completion date of the contract, which may require a change due to accelerations, delays or other adjustments
to the contract period or work performed. Changes in these estimates could have a significant effect on the amount of R&D costs in a specific period.



Stock-Based Compensation



We account for stock-based employee compensation under the intrinsic value-based method set forth by Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Effective January 1, 1996, we adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation. Stock or other equity-based compensation for non-employees must be accounted for under the fair value-based method as required by SFAS No. 123 and Emerging Issues Task Force (EITF) 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 either the fair value of 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. A change in the fair value estimate could have a significant effect on the amount of compensation cost.



Risk Factors Related to Our Business



Any investment in shares of our common stock involves a high
degree of risk. You should carefully consider the following risk factors, together with the other information presented in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2002.



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



We maintained cash and investments of $7.8 million at March 31, 2003. At March 31, 2003, we had current liabilities of $3.9 million, long-term liabilities of $1.7 million and redeemable convertible
preferred stock of $1.1 million. We believe these resources are sufficient to meet our research and development goals and sustain operations into 2004. 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
to provide 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



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arrangements. If we raise additional capital by issuing equity or securities convertible into equity, our
stockholders may experience dilution and our share price may decline. Any debt financing may result in restrictions on spending or payment of dividends. If we engage in collaborations, we will 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.



We expect to continue to incur substantial losses in the foreseeable future and 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 March 31, 2003, we had an accumulated deficit of approximately $184.4 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 also are 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.



We may be unable to maintain the standards for
listing on the Nasdaq SmallCap 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 SmallCap Market. There are several requirements that we
must satisfy in order for our common stock to continue to be listed on the Nasdaq SmallCap Market. These requirements include, but are not limited to, maintaining a minimum per share price of our common stock of one dollar. The per share price of
our common stock does not currently satisfy requirements to remain listed on the Nasdaq SmallCap Market. We have received notification from The Nasdaq Stock Market, Inc. that our common stock will be delisted from the Nasdaq SmallCap Market unless
the stock closes at or above one dollar per share for at least ten consecutive days by September 18, 2003. In addition, in the future we may not comply with other listing requirements, which might result in the delisting of our common stock.
Delisting from the Nasdaq SmallCap Market could also 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 then
be traded on an electronic bulletin board established for securities that are not included in Nasdaq or traded on a national securities exchange or in quotations published by the National Quotation Bureau, Inc. that are commonly referred to as the
pink sheets. If this occurs, it could be more 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 Securities and Exchange Commission has adopted regulations that define a penny stock to be any equity security that has a market price of less than $5.00 per share, 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



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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.



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.



If we do not obtain required regulatory approvals, we will not be able
to commercialize any of our product candidates.



Numerous governmental authorities, including the FDA in the United States, regulate our business and activities. Federal, state and foreign government agencies impose rigorous preclinical and clinical testing and approval
requirements on our product candidates. In general, the process of obtaining government approval for pharmaceutical products is time consuming and costly.



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, such as that which occurred for LOCILEXCream, 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 enter into marketing and distribution arrangements with third parties. We also



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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 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. For example, GlaxoSmithKline, a current
collaborative partner, which entered into an agreement with us relating to the development of LOCILEXCream,
maintains a significant presence in the antibiotic area and currently sells a topical antibiotic product indicated for the treatment of certain skin infections. In addition, a collaborator may decide to end a relationship with us. For example, in
December 2000, Genentech provided notice to us of its election to terminate the collaboration agreement covering the IL9 antibody development program and related respiratory technology.



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 our competitors.



We face formidable
competition with respect to the products we are seeking to develop and the recruitment of highly trained personnel.



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. 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 research on compounds derived from animal host-defense systems is being conducted by others. We also may face competition from companies using different or advanced techniques that
could render our future products obsolete. Most of these entities have substantially greater financial, technical, manufacturing, marketing, distribution and other resources than we have.



Many companies are working to develop and market products intended for the additional disease areas being
targeted by us, including cancer, age-related macular degeneration (AMD) and chronic obstructive 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 cancer and AMD, anti-angiogenic agents are under development at a number of companies. In the respiratory field, other biopharmaceutical companies also have reported the discovery of genes relating
to asthma and other respiratory diseases.



Many
of the companies developing or marketing competing products have significantly more experience than we 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. Accordingly, we must continue to



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devote substantial resources
and efforts to research and development activities in order to maintain a competitive position in this field. Our efforts may not be successful.



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. In addition, these institutions, along with pharmaceutical and
specialized biotechnology companies, can be expected to compete with us in recruiting highly qualified scientific personnel.



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 manufacture 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 also may 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 and, 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 likely would 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 because U.S. patent applications are maintained in secrecy by the U.S. Patent and Trademark Office until a patent



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issues, and publications in
the scientific or patent literature concerning new technologies occur some time after actual discoveries of the technologies are made.



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;
| | - |  | ---------------------------------------------------------------------



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



| |  |  | an adverse outcome in a suit challenging our patents would not subject us to significant liabilities to third parties, require rights to be licensed from third
parties, or require us to cease using such technology.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Other Intellectual Property



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 will be 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 pay royalties on sales of any products that are covered by patent claims. If we are unable to pay the royalties, we may lose our patent rights. Additionally,
some of these agreements also require that we develop the licensed technology under certain timelines. 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 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 and were resolved. However, we may not prevail in any such disputes.



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. 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.



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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 liability.
| | - |  | ---------------------------------------------------------------



While we carry insurance, this coverage is expensive and we may be unable to maintain adequate coverage on
acceptable terms.



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.



The FDA has deemed our NDA for LOCILEXCream to be not approvable, and the product may never be approved.



In July 1999, we received notification from the FDA that our NDA for LOCILEXCream had been deemed not approvable. LOCILEXCream, a topical cream antibiotic for the treatment of infection in diabetic foot ulcers, had been our lead product development candidate. As a result of the FDAs decision, near-term
commercialization of LOCILEXCream will not occur, and we will generate no revenues from LOCILEXCream in the near future, if ever.



In order to again seek approval of LOCILEXCream, the FDA has indicated that we must conduct further development activities, including clinical and manufacturing activities. As a result of
its review of manufacturing of the cream product, the FDA issued certain observations of deficiencies in compliance with their current good manufacturing procedures regulations. The Company will need to initiate new manufacturing relationships to
conduct further development activities. Any additional manufacturing batches of the active ingredient and cream product that must be manufactured must meet strict product specifications in compliance with FDA determined current GMPs. The time
required to conduct such further clinical and manufacturing development efforts may be lengthy and costly, and the results may ultimately prove unsuccessful.



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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;
| | - |  | ---------------------------------------------------



| |  |  | regulatory developments in the Untied 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 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.



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



As of March 31, 2003, there were outstanding options to purchase an aggregate of approximately 3,981,000 shares of our common stock at
prices ranging from $0.40 per share to $16.75 per share, of which options to purchase approximately 2,393,000 shares were exercisable as of such date. As of March 31, 2003, there were outstanding warrants to purchase 217,166 shares of our common
stock, of which warrants to purchase 167,166 shares of our common stock are currently exercisable at $3.50 per share and warrants to purchase 50,000 shares are currently exercisable at $3.79 per share, all subject to adjustment under the
anti-dilution provisions of the warrants. 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 March 31, 2003, 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.



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 Genaera. The effect of these provisions of our certificate of incorporation and Delaware law provisions 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.



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If our stockholders
approve a reverse stock split of our common stock at our upcoming annual meeting and our Board of Directors effects the reverse stock split, there can be no assurance that the total market capitalization of our common stock (the aggregate value of
all our common stock at the then market price) after the proposed reverse stock split will be equal to or greater than the total market capitalization before the proposed reverse stock split or that the per share market price of our common stock
following the reverse stock split will either equal or exceed the current per share market price.



There can be no assurance that the market price per new share of our common stock after the reverse stock split will remain unchanged or
increase in proportion to the reduction in the number of old shares of our common stock outstanding before the reverse stock split. For example, based on the last reported bid price of our common stock on March 31, 2003 of $0.61 per share, if the
Board of Directors decided to implement the reverse stock split and selects a reverse stock split ratio of one-for-five, there can be no assurance that the post-split market price of our common stock would be $3.05 per share or greater. Accordingly,
the total market capitalization of our common stock after the proposed reverse stock split may be lower than the total market capitalization before the proposed reverse stock split and, in the future, the market price of our common stock following
the reverse stock split may not exceed or remain higher than the market price prior to the proposed reverse stock split.



If our stockholders approve a reverse stock split of our common stock at our upcoming annual meeting and our Board of Directors effects the reverse
stock split, the resulting per-share stock price may not attract institutional investors or investment funds and may not satisfy the investing guidelines of such investors and, consequently, the trading liquidity of our common stock may not improve.



While the Board of Directors believes
that a higher stock price may help generate investor interest, there can be no assurance that the reverse stock split will result in a per-share price that will attract institutional investors or investment funds or that such share price will
satisfy the investing guidelines of institutional investors or investment funds. As a result, the trading liquidity of our common stock may not necessarily improve.



If our stockholders approve a reverse stock split of our common stock at our upcoming annual meeting and our Board of
Directors effects the reverse stock split, a decline in the market price of our common stock after the reverse stock split may result in a greater percentage decline than would occur in the absence of a reverse stock split, and the liquidity of our
common stock could be adversely affected following such a reverse stock split.



If the reverse stock split is effected and the market price of our common stock declines, the percentage decline may be greater than would occur in the absence of a reverse stock split. The market
price of our common stock will, however, also be based on our performance and other factors, which are unrelated to the number of shares outstanding. Furthermore, the liquidity of our common stock could be adversely affected by the reduced number of
shares that would be outstanding after the reverse stock split.



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Results of Operations



Revenues



We have received no revenues to date from product sales. Our
revenues 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 is expected to fund at least $2.5 million for our research and development activities, payable in eight equal quarterly installments, plus external cost reimbursement for our research and development activities through
April 2003. For the three-month periods ended March 31, 2003 and 2002, we recognized $487,000 and $436,000, respectively, in revenue related to this agreement, of which $179,000 and $128,000, respectively, related to external cost reimbursements.



Research and Development Expenses



We recognized research and development expenses of $1.7
million and $3.7 million for the three-month periods ended March 31, 2003 and 2002, respectively. Research and development expenses consist principally of personnel costs, contract research, development and manufacturing costs and facility costs.
Research and development expenses decreased for the three-month period ended March 31, 2003, as compared to the same period in 2002, due to reduced manufacturing and development efforts, as well as reduced continuing payroll and related costs
associated with the realignments of operations in August and November of 2002. 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.



General and Administrative Expenses



We recognized general and administrative
expenses of $327,000 and $875,000 for the three-month periods ended March 31, 2003 and 2002, respectively. General and administrative expenses consist principally of personnel costs, professional fees and public company expenses. General and
administrative expenses decreased for the three-month period ended March 31, 2003, as compared to the same period in 2002, due principally to decreases in personnel related to general corporate and business development activities.



Other Income and Expense



We recognized interest income of $24,000 and $82,000 for the
three-month periods ended March 31, 2003 and 2002, respectively. We recognized interest expense of $34,000 and $43,000 for the three-month periods ended March 31, 2003 and 2002, respectively. Interest income is primarily comprised of income
generated from cash and investments. Interest expense is primarily comprised of expense related to our indebtedness to a bank. Interest income for the three-month period ended March 31, 2003 decreased, as compared to the same period in 2002, due to
declining investment interest yields and lower average investment balances. Interest expense for the three-month period ended March 31, 2003 decreased, as compared to the same period in 2002, due to the decline in the interest rate on our
indebtedness.



Financial Condition, Liquidity and Capital
Resources



Cash and short-term investments
were $7.8 million at March 31, 2003 as compared to $9.4 million at December 31, 2002. The primary use of cash was to finance our research and development operations.



Current liabilities were $3.9 million at March 31, 2003 and December 31, 2002. Under the terms of our $2.5
million note payable, we make monthly interest-only payments at an annual rate of 5.346%, with principal due in June 2003. We maintain investments of approximately $2.8 million as collateral for the note payable. Long-term liabilities include $1.5
million due to Abbott Laboratories under our agreement with



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them, as well as, $125,000
received as a contingent award from the Cystic Fibrosis Foundation.



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 March 31, 2003.



In the
absence of raising additional funds or significantly reducing expenses, we have sufficient resources to sustain operations into 2004. 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 such 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 and collaborative arrangements with third parties. 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 will 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.



Contractual Cash Obligations



The table below sets forth our contractual cash obligations at March 31, 2003 (in thousands):



|                                                        |  |       |       | Cash Payments Due by Period
|------------------------------------------------------- |  | ----- | ----- | ---------------------------
|Contractual Cash Obligations                            |  | Total |       | Less than 1 year           
|Bank debt1                                              |  | $     | 2,500 |                            
|Abbott settlement2                                      |  |       | 1,529 |                            
|Operating lease on building3                            |  |       | 1,884 |                            
|Operating leases and maintenance contracts on equipment |  |       | 472   |                            
|Clinical trial contracts                                |  |       | 658   |                            
|Research and development contracts                      |  |       | 241   |                            
|Manufacturing contracts                                 |  |       | 18    |                            
|                                                        |  |       |       |                            
|Total contractual cash obligations                      |  | $     | 7,302 |                            
|                                                        |  |       |       |                            

---

|1 |  | We maintain cash and investments of approximately $2.8 million as collateral for this obligation.
|- |  | -------------------------------------------------------------------------------------------------



|2 |  | Payable if we receive in excess of $10 million of additional funds in any year beginning in
2000, in which case 15% of such excess over $10 million shall be payable to Abbott.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3 |  | The lease provides for escalations relating to increases in the Consumer Price Index not to exceed 7% but no less than 3.5% beginning in December 2002. We have
assumed a minimum lease payment escalation of 3.5% for the purposes of this table.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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 invest in only U.S. government
debt instruments that meet high quality credit standards, as specified in our investment policy. The policy also limits the amount of credit exposure we may have to any one issue, issuer or type of investment.



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As of March
31, 2003, our portfolio investments consisted of $0.5 million in cash and $7.3 million in U.S government 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 three-month period
ended March 31, 2003 would have decreased by approximately $20,000. This estimate assumes that the decrease occurred on the first day of 2003 and reduced the annualized yield of each investment instrument by 100 basis points. Correspondingly, if the
average annualized yield of our investments had increased by 100 basis points, our interest income for the three-month period ended March 31, 2003 would have increased by $20,000. This estimate assumes that the increase occurred on the first day of
2003 and increased 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



(a) Evaluation of disclosure controls and procedures: For the quarterly period ended March 31, 2003, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief
Executive Officer and our Senior 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-14 and
15d-14 under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based upon this evaluation, our President and Chief Executive Officer and our Senior Vice President and Chief Financial Officer concluded that, as of March
31, 2003, our disclosure controls and procedures were adequate to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the rules and forms of the Securities and Exchange Commission.



(b) Changes in internal controls: Our President and Chief Executive Officer and our Senior Vice President and Chief Financial Officer determined that there were no significant changes in our internal
controls or other factors that could significantly affect those controls subsequent to the date of their evaluation.



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PART IIOTHER
INFORMATION



ITEM 1. LEGAL PROCEEDINGS



We are not a party to any material litigation.



ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS



None.



ITEM 3. DEFAULTS UPON SENIOR SECURITIES



None.



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



None.



ITEM 5. OTHER INFORMATION



None.



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



(a) Exhibits



| | 99.1 |  | * 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
| | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| | 99.2 |  | * 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
| | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------






| | * |  | Filed herewith.
| | - |  | ---------------



(b) Reports on Form 8-K



We filed a Current Report on Form 8-K on January 28, 2003 incorporating a press release regarding our ending of enrollment in our
squalamine clinical trial for lung cancer.



We
filed a Current Report on Form 8-K on March 26, 2003 incorporating a press release regarding our receipt of a letter from The Nasdaq Stock Market, Inc. granting us an additional 180-day grace period to demonstrate compliance with the $1.00 minimum
bid price per share requirement in accordance with Marketplace Rule 4310(c)(8)(D).



We filed a Current Report on Form 8-K on March 31, 2003 incorporating a press release regarding our 2002 financial results.



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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:May 8, 2003 |  |  |  | By:                
|                 |  |  |  |                    



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CERTIFICATION



I, Roy C. Levitt, M.D.,
certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Genaera Corporation;
|-- |  | --------------------------------------------------------------------------



|2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and have:
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the audit committee
of registrants board of directors (or persons performing the equivalent function):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process, summarize
and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Date: May 8, 2003 |  |  |  |  |  | /s/    ROY C.
LEVITT
|----------------- |  |  |  |  |  | --------------------
|                  |  |  |  |  |  |                     



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CERTIFICATION



I, Christopher P.
Schnittker, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Genaera Corporation;
|-- |  | --------------------------------------------------------------------------



|2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and have:
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report
(the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation
Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the audit committee
of registrants board of directors (or persons performing the equivalent function):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process, summarize
and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



|6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Date: May 8, 2003 |  |  |  |  |  | /s/    CHRISTOPHER P.
SCHNITTKER
|----------------- |  |  |  |  |  | --------------------------------
|                  |  |  |  |  |  |                                 



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EXHIBIT
INDEX



|Exhibit No. |  | Description                                                                                                                                      
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|99.1        |  | 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
|           
|99.2        |  | 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