** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**
| **ý** | ** ** | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                    |
|------------|------------|----------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                           |
| ** ** | ** ** | **For  Quarterly Period Ended March 31, 2006**                                                                  |
| ** ** | ** ** | ** **                                                                                                           |
|       | ** ** | **Or**                                                                                                               |
|       |       |                                                                                                                 |
| **o**      | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15 (d) OF THE  SECURITIES EXCHANGE ACT OF****1934**         |
| ** ** | ** ** | ** **                                                                                                           |
| ** ** | ** ** | **For the  transition period  from             to** |
| ** ** | ** ** | ** **                                                                                                           |
| ** ** | ** ** | **Commission  file number 33-90516**                                                                                 |

 

**NEOPHARM, INC.**

(Exact name of Registrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **51-0327886**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                             |       |                                     |
|                                                             |       |                                     |
| **1850  Lakeside Drive  Waukegan, Illinois 60085**               |
| (Address of  principal executive offices) (Zip Code)             |
|                                                             | ** ** | ** **                               |
|                                                             | ** ** | ** **                               |
| **(847)  887-0800**                                              |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý   No o

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

Large accelerated filer o                       Accelerated filer x            Non-accelerated filer o

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

As of April 28, 2006, the number of shares outstanding of each ofthe issuer’s classes of common stock was as follows:
| Title  of each class                | ** ** | **Number of shares outstanding** |
|-------------------------------------|------------|----------------------------------|
| Common Stock  ($.0002145 par value) |       | 27,783,001                       |

 

 

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NEOPHARM, INC.

FORM 10-QINDEX
| PART I. FINANCIAL  INFORMATION |
|-------------------------------------|
| Item  1.                            |   | Financial  Statements |
|                                |   | Condensed Consolidated Balance Sheets as of  March 31, 2006 (unaudited) and December 31, 2005 |
|                                |   | Condensed Consolidated Statements of Operations for  the three months ended March 31, 2006 and 2005 (unaudited) |
|                                |   | Condensed Consolidated Statements of Cash Flows for  the three months ended March 31, 2006 and 2005 (unaudited) |
|                                |   | Notes to Condensed Consolidated Financial Statements  (unaudited) |
| Item 2.                             |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |
| Item 3.                             |   | Quantitative and Qualitative Disclosures About Market  Risk |
| Item  4.                            |   | Controls  and Procedures |
| PART II. OTHER INFORMATION     |
| Item  1.                            |   | Legal Proceedings |
| Item  1A.                           |   | Risk Factors |
| Item 2.                             |   | Unregistered Sales of Equity Securities and Use of  Proceeds |
| Item 3.                             |   | Defaults Upon Senior Securities |
| Item 4.                             |   | Submission of Matters to a Vote of Security Holders |
| Item  5.                            |   | Other Information |
| Item 6.                             |   | Exhibits |
| SIGNATURE PAGE                      |

 

2

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**PART I - FINANCIAL INFORMATION**

**Item 1 - Financial Statements**

**NEOPHARM,INC.Condensed Consolidated Balance Sheets**
| ** **                                                                                                                                | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                | ** ** | **(Unaudited)**              | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                |       |                         |       |                            |       |
| Current assets:                                                                                                                           |       |                         |       |                            |       |
| Cash and cash equivalents                                                                                                                 |       | $                            | 6,283,879  |                            | $          | 1,486,172 |   |
| Short-term investments                                                                                                                    |       | 53,473,297                   |       | 28,776,020                      |       |
| Trade accounts receivable, net                                                                                                            |       | 1,735                        |       | 1,285                           |       |
| Inventories                                                                                                                               |       | 5,607                        |       | 5,677                           |       |
| Prepaid expenses                                                                                                                          |       | 619,902                      |       | 727,432                         |       |
| Other receivables                                                                                                                         |       | —                       |       | 155                             |       |
| Total current assets                                                                                                                      |       | 60,384,420                   |       | 30,996,741                      |       |
| Fixed assets,  net                                                                                                                        |       | 2,013,290                    |       | 2,157,507                       |       |
| Other assets                                                                                                                              |       | 217,250                      |       | 215,737                         |       |
| Total assets                                                                                                                              |       | $                            | 62,614,960 |                            | $          | 33,369,985 |   |
|                                                                                                                                      |       |                         |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                            |       |                         |       |                            |       |
| Current liabilities:                                                                                                                      |       |                         |       |                            |       |
| Obligations under capital lease                                                                                                           |       | $                            | 28,489     |                            | $          | — |   |
| Accounts payable                                                                                                                          |       | 457,103                      |       | 683,168                         |       |
| Accrued clinical trial expense                                                                                                            |       | 4,941,861                    |       | 5,369,507                       |       |
| Accrued compensation                                                                                                                      |       | 1,062,596                    |       | 1,888,534                       |       |
| Other accrued expenses                                                                                                                    |       | 918,791                      |       | 1,447,265                       |       |
| Derivative financial instruments                                                                                                          |       | 262,614                      |       | —                          |       |
| Deferred and unearned revenue                                                                                                             |       | 1,170                        |       | —                          |       |
| Total current liabilities                                                                                                                 |       | 7,672,624                    |       | 9,388,474                       |       |
|                                                                                                                                      |       |                         |       |                            |       |
| Obligations  under capital lease                                                                                                          |       | 128,035                      |       | —                          |       |
| Deferred revenue                                                                                                                          |       | 2,000,000                    |       | 2,000,000                       |       |
| Deferred rent                                                                                                                             |       | 50,768                       |       | 36,187                          |       |
| Derivative  financial instruments                                                                                                         |       | 845,969                      |       | —                          |       |
|                                                                                                                                      |       |                         |       |                            |       |
| Stockholders’ equity:                                                                                                                |       |                         |       |                            |       |
| Preferred stock,  $0.01 par value; 15,000,000 shares authorized: none issued and outstanding                                              |       | —                       |       | —                          |       |
| Common stock,  $0.0002145 par value; 50,000,000 shares authorized: 27,765,051 and 23,740,051  shares issued and outstanding, respectively |       | 5,956                        |       | 5,092                           |       |
| Additional  paid-in capital                                                                                                               |       | 287,615,287                  |       | 249,964,947                     |       |
| Accumulated  deficit                                                                                                                      |       | (235,703,679                 | )          | (228,024,715                    | )          |
| Total stockholders’ equity                                                                                                           |       | 51,917,564                   |       | 21,945,324                      |       |
| Total  liabilities and stockholders’ equity                                                                                          |       | $                            | 62,614,960 |                            | $          | 33,369,985 |   |

 

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

3

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**NEOPHARM, INC.**

**Condensed Consolidated Statements of OperationsThree Months Ended March 31, 2006 and 2005**(Unaudited)
| ** **                                                | ** ** | **Three-Month Periods Ended** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                | ** ** | **March 31, 2006**            | ** ** | **March 31, 2005** | ** ** |
| Collaboration  revenue                                    |       | $                                       | —     |   | $ | 65,000 |   |
| Product revenue                                           |       | 1,610                                   |       | 6,300 |   |
| Total revenue                                             |       | 1,610                                   |       | 71,300 |   |
|                                                      |       |                                    |       |   |   |
| Expenses:                                                 |       |                                    |       |   |   |
| Cost of product revenue                                   |       | 70                                      |       | 290 |   |
| Research and development                                  |       | 5,843,761                               |       | 8,073,761 |   |
| Selling, general, and administrative                      |       | 3,045,558                               |       | 3,233,309 |   |
| Change in fair value of derivative financial  instruments |       | (543,128                                | )          | — |   |
| Total expenses                                            |       | 8,346,261                               |       | 11,307,360 |   |
| Loss from  operations                                     |       | (8,344,651                              | )          | (11,236,060 | ) |
|                                                      |       |                                    |       |   |   |
| Interest income,  net                                     |       | 665,687                                 |       | 371,787 |   |
| Net loss                                                  |       | $                                       | (7,678,964 | ) | $ | (10,864,273 | ) |
| Net loss per share —                                 |       |                                    |       |   |   |
| Basic and diluted                                         |       | $                                       | (0.28      | ) | $ | (0.46 | ) |
| Weighted average shares  outstanding —               |       |                                    |       |   |   |
| Basic and  diluted                                        |       | 27,317,829                              |       | 23,469,462 |   |

 

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

4

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**NEOPHARM, INC.**

**Condensed Consolidated Statements of Cash FlowsThree Months Ended March 31, 2006 and 2005**(Unaudited)
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (7,678,964 | ) | $ | (10,864,273 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                             |       |   |   |
| Depreciation and  amortization                                               |       | 334,472                          |       | 333,764 |   |
| Stock-based  compensation expense                                            |       | 571,529                          |       | 152,719 |   |
| Change in fair  value of derivative financial instruments                    |       | (543,128                         | )          | — |   |
| (Gain)/loss on  retirement of equipment and furniture                        |       | (511                             | )          | 6,773 |   |
| Changes in  assets and liabilities:                                          |       |                             |       |   |   |
| Decrease in current assets                                                   |       | 60,028                           |       | 352,809 |   |
| Increase in other assets                                                     |       | (1,513                           | )          | — |   |
| Decrease in other current liabilities                                        |       | (2,008,123                       | )          | (1,201,256 | ) |
| Increase in deferred and unearned revenue                                    |       | 1,170                            |       | 1,840,495 |   |
| Increase in deferred rent                                                    |       | 14,581                           |       | — |   |
| Net cash and  cash equivalents used in operating activities                  |       | (9,250,459                       | )          | (9,378,969 | ) |
|                                                                         |       |                             |       |   |   |
| Cash flows from  investing activities:                                       |       |                             |       |   |   |
| Proceeds from  sales of marketable securities                                |       | 16,150,000                       |       | 11,500,000 |   |
| Purchase of  marketable securities                                           |       | (40,800,000                      | )          | (54,050,000 | ) |
| Purchase of  equipment and furniture                                         |       | (28,649                          | )          | (7,319 | ) |
|                                                                         |       |                             |       |   |   |
| Net cash and  cash equivalents used in investing activities                  |       | (24,678,649                      | )          | (42,557,319 | ) |
|                                                                         |       |                             |       |   |   |
| Cash flows from  financing activities:                                       |       |                             |       |   |   |
| Proceeds from  issuance of common stock                                      |       | 38,731,386                       |       | — |   |
| Proceeds from  exercise of stock options                                     |       | —                           |       | 644,461 |   |
| Repayment of  capital lease obligation                                       |       | (4,571                           | )          | — |   |
| Net cash and  cash equivalents provided by financing activities              |       | 38,726,815                       |       | 644,461 |   |
|                                                                         |       |                             |       |   |   |
| Net increase  /(decrease) in cash and cash equivalents                       |       | 4,797,707                        |       | (51,291,827 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 1,486,172                        |       | 52,736,320 |   |
| Cash and cash  equivalents, end of period                                    |       | $                                | 6,283,879  |   | $ | 1,444,493 |   |
|                                                                         |       |                             |       |   |   |
| Supplemental  disclosure of cash paid for:                                   |       |                             |       |   |   |
| Interest                                                                     |       | $                                | —     |   | $ | — |   |
| Income taxes                                                                 |       | $                                | —     |   | $ | — |   |

 

Supplementalschedule of non-cash investing and financing activities:

During the threemonths ended March 31, 2006, the Company entered into a capital leaseobligation for office equipment of $161,095.

During the threemonths ended March 31, 2005, the Company issued 23,692 shares of theCompany’s common stock in satisfaction of a liability in the amount of$188,353.

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

5

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**NEOPHARM, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS****(unaudited)**

**Note 1  Basis of Presentation**

The financialinformation herein is unaudited. The balance sheet as of December 31, 2005is derived from audited financial statements.

The accompanyingunaudited condensed consolidated financial statements of NeoPharm, Inc.and subsidiary (the “Company”) have been prepared in accordance with U.S.generally accepted accounting principles (“GAAP”) for interim financialinformation and with the instructions to Form 10-Q and Rule 10-01of Regulation S-X. Accordingly, they do not contain all of the information andnotes required by U.S. GAAP for complete financial statements. In the opinionof the Company, the accompanying unaudited condensed consolidated interimfinancial statements contain all adjustments (consisting of normal recurringadjustments) necessary to present fairly the Company’s financial position as ofMarch 31, 2006 and the results of their operations and their cash flowsfor the three months ended March 31, 2006 and 2005. The results ofoperations for the three months ended March 31, 2006 are not necessarilyindicative of operating results for fiscal 2006 or future interim periods.

The unauditedcondensed consolidated financial statements include the accounts of NeoPharm, Inc.and its wholly owned subsidiary, NeoPharm EU Limited. NeoPharm EU Limited wascreated in 2004 to comply with regulatory requirements enacted for clinicaltrials conducted in the European Union. This subsidiary has nominal assets andhad not conducted any business. All significant intercompany accounts andtransactions are eliminated in consolidation.

While the Companybelieves that the disclosures presented are adequate to make the informationnot misleading, it is suggested that these financial statements be read inconjunction with the consolidated financial statements and notes included inthe Company’s 2005 Annual Report on Form 10-K filed with theSecurities and Exchange Commission (“SEC”).

The preparation offinancial statements in conformity with U.S. GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amounts of revenue andexpense during the reporting period. Actual results could differ from thoseestimates.

Certain amounts in2005 have been reclassified to conform to the current year presentation. Inparticular, the Company classifies investments in auction rate certificates asshort-term investments, which had previously been classified as a cashequivalent. This reclassification affected the classification of cash flowsfrom investing activities on the Condensed Consolidated Statement of Cash Flowsfor the three months ended March 31, 2005 which reflects purchases ofmarketable securities of $54,050,000 and proceeds from sales of marketablesecurities of 11,500,000, related to the auction rate certificates.

The Companyadopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires therecognition of compensation expense related to the fair value of the Company’sstock-based compensation awards effective January 1, 2006. Prior to theadoption of SFAS 123R, the Company accounted for stock-based awards todirectors, officers, and employees using the intrinsic value method inaccordance with Accounting Principles Board Opinion No. 25 (“APB 25”) asallowed under Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method,compensation expense is measured on the date of grant if the current marketprice of the underlying stock exceeded the exercise price or when the number ofshares and exercise price are known if both are not determinable at the date ofgrant. Compensation expense for fixed stock options is recognized ratably overthe vesting period. SFAS 123 established accounting and disclosure requirementsusing a fair value method of accounting for stock-based employee compensationplans. As allowed by SFAS 123, the Company elected to apply the intrinsic valuemethod of accounting described above, and only adopted the disclosurerequirements of SFAS 123.

The Companyadopted SFAS No. 123R using the modified prospective method. Under thistransition method, compensation expense recognized in the 2006 condensedconsolidated statement of operations includes: a) compensation expense for the fair value of the remaining portion ofthe requisite service period for all share-based awards granted prior to, butnot vested as of January 1, 2006, and b) compensation expense for the fairvalue for all share-based awards granted or modified subsequent to January 1,2006. In conjunction with the adoption of SFAS No. 123R, the Company hasadopted a policy of recognizing compensation expense on a straight-line basis. Underthe pro forma disclosure requirements of SFAS No. 123, in prior periods,the Company recognized expense on a straight-line basis and considered theeffect of forfeitures in the period an award was cancelled.

In February 2006,the FASB issued SFAS No. 155, Accounting for Certain Hybrid FinancialInstruments-an amendment of FASB Statements No. 133 and 140, to simplifyand make more consistent the accounting for certain financial instruments. SFASNo. 155 applies to all financial instruments acquired or issued after thebeginning of an entity’s first fiscal year that begins after September 15,2006 with earlier application allowed. The adoption of SFAS No. 155 is notexpected to have a material impact on the 

6

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Company’s consolidatedfinancial condition or results of operations.

**Note 2  Loss Per Share**

Thefollowing table sets forth the computation of basic and diluted net loss pershare:

|                                      | ** ** | **Three months ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| Numerator:                           |       |                             |       |   |   |
| Net loss                             |       | $                                | (7,678,964 | ) | $ | (10,864,273 | ) |
|                                 |       |                             |       |   |   |
| Denominator:                         |       |                             |       |   |   |
| Weighted average shares outstanding  |       | 27,317,829                       |       | 23,469,462 |   |
|                                 |       |                             |       |   |   |
| Loss per share -  basic and diluted  |       | $                                | (0.28      | ) | $ | (0.46 | ) |
|                                 |       |                             |       |   |   |
| Potential common share  equivalents: |       |                             |       |   |   |
| Stock options                        |       | 4,094,857                        |       | 3,572,677 |   |

 

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

**Note 3  Stock-based Compensation**

The Companycurrently has a share-based payment plan in place, which is described below. Amountsrecognized in the condensed consolidated financial statements with respect tothis plan are as follows:

|                                                             | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
|                                                        |       |                             |       |   |   |
| Research and  development                                   |       | $                                | 167,187    |   | $ | — |   |
| General and  administrative                                 |       | 404,342                          |       | 152,719 |   |
|                                                        |       |                             |       |   |   |
| Total cost of  share-based payment plans  during the period |       | $                                | 571,529    |   | $ | 152,719 |   |

 

No amounts of share-basedcompensation cost have been capitalized into inventory or other assets duringthe quarters ended March 31, 2006 or 2005.

Prior to theadoption of SFAS No. 123R, the Company applied the intrinsic-value methodof accounting for share-based compensation. The following table illustrates theeffect on net loss if the fair-value method of accounting, as prescribed bySFAS No. 123, had been applied:

|                                                                                                                  | ** ** | **Three months ended** | ** **  |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                                                                       | ** ** | **March 31, 2005**     | ** **  |
| Net loss as  reported                                                                                            |       | $                                | (10,864,273 | ) |
|                                                                                                             |       |                             |        |
| Add: stock-based  employee compensation  expense included in reported net loss (1)                               |       | 152,719                          |        |
|                                                                                                             |       |                             |        |
| Less: total  stock-based employee compensation  expense determined under fair value based  method for all awards |       | (178,341                         | )           |
|                                                                                                             |       |                             |        |
| Pro forma net  loss                                                                                              |       | $                                | (10,889,895 | ) |
|                                                                                                             |       |                             |        |
| Basic and diluted loss  per common share                                                                         |       |                             |        |
| As reported                                                                                                      |       | $                                | (0.46       | ) |
| Pro forma                                                                                                        |       | $                                | (0.46       | ) |

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(1)               Value of restrictedstock granted to non-employee directors and compensation expense relating tooptions granted to an executive at 85% of fair value.

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The Companymaintains the 1998 Equity Incentive Plan (Option Plan), which replaced allprior equity incentive plans. The Option Plan, provides for the grant of awards(options, nonvested stock, performance units or performance shares) toemployees, directors, and consultants to acquire up to 4,600,000 shares of theCompany’s common stock. Option awards are generally granted with an exerciseprice equal to the market price of the Company’s common stock at the date ofgrant, but may be granted with an exercise price less than 85% of the fairmarket value of the Company’s common stock. Option awards typically vest basedupon continuous service in increments of 25% of the total grant on the firstfour anniversaries of the original grant and are exercisable as the optionsvest, subject to the Company’s policies in effect from time to time concerningtransactions by employees in the Company’s securities. Option awards typicallyhave 10 year contractual terms. Nonvested stock awards are granted tonon-employee directors of the Company and typically vest after a service periodof 1 year. Option and nonvested stock awards provide for accelerated vesting ifthere is a change in control (as defined in the Option Plan). Although theOption Plan provides for the grant of performance units and performance shares,the Company has not made grants of these types of awards. As of March 31,2006, approximately 345,323 shares were available for issuance under the OptionPlan.

The following is a summary of activity relating tooption awards to employees and non-employee directors during the three monthsended March 31, 2006:
|                                                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding - beginning of year                                   |       | 3,571,132  |       | $                                      | 13.07      |                                                |       |                                |       |   |
| Granted                                                           |       | 297,400    |       | $                                      | 12.31      |                                                |       |                                |       |   |
| Exercised                                                         |       | —     |       |                                   |       |                                                |       |                                |       |
| Forfeited/expired/cancelled                                       |       | (7,700     | )          | $                                      | 12.20      |                                                |       |                                |       |   |
| Outstanding -  end of period                                      |       | 3,860,832  |       | $                                      | 13.02      |                                                | 4.77       |                                | $          | 1,299,548 |   |
|                                                              |       |       |       |                                   |       |                                                |       |                                |       |
| Exercisable -  end of period                                      |       | 2,701,707  |       | $                                      | 14.50      |                                                | 3.06       |                                | $          | 1,159,564 |   |
|                                                              |       |       |       |                                   |       |                                                |       |                                |       |
| Weighted-average fair  value of options granted during the period |       |       |       | $                                      | 8.02       |                                                |       |                                |       |   |

 

There were no optionawards exercised during the three months ended March 31, 2006.

Asof March 31, 2006, the Company expects to recognize approximately $6.3million of unrecognized compensation cost related to stock options over aweighted-average period of 2.3 years.

Duringthe three months ended March 31, 2005, the Company granted 80,000 optionswith a weighted average grant date fair value of $5.33. 180,920 options wereexercised during the three months ended March 31, 2005 with an intrinsicvalue of approximately $628,705.

In2005, the Company granted 36,010 shares of nonvested common stock tonon-employee directors of the Company with a weighted average granted date fairvalue of $9.76. As of March 31, 2006, there were 36,010 nonvestedrestricted shares outstanding, with $77,911 of remaining unrecognizedcompensation expense to be recognized over a weighted average period of 2.1months.

Through2000, the Company granted option awards to certain non-employees. Upon theadoption of SFAS No. 123R, these awards were required to be classified asa liability and are subject to the provisions of SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*(“SFAS No. 133”). See Note 9, Derivative Financial Instruments.

**Valuation Information**

The Company estimated thefair value of stock options using the Black-Scholes option-pricing model. Thismodel requires 

8

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the input of subjective assumptions that will usuallyhave a significant impact on the fair value estimate. The weighted-averageestimated fair value of employee stock options granted during the three monthsended March 31, 2006 was $8.02 per share using the Black Scholes modelwith the following weighted-average assumptions:
|                           | ** ** | **Three months  ended** | ** ** |
|---------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **March 31, 2006** | ** ** |
| Expected  volatility      |       | 71.33                        | %          |
| Risk-free  interest rate  |       | 4.38                         | %          |
| Expected term  (in years) |       | 6.25                         |       |
| Expected dividend yield   |       | 0.0                          | %          |

 

The Company based thecalculation of expected volatility on the historical volatility of the Company’scommon stock over the expected term. The Company based the risk-free interestrate on the U.S. Treasury yield curve in effect at the time of option grant,and the expected term of options was determined using the SAB 107 “Safe Harbor.”  Assumptions used in the Black-Scholesoption-pricing model for calculating the weighted average fair value of $5.73for options granted in fiscal year 2005 are as follows: expected volatility was70.46%, weighted average risk-free interest rate was 4.25%, weighted averageexpected term was 6.25 years, and expected dividend yield was 0.0%.

**Note 4Cash and Cash Equivalents**

The Companyconsiders all highly liquid investments purchased with an original maturity ofthree months or less to be cash equivalents. Included with cash are cashequivalents of $3,055,896 and $104,305 as of March 31, 2006 and December 31,2005, respectively. The carrying value of these investments approximates theirfair market value due to their short maturity and liquidity.

**Note 5Short-term Investments**

Short-terminvestments represent investments in auction rate certificates and have beenclassified as available-for-sale. Short-term investments as of March 31,2006 and December 31, 2005 are summarized as follows:

|                            | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| State government  agencies |       | $                        | 53,350,000 |                        | $          | 28,700,000 |   |
| Total                      |       | $                        | 53,350,000 |                        | $          | 28,700,000 |   |

 

Included with thecarrying value of the investments is accrued interest income receivable of$123,297 and $76,020 as of March 31, 2006 and December 31, 2005,respectively.

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

**Note 6Inventory**

Inventory iscomprised solely of finished goods associated with NeoPhectin and is stated atthe lower of cost or market, as determined by the first in, first out method (“FIFO”).Inventory cost consists of direct material and direct labor costs. Sinceproducts are currently produced in the Company’s research and developmentfacilities, the Company has not allocated any overhead costs as a product cost.Application of overhead as a product cost is not material.

Inventory at March 31,2006 and December 31, 2005 consisted of the following:

|                              | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------|------------|------------------------------|------------|---------------------------------|------------|
|                         |       |                         |       |                            |       |
| Finished goods  on hand      |       | $                            | 5,537      |                            | $          | 5,677 |   |
| Inventory  subject to return |       | 70                           |       | —                          |       |
|                         |       |                         |       |                            |       |
|                         |       | $                            | 5,607      |                            | $          | 5,677 |   |

 

Inventory subject toreturn represents NeoPhectin products shipped to wholesale customers that havenot been recognized as revenue.

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**Note7  Fixed Assets**

Fixed assets arerecorded at cost and are depreciated using the straight-line method over theirestimated useful lives. Maintenance and repairs that do not extend the life ofassets are charged to expense when incurred. When properties are disposed of,the related costs and accumulated depreciation are removed from the accountsand any gain or loss is reported in the period the disposition takes place.Total depreciation and amortization expense for the three months ended March 31,2006 and 2005 was $334,472 and $333,764, respectively. During the three monthsended March 31, 2006, the Company acquired office equipment under a 5-yearcapital lease for $161,095.

Long-lived assetsare reviewed for impairment whenever events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable. Recoverabilityof assets to be held and used is measured by a comparison of the carryingamount of an asset to estimated undiscounted cash flows expected to begenerated by the asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized by the amountby which the carrying amount of the asset exceeds the fair value of the asset.

**Note8  Capital Lease**

Minimum future leasepayments under capital lease as of March 31, 2006 for each of the nextfive years and in the aggregate are as follows:

| For the period April 1,  2006 through December 31, 2006 |   | $      | 28,368  |   |
|-------------------------------------------------------------------|--------|--------|---------|--------|
| For the year ended  December 31, 2007                        |   | $      | 37,824  |   |
| For the year  ended December 31, 2008                        |   | $      | 37,824  |   |
| For the year  ended December 31, 2009                        |   | $      | 37,824  |   |
| For the year  ended December 31, 2010                        |   | $      | 37,824  |   |
| Subsequent to  2010                                               |   | $      | 3,152   |   |
|                                                              |   |   |    |
| Total minimum  lease payments                                     |   | $      | 182,816 |   |
| Less amount  representing interest                                |   | 26,292 |    |
| Present value of  minimum lease payments                          |   | $      | 156,524 |   |

 

**Note9  Derivative Financial Instruments**

Through 2000, theCompany had granted common stock options to certain non-employees, ascompensation associated with research and development activities, to purchaseshares of which 234,025 were fully vested and unexercised as of January 1,2006, the effective date of SFAS No. 123R. Upon adoption of SFAS No. 123R,these non-employee common stock options were required to be classified as aliability and became subject to the provisions of SFAS No. 133, whichrequires these non-employee options to be accounted for as a derivativeinstrument.

As of January 1,2006, the Company calculated the estimated fair value of the optionsoutstanding granted to non-employees to be $1,651,711 and reclassified thisamount from additional paid-in-capital to a liability. The estimated fair valueof the non-employee options is remeasured each reporting period and the changein estimated fair value is recorded in the condensed consolidated statement ofoperations. Accordingly, as of March 31, 2006, the Company remeasured andcalculated the estimated fair value of the outstanding non-employee options tobe $1,108,583 and recorded the change in fair value of $543,128 as a change infair value of derivative financial instruments on the Company’s unauditedcondensed consolidated statement of operations for the three months March 31,2006.

The Company usesthe Black-Scholes option pricing model to estimate the fair value of thenon-employee option grants. As of March 31, 2006, the remainingcontractual terms of the outstanding non-employee options granted ranged from1.2 months to 45.8 months. Other option pricing model inputs were determinedbased upon the remaining contractual terms of the non-employee options at thedate of measurement for initial classification as a liability as of January 1,2006 and the remeasurement of estimated fair value as of March 31, 2006.

**Note10  Stockholders’ Equity**

On January 10,2006, the Company received proceeds of $39,002,250 (net of underwritingdiscounts and commissions of $2,052,750 but before expenses of $270,864) byissuing 4,025,000 shares of common stock in a public offering.

In October 2005,the Company’s Board of Directors adopted, subject to shareholder approval, anEmployee Stock Purchase Plan (the “Purchase Plan”) in which eligible employeesof the Company may purchase shares of common stock at quarterly intervals,through payroll deductions. The purchase price per share is 85% of the closingprice of the common stock on (i) the first business day of the plan 

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period or (ii) thepurchase date, whichever closing price is less. The Purchase Plan imposes alimitation upon a participant’s right to acquire common stock if immediatelyafter or prior to purchase the employee owns 5% or more of the total combinedvoting power or value of the Company’s common stock. The Purchase Plan issubject to shareholder approval and purchases under the Purchase Plan will nottake place unless shareholder approval is received and accordingly, there is nofinancial statement impact until the Plan is approved and purchases are madeunder the Plan.

TheCompany maintains a Stockholder Rights Plan whereby rights to purchase sharesof Series A Participating Preferred Stock become exercisable by theCompany’s stockholders after any non-excluded party acquires, or announces anintention to acquire, 15% or more of the Company’s outstanding common stock.

**Note11  Revenue Recognition**

The Companyrecognizes revenue when persuasive evidence of an arrangement exists, deliveryhas occurred or services have been rendered, the price is fixed ordeterminable, and collectibility is reasonably assured.

For product salesnot subject to unconditional rights of return, the Company recognizes revenueupon shipment as title and risk of loss has passed to the customer. For productsales subject to unconditional rights of return, the Company recognizes revenueupon shipment when it can reasonably estimate the level of returns at the timeof shipment. Given the limited sales history of its products, the Company iscurrently unable to reasonably estimate the level of returns at the time ofshipment. Accordingly, revenue related to shipments to distributors that havebeen granted an unconditional right of return is currently being recognizedwhen the right of return has expired, which occurs upon the earlier of shipmentof the product by the distributor to an end user or expiration of the right ofreturn, which is 60-180 days depending upon the distributor. The Companywarrants its products in a manner consistent with industry standards and hasnot incurred any warranty costs related to the sale of NeoPhectin.

The Company entersinto collaboration and technology licensing arrangements, which containmultiple deliverables. Under the provisions of Emerging Issues Task Force(EITF) No. 00-21, *Accounting forRevenue Arrangements with Multiple Deliverables*, the Companyevaluates whether these deliverables constitute separate units of accounting towhich total arrangement consideration is allocated. A deliverable qualifies asa separate unit of accounting when the item delivered to the customer hasstandalone value, there is objective and reliable evidence of fair value ofitems that have not been delivered to the customer, and, if there is a generalright of return for the items delivered to the customer, delivery orperformance of the undelivered items is considered probable and substantiallyin the control of the Company. Arrangement consideration is allocated to unitsof accounting on a relative fair-value basis or the residual method if theCompany is unable to determine the fair value of all deliverables in thearrangement. Consideration allocated to a unit of accounting is limited to theamount that is not contingent upon future performance by the Company. Upondetermination of separate units of accounting and allocated consideration, thegeneral criteria for revenue recognition are applied to each unit of accounting.

The Company hasentered into an agreement with Nippon Kayaku Co., Ltd (“Nippon”) in which thedevelopment and commercialization rights in Japan for cintredekin besudotoxwere licensed. The Company received a $2 million upfront nonrefundable fee in January 2005and is entitled to receive future additional fees, milestone payments androyalties. Nippon is responsible for all development costs in Japan. TheCompany has agreed to provide or arrange for contract manufacture of acommercial supply of cintredekin besudotox upon receipt of marketing approvalby Nippon. The up-front nonrefundable fee received by the Company will berecognized ratably as revenue once the general criteria for revenue recognitionhas been met for the unit of accounting to which the fee has been allocated.

**Note 12 Commitments**

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

**Note13  Contingencies**

The Company hasbeen named in several putative class action lawsuits (the” Class ActionSuits”) each of which alleges various violations of the federal securities lawsin connection with the Company’s public statements during the period from September 25,2000 through April 19, 2002 as they relate to the Company’s LEP drugproduct candidate. The original lawsuits also named as individual defendantsJohn N. Kapoor, the former Chairman of the Company, and James M. Hussey,the Company’s former President and CEO, and Dr. Aquilur Rahman, a formerdirector and executive officer of the Company. The first of these Class ActionSuits was filed on April 26, 2002 and all of the Class Action Suitshave been filed in the United States District Court for the Northern Districtof Illinois, Eastern District. On September 16, 2002, a consolidatedamended complaint was filed against NeoPharm in this 

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matter. The amendedcomplaint shortened the class period to October 31, 2001 through April 19,2002, removed Dr. Rahman as a defendant, and added Dr. Imran Ahmad,the Company’s former Chief Scientific Officer and Executive Vice President of Researchand Development, as a defendant. The Company intends to vigorously defend eachand every claim in the Class Action Suits and, on November 4, 2002,moved to have the complaint dismissed. The Company’s motion to dismiss wasgranted in part and denied in part in February 2003. Dr. Kapoor wasdismissed from the lawsuit at that time. In November 2004, the plaintiffsfiled a motion to amend and a motion for summary adjudication. The motion toamend seeks to again make Dr. Kapoor a defendant, and realleges thatcertain pre-class period statements are actionable. The motion for summaryadjudication asks the Court to rule that certain statements made inthe arbitration award between the Company and Pharmacia be deemed factsestablished in this proceeding. The Company filed oppositions to both motions.The Court has not yet ruled on the motions. No trial date has been set anddiscovery is ongoing. Management is unable to estimate the potential outcome ora range of possible losses, if any. The Company maintains insurance coverage tomitigate the financial impact of any potential loss.

On March 26,2004, the Company received a letter from the Securities and Exchange Commission(“SEC”) stating that the SEC is conducting a formal investigation of theCompany. The SEC stated in its letter that it had made no determination of anyviolation of law by the Company or any individual at this time. Previously,this matter had been the subject of an informal SEC inquiry. The Company hasfully cooperated with the SEC. The Company believes the investigation is anoutgrowth of the arbitration claim filed by the Company against Pharmacia (nowPfizer) regarding the development of its LEP and LED drug product candidatesand the Class Action Suits which have been filed against the Companyrelating to its public statements regarding the development of LEP. The Companycannot predict with certainty the direction the investigation will take or itsultimate outcome, and therefore is unable to determine whether the results ofthe investigation will have a material adverse impact on the Company’s resultsof operations or financial position.

Thepharmaceutical industry has traditionally experienced difficulty in maintainingproduct liability insurance coverage at desired levels. To date, no significantproduct liability suit has ever been filed against the Company. However, if asuit was filed and a judgment entered against the Company, it could have amaterial adverse effect upon the Company’s operations and financial position.While the Company maintains insurance to cover the use of its drug productcandidates in clinical trials, the Company does not maintain insurance coveringthe sale of its drug product candidates nor is there any assurance that it willbe able to obtain or maintain such insurance on acceptable terms or withadequate coverage against potential liabilities.

**Note14  Subsequent Events**

On April 28,2006, the Company announced a plan to reduce its workforce by a total of 22employees (approximately 23%) consisting of 20 employees from its research anddevelopment groups and 2 employees from the administrative group. Terminatedemployees will receive severance, a portion of 2006 earned bonus, three monthsCompany paid insurance benefits and outplacement services. Additionally, theCompany announced it will consolidate its operations to its corporateheadquarters in Waukegan, Illinois.

On May 3, 2006, the Company announced theresignation of Imran Ahmad as the Company’s Executive Vice President and ChiefScientific Officer, effective May 2, 2006.

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**Item 2 - Management’s Discussionand Analysis of Financial Condition and Results of Operations**

Any statements made by NeoPharm, Inc. (“we”, “us”,“our”, or the “Company”) in this quarterly report that are forward looking aremade pursuant to the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995. The Company cautions readers that importantfactors may affect the Company’s actual results and could cause such results todiffer materially from forward-looking statements made by or on behalf of theCompany. Such factors include, but are not limited to, those risks anduncertainties relating to difficulties or delays in development, testing,regulatory approval, recruitment of patients, production and marketing of theCompany’s drug candidates, including, but not limited to cintredekin besudotox(“IL13-PE38QQR”), including the PRECISE trial, the marketing of non-drugproducts such as NeoPhectinTM and NeoPhectin-ATTM, uncertainty regarding theoutcome of class action litigation against the Company, resolution of theongoing SEC investigation, unexpected adverse side effects or inadequatetherapeutic efficacy of the Company’s drug candidates that could slow orprevent products coming to market, the uncertainty of patent protection for theCompany’s intellectual property or trade secrets, the ability of the Company toraise additional funds on terms acceptable to the Company and other factorsreferenced under “Risk Factors” in the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2005.

Thefollowing should be read in conjunction with the financial statements andrelated notes and Management’s Discussion and Analysis of Financial Conditionand Results of Operations and the Risk Factors section included as Item 1Aherein and in the Company’s 2005 Annual Report on Form 10-K. Theresults discussed below are not necessarily indicative of the results to beexpected in any future periods. The following discussion containsforward-looking statements that are subject to risks and uncertainties, whichcould cause actual results to differ from statements made.

**Overview**

We area biopharmaceutical company engaged in the research, development, andcommercialization of drugs for the treatment of various cancers. Our corporatestrategy is to become a leader in the research, development, andcommercialization of new and innovative anti-cancer treatments. We currentlyoperate at two locations, and had 96 full time employees as of March 31,2006. Our corporate headquarters and research and development facility arelocated in Waukegan, Illinois and our clinical development personnel arelocated in Lake Forest, Illinois.

Sincewe began doing business in June 1990, we have devoted our resourcesprimarily to funding research and product development programs. To date, wehave not received Food and Drug Administration (“FDA”) approval of any of ourdrug product candidates. We expect to continue to incur losses for theforeseeable future as we continue our research and development activities,which include the sponsorship of human clinical trials for our drug productcandidates. Until we are able to consistently generate revenue through the saleof drug or non-drug products, we anticipate that we will be required to fundthe development of our pre-clinical compounds and drug product candidatesprimarily by other means, including, but not limited to, licensing the developmentrights to some of our drug product candidates to third parties, collaboratingwith third parties to develop formulations of their compounds using ourtechnology, or selling Company issued securities.

We began enrollingpatients in the Phase III PRECISE clinical trial for cintredekin besudotox in March 2004and completed patient enrollment in December 2005. In June and December 2005,the independent Data Monitoring Committee (“iDMC”) for the PRECISE Trial met,analyzed, and reviewed the data for the PRECISE trial futility analyses, andrecommended that the PRECISE trial continue as planned under the approvedprotocol. The next milestones for PRECISE are an interim efficacy analysisafter 160 deaths, currently expected as early as the second quarter of 2006,and the final efficacy analysis after 215 deaths, potentially in late 2006 orearly 2007. We are currently preparing to submit a BLA to the FDA as early asthe second half of 2006 to seek marketing approval of the drug, in the eventthat the PRECISE trial achieves its endpoint of a statistically significantimprovement in overall survival compared to the control arm. However, there canbe no assurance that the trial will meet its endpoint in the time anticipated,that the FDA will approve the BLA or that the FDA will not require additionaldata or testing. Additionally, enrollment has now been completed in our Phase Iclinical trial of cintredekin besudotox for malignant glioma patients atinitial diagnosis.

In thequarter ended March 31, 2006, management’s efforts were primarily devotedto planning the further development of its drug product candidates, completinga public common stock offering in January 2006, and exploring potentialopportunities to reduce expenses in an effort to reduce the amount of cash usedin operations. Additionally, in January 2006, we hired Timothy P. Walbertas Executive Vice President Commercial Operations. Mr. Walbert, along withother members of senior management, is responsible for the development andexecution of our overall commercialization strategy; including globalmarketing, business development, sales, reimbursement and commercialization.

In April 2006,we reprioritized our NeoLipid® platform and strategy to focus our efforts onthe two most promising drug product candidates in the platform, LEP-ETU andLE-SN38. We are preparing to initiate a Phase II clinical trial for LE-SN38 inthe second quarter of 2006 and reviewing our LEP-ETU regulatory strategy under Section 505(b)(2) forfurther review by the FDA later this year. We believe that a regulatorystrategy based solely on bioequivalence does not provide the information tofully differentiate LEP-ETU from other taxane-based anti-cancer products, whichwe believe is important to achieve commercial success with the product, if thisdrug candidate is ultimately approved by the FDA. Additionally, pre-clinicalwork continues on our earlier stage liposomal formulations of the anti-canceragents docetaxel 

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and gemcitabine,while the LErafAON program is on hold pending analysis of the data gathered inPhase I.

It isdifficult to predict with any certainty the timing of and total estimated coststo complete development of drug product candidates in early stage, or PhaseI/II, clinical development, as well as the estimated date such drug productcandidates would be available for sale, if approved by the FDA. A number offactors contribute to this uncertainty, including: side effects encountered inearly stage clinical trials, ability to scale up manufacturing for commercial supply,and the fact that the size and scope of pivotal Phase III clinical trials areunknown until sufficient data is available to present a Phase III plan to theFDA for approval. In addition, our drug product candidates are required to beapproved by the FDA after completing Phase III clinical trials before we cansell the drugs to generate revenue and, potentially, realize net cash inflows.Because our lead product candidate, cintredekin besudotox, is in the finalstages of a Phase III clinical trial, we are able to estimate that we willincur further direct expenses of approximately $3 million to complete thePhase III PRECISE study. Additional clinical trial expenses are also expectedto be incurred for cintredekin besudotox as we conduct other clinical trials toinvestigate the potential to use cintredekin besudotox in other forms andstages of malignant glioma, in addition to recurrent glioblastoma multiforme.We also expect to incur additional expenses related to the preparation of acintredekin besudotox BLA submission.

The table below includes a summary of identifieddirect project costs incurred to date for our clinical research and developmentprojects. Generally, identified project costs include expenses incurredspecifically for clinical trials and pre-clinical studies we conduct, andexclude expenses incurred for salaries paid to our professional staff, overheadexpenses for our Lake Forest and Waukegan facilities and general laboratorysupplies used in our research, which are included with non-project specific.

| Research Project                     | ** ** | **Total Direct Costs  Incurred in  Current Quarter** | ** ** | **Total Direct Costs  Incurred Since  Beginning of Project** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| Cintredekin  besudotox                    |       | $                                                                        | 2,146,813  |                                                                                  | $          | 56,871,879 |   |
| LEP-ETU                                   |       | 584,725                                                                  |       | 7,291,695                                                                             |       |
| LE-SN38                                   |       | 35,394                                                                   |       | 5,009,102                                                                             |       |
| LErafAON                                  |       | 55,095                                                                   |       | 7,792,777                                                                             |       |
| Non-project  specific                     |       | 3,021,734                                                                |       | N/A                                                                                   |       |
| Total research and  development  expenses |       | $                                                                        | 5,843,761  |                                                                                  | N/A        |   |
|                                           |            |                                                                          |            |                                                                                       |            |  |  |

 

**Results of Operations — ThreeMonths Ended March 31, 2006 vs. Three Months Ended March 31, 2005.**

The Companyrecorded product revenue of $1,610 for the three months ended March 31,2006 as compared to $6,300 for the three months ended March 31, 2005. Thesole source of product revenue in both periods was from sales of NeoPhectin andNeoPhectin-AT. During the three month period ended March 31, 2005, we alsorecognized $65,000 of revenue from collaboration fees received in 2005.

Research anddevelopment expense for the three months ended March 31, 2006 decreased byapproximately $2.2 million as compared to the same period in 2005. The decreasein research and development expenses was primarily related to the completion ofpatient enrollment in the PRECISE trial in December 2005.

Selling,general, and administrative expenses were approximately $3.0 million for thethree months ended March 31, 2006 and approximately $3.2 million for thethree months ended March 31, 2005. Compensation expense for the threemonths ended March 31, 2006 was reduced by approximately $0.3 million ascompared to the three months ended March 31, 2005 as a result of theresignation of our former CEO Gregory Young in March 2005.

TheCompany recorded a benefit of $0.5 million relating to the change in theestimated fair value of derivative financial instruments for the three monthsended March 31, 2006 as a result of the requirements to account foroptions previously granted to non-employees as derivative financial instrumentsupon the adoption of SFAS No. 123R.

TheCompany generated interest income on cash and investments of approximately $0.7million and $0.4 million for the three months ended March 31, 2006 and2005, respectively. The increase in interest income during the period wasprimarily due to an increase in average cash and short-term investment balancesas a result of the public stock offering completed in January 2006, inaddition to increases in short-term interest rates.

**Liquidityand Capital Resources**

Our primary source ofcash has been from proceeds from issuance of equity securities.

In 2005, we reclassifiedall auction rate certificates to short-term investments. We believe thestructural features of the auction rate certificates, now classified asshort-term investments, provide the Company with liquidity characteristicssimilar to cash equivalents.

On January 10, 2006, wereceived proceeds of approximately $39 million (net of underwritingdiscounts and commissions, but before expenses) by issuing4,025,000 shares of common stock in a public offering.

As of March 31,2006, we had approximately $6.3 million in cash and cash equivalents and$53.5 million in short-term 

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investments. We currently believe that our cash, cashequivalents and short-term investments on hand at March 31, 2006, cansupport our activities through the fourth quarter of 2007 at current andprojected levels of development and general corporate activity. This estimatereflects the effects of the NeoLipid® platform reprioritization that isexpected to result in a reduction in research costs, and also included aworkforce reduction.

The primary use of cashover the next 12-24 months will be to fund our regulatory and commercialefforts for cintredekin besudotox and our clinical and pre-clinical researchand development efforts. The most significant expenses will be incurred inrelation to completing the work necessary for a possible cintredekin besudotoxBLA submission and completion of the PRECISE trial. As we continue to move ourdrug product candidates towards the next phase of development, we expect toincur additional expenses.

We may seek to satisfyfuture funding requirements through public or private offerings of securitiesor with collaborative or other arrangements with corporate partners. Additionalfinancing may not be available when needed or on terms acceptable to us. Ifadequate financing is not available, we may be required to delay, scale back,or eliminate certain of our research and development programs, relinquishrights to certain of our technologies, drugs or products, or license thirdparties to commercialize products or technologies that we would otherwise seekto develop ourselves.

NeoPharm has no exposureto off-balance sheet arrangements, no special purpose entities, or activitiesthat include non-exchange-traded contracts accounted for at fair value.

Thefollowing table summarizes our estimated contractual obligations as of March 31,2006:
| ** **                                            | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                      | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Operating leases                                      |       | $                                         | 863,119    |   | $ | 417,137 |   | $ | 443,422 |   | $ | 2,560 |   | $ | — |   |
| Capital lease                                         |       | 182,816                                   |       | 37,824 |   | 75,648 |   | 69,344 |   | — |   |
| Clinical trial  monitoring (CRO) agreements (1)       |       | 704,654                                   |       | 704,654 |   | — |   | — |   | — |   |
| License  agreements—milestone based payments (2) |       | 2,050,000                                 |       | 300,000 |   | 900,000 |   | — |   | 850,000 |   |
| Total                                                 |       | $                                         | 3,800,589  |   | $ | 1,459,615 |   | $ | 1,419,070 |   | $ | 71,904 |   | $ | 850,000 |   |

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(1)                                Theseamounts include only contractual obligations for direct expenses for thePRECISE trial, exclusive of clinical trial site costs for treating patients.

(2)                                Theseamounts do not include potential sales-based royalty payments that may berequired under the various license agreements. Milestone based paymentobligations are contingent upon successfully reaching objectively determinablestages in the development of drug product candidates. The Company has estimatedthe period the payment may be due, if at all, based upon its expectations ofthe timeline for continued successful development of the drug productcandidates.

**CriticalAccounting Policies**

Inpreparing the Company’s financial statements in conformity with U.S. generallyaccepted accounting principles (“GAAP”), management must make a variety ofdecisions that impact the reported amounts and related disclosures. Suchdecisions include the selection of the appropriate accounting principles to beapplied, the assumptions on which to base accounting estimates, and theconsistent application of those accounting principles. Due to the type ofindustry in which the Company operates and the nature of its business, thefollowing accounting policies are those that management believes are mostimportant to the portrayal of the Company’s financial condition and results andthat require management’s most difficult, subjective or complex judgments,often as a result of the need to make estimates about the effect of mattersthat are inherently uncertain.

*IncomeTaxes*

Inassessing the realizability of deferred tax assets, management considerswhether it is more likely than not that some portion or all of the deferred taxassets will not be realized. The ultimate realization of deferred tax assets isdependent upon the generation of future taxable income during the periods inwhich those temporary differences become deductible. Management considers thescheduled reversal of deferred tax liabilities, projected future taxableincome, and tax planning strategies in making this assessment. Significantjudgments are required to estimate the generation of future taxable income andthe timing of the reversal of deferred tax liabilities.

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*Contingencies*

To properlyaccount for and provide disclosure of loss contingencies, management must applyjudgment in determining whether a loss contingency is: probable, reasonablypossible, or remote. In instances where management has determined that a losscontingency is probable, it must make use of estimates to determine the amountof probable loss. Management must apply judgment in determining whether or notit can make a reasonable estimate. Management must also apply judgment indetermining whether or not disclosure of loss contingencies that have beenaccrued should be made for the consolidated financial statements not to bemisleading.

*Stock-BasedCompensation*

The Company accounts for stock-based compensation in accordance withSFAS No. 123R, *Share-Based Payment*.Under the fair value recognition provisions of this statement, we measurestock-based compensation cost at the grant date based upon the fair value ofthe award and recognize the cost of awards that are expected to ultimately vestas expense over the requisite service period. Management judgment and the useof estimates are required in determining the inputs to an option pricing modelused to estimate fair value of stock-based awards. Management judgment and theuse of estimates are also required in estimating the number of stock-basedawards that are will ultimately vest. Additionally, management judgment and theuse of estimates may be required in determining the requisite service periodover which to recognize the compensation cost as expense.

*RevenueRecognition*

The Companyfollows the provisions as set forth by current accounting rules, whichprimarily include Staff Accounting Bulletin (“SAB”) 104, *Revenue Recognition,*and Emerging IssuesTask Force (“EITF”) No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables.*Generally,revenue is recognized when evidence of an arrangement exists, delivery hasoccurred or services have been rendered, the price is fixed and determinable,and collectibility is reasonably assured.

The Companyprovides for general rights of return of products sold to its distributors.Appropriately determining revenue recognition when the general right of returnexists requires the use of judgment in estimating the level of returns. Incertain circumstances, management may not be able to develop a reasonableestimate of the level of returns. Making such a determination requires the useof significant judgment. Management has determined that given the limited saleshistory of NeoPhectinTM, the Company is unable to develop a reasonable estimateof the level of returns. Accordingly, the Company is currently recognizingrevenue for products shipped to its distributor upon the expiration of theright of return, which occurs upon the earlier of the shipment by thedistributor to an end user or, depending on the distributor, 60 to 180 days.

The Company hasentered into collaboration and license agreements with third parties thatcontain multiple deliverables. Under the provisions of EITF 00-21, adetermination must be made on each contract as to whether a deliverableconstitutes a separate unit of accounting. The amount of revenue to berecognized is based on the fair value for each unit of accounting within thearrangement. Management’s judgment is required to determine, based upon thefacts and circumstances of each arrangement, whether or not each deliverablehas standalone value and whether or not there exists a sufficient level ofobjective and reliable evidence of fair value of the undelivered items.Additionally, units of accounting may be delivered over an indeterminate periodof time. Management judgment is required to estimate the period over whichrecognition of allocated revenue occurs.

**Item 3 – Quantitative andQualitative Disclosures about Market Risk**

As of March 31,2006, we did not own any derivative instruments, but we were exposed to marketrisks, primarily changes in U.S. interest rates. As of March 31, 2006, weheld total cash and cash equivalents of $6,283,879 and short-term investmentsin auction rate certificates of $53,473,297. All cash equivalents have amaturity less than 90 days. Declines in interest rates over time willreduce our interest income from our investments. Based upon our balance ofcash, cash equivalents and short-term investments as of March 31, 2006, adecrease in interest rates of 1.0% would cause a corresponding decrease in ourannual interest income of $597,572.

**Item 4 – Controls and Procedures**

As ofMarch 31, 2006, we carried out an evaluation, under the supervision and withthe participation of our management, 

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includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures. Based onthat evaluation, our management, including the Chief Executive Officer andChief Financial Officer, have concluded, as a result of the material weaknessin internal control over financial reporting discussed below, our disclosurecontrols and procedures were not effective to ensure that information requiredto be disclosed by us in the reports we file or submit under the Exchange Actis recorded, processed, summarized, accumulated, communicated and reported,within the time periods specified in the Securities and Exchange Commission’srules and forms.  

In May 2006, management concluded that a controldeficiency with respect to the review and verification of the accuracy of thecalculation estimating the fair value of non-employee stock options constituteda material weakness in internal control over financial reporting.  A material weakness is a control deficiency,or combination of control deficiencies that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. This control deficiency resulted in an adjustment to the unaudited interimcondensed consolidated financial statements for the quarter ended March 31,2006 affecting derivative financial instruments and the change in fair value ofderivative financial instruments.

Management is in the process of reviewing and, asnecessary, revising its policies and procedures with respect to its controlsover the review and verification of the accuracy of the calculation estimatingthe fair value of non-employee stock options to ensure that all reasonablesteps will be taken to correct this material weakness.  As part of this process, management expectsto further train the Company’s accounting personnel and add additional reviewsand controls.  The deficiency will not beconsidered remediated until the new internal controls are operational for aperiod of time and are tested and management has concluded that the controlsare operating effectively. Until it is remediated, the identified controldeficiency could result in a misstatement in the derivative financialinstruments and the change in fair value of derivative financial instrumentsbalances that would not be prevented or detected.  

There have been no significant changes in our internalcontrol over financial reporting that occurred during the period covered bythis report, other than the material weakness described above, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II - OTHER INFORMATION**

**Item 1 - Legal Proceedings**

The Company has beennamed in several putative class action lawsuits (the “Class Action Suits”)each of which alleges various violations of the federal securities laws inconnection with the Company’s public statements during the period from September 25,2000 through April 19, 2002 as they relate to the Company’s LEP drugproduct candidate. The original lawsuits also named as individual defendantsJohn N. Kapoor, the former Chairman of the Company, and James M. Hussey,the Company’s former President and CEO, and Dr. Aquilur Rahman, a formerdirector and executive officer of the Company. The first of these Class ActionSuits was filed on April 26, 2002 and all of the Class Action Suitshave been filed in the United States District Court for the Northern Districtof Illinois, Eastern District. On September 16, 2002, a consolidatedamended complaint was filed against NeoPharm in this matter. The amendedcomplaint shortened the class period to October 31, 2001 through April 19,2002, removed Dr. Rahman as a defendant, and added Dr. Imran Ahmad,the Company’s former Chief Scientific Officer and Executive Vice President ofResearch and Development, as a defendant. The Company intends to vigorouslydefend each and every claim in the Class Action Suits and, on November 4,2002, moved to have the complaint dismissed. The Company’s motion to dismisswas granted in part and denied in part in February 2003. Dr. Kapoorwas dismissed from the lawsuit at that time. In November 2004, theplaintiffs filed a motion to amend and a motion for summary adjudication. Themotion to amend seeks to again make Dr. Kapoor a defendant, and reallegesthat certain pre-class period statements are actionable. The motion for summaryadjudication asks the Court to rule that certain statements made inthe arbitration award between the Company and Pharmacia be deemed factsestablished in this proceeding. The Company filed oppositions to both motions.The Court has not yet ruled on the motions. No trial date has been set anddiscovery is ongoing. Management is unable to estimate the potential outcome ora range of possible losses, if any. The Company maintains insurance coverage tomitigate the financial impact of any potential loss.

On March 26, 2004,the Company received a letter from the Securities and Exchange Commission (“SEC”)stating that the SEC is conducting a formal investigation of the Company. TheSEC stated in its letter that it had made no determination of any violation oflaw by the Company or any individual at this time. Previously, this matter hadbeen the subject of an informal SEC inquiry. The Company has fully cooperatedwith the SEC. The Company believes the investigation is an outgrowth of thearbitration claim filed by the Company against Pharmacia (now Pfizer) regardingthe development of its LEP and LED drug product candidates and the Class ActionSuits which have been filed against the Company relating to its publicstatements regarding the development of LEP. The Company cannot predict withcertainty the direction the investigation will take or its ultimate outcome,and therefore is unable to determine whether the results of the investigationwill have a material adverse impact on the Company’s results of operations orfinancial position.

**Item 1A. - Risk Factors**

You should carefullyconsider the following risk factors, in addition to the other information setforth in this document as well as other information contained in the periodicreports we file with the SEC. Each of these risk factors could adversely affectour business, operating results and financial condition, as well as the valueof an investment in our common stock.

**If we were unable to develop, obtainregulatory approvals for, and then market our drug product candidates, ourbusiness would be harmed.**

The process fordeveloping new therapeutic products is inherently long, complex, and uncertain.We must make long-term investments and commit significant resources beforeknowing whether our development programs will eventually result in productsthat will receive regulatory approval and achieve market acceptance.

We currently have fourdrug product candidates in various stages of clinical development. Eachcandidate is the subject of an effective IND that we filed with FDA. Theprotocols for any clinical trials we perform under these INDs must haveinstitutional review board (“IRB”) approval, and the trials must comply withFDA’s good clinical practices (“GCP”) and other regulations. There is noassurance that the clinical trials we may seek to conduct under these INDs willobtain IRB approval. There is also no assurance that FDA will allow us tocontinue the clinical trials that we have begun. FDA may suspend a clinicaltrial at any time if the agency believes that the patients participating in thestudy are or will be exposed to unacceptable health risks. FDA may alsoterminate an IND and require the sponsor to end all clinical trials under thatIND, if it finds deficiencies in the IND or in the conduct of a trial under theIND. Some of our clinical trials are conducted in foreign countries, and theregulatory authorities of those countries have comparable authority to suspendand terminate clinical trials. Suspension or termination of the clinical trialsof our drug product candidates could substantially delay or even preventregulatory approval of the drug product candidates. There is no guarantee thatclinical studies, if performed, will demonstrate the safety and efficacy of anydrug product candidate we have in development.

Sales of our drug productcandidates will be subject to pre-market approval requirements in the UnitedStates and in other countries. These requirements vary widely from country tocountry. We cannot assure you that we will receive approval to market 

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any of our drug product candidates in any country. Wehave yet to submit an application for marketing approval for any of the drugproduct candidates we currently have under development. We cannot predict withcertainty if or when we might submit any of these drug product candidates forregulatory review. We cannot assure you that once we submit a drug productcandidate for review, FDA or any other regulatory agency will approve thatproduct on a timely basis or at all.

Approval of our drugproduct candidates in the United States or a foreign country may depend on ouragreement to perform burdensome and expensive post-marketing studies or ouragreement to a burdensome risk management plan that could interfere withphysician and patient acceptance of our product. We cannot assure you that wewill agree to perform such additional studies or to accept such a riskmanagement plan. If we agree to perform post-market studies and then fail toconduct those studies with due diligence, or if those studies fail to verifythe product’s clinical benefit, FDA may withdraw its approval of the product.

If FDA or a foreignregulatory authority approves one of our drug product candidates, we will needto manufacture, or contract with third parties to manufacture, a sufficientvolume of that product to meet market demand. This will require accurateforecasting of market demand. There is no guarantee that we will accuratelyforecast the market demand for any of our drug product candidates or that therewill be any market demand. There is also no assurance that we will be able tosuccessfully manufacture, or find a third party to manufacture, adequatequantities of any of our drug product candidates to meet any market demand.

Our most advanced drugproduct candidate is cintredekin besudotox (IL13-PE38QQR), which webelieve has potential to be used as a treatment for malignant gliomas. In September 1997,we exclusively licensed worldwide rights to cintredekin besudotox from the NIHand FDA. Our Phase I clinical trials to date involving this drug productcandidate have enrolled approximately 100 patients. On the basis of ourpreliminary Phase I clinical trial findings for this drug product candidate, weinitiated the PRECISE trial, a pivotal Phase III multi-center, multi-nationalclinical trial that enrolled a total of 294 patients, of which, in accordancewith the trial protocol, approximately 196 patients received cintredekinbesudotox. There are no assurances that cintredekin besudotox will prove to besafe and effective or receive regulatory approval for any indication.

We also have three otherdrug product candidates in clinical development for the treatment of variouscancers: LE-SN38, LEP-ETU, and LErafAON. Each of these drug product candidateshas either completed or is currently in Phase I clinical testing and are invarious stages of development or evaluation. There are no assurances that anyof these drug product candidates will proceed to the next phase of clinicaldevelopment, or prove to be safe and effective, or that any of them willreceive regulatory approval for the treatment of the indications which we maypursue.

Even if we receiveregulatory approval for one of our drug product candidates in the United Statesor a foreign country, there are no assurances that the product will prove to becommercially successful or profitable.

**We are highly dependent on achievingsuccess in the clinical testing, regulatory approval, and commercialization ofour most advanced drug product candidate, cintredekin besudotox, which may neverbe approved for commercial use. If we are unable to commercialize cintredekinbesudotox, our ability to generate revenues would be impaired and our businesswould be harmed.**

We have invested asignificant portion of our time and financial resources in the development ofcintredekin besudotox, and we anticipate that for the foreseeable future, ourpotential to achieve revenues from drug product sales will be dependent on itssuccessful clinical testing, regulatory approval in the United States, and successfulcommercialization. Development, approval, and successful commercialization ofnew drug products is a highly uncertain process.

We may suffer significantsetbacks in our Phase III clinical trial of cintredekin besudotox (the PRECISEtrial), even after achieving potentially promising results in earlier clinicaltrials. In the fourth quarter of 2005, we completed enrollment in the PRECISEtrial for patients suffering from first recurrent glioblastoma multiformetumors. Patients in the PRECISE trial received treatment either withcintredekin besudotox or with Gliadel® Wafers, a product currently approved totreat this disease. The primary endpoint of the study is to determine if thereis a statistically significant overall patient survival difference betweenpatients treated with cintredekin besudotox and patients treated with Gliadel®Wafers. The results from our clinical trial may not demonstrate a statisticallysignificant difference. If the results from the PRECISE trial do notdemonstrate a statistically significant difference, FDA could determine thatadditional clinical trials are necessary, which could delay or even preventapproval and commercialization.

Even if we conclude thatthe results from our clinical trial demonstrate a statistically significantdifference, FDA may not agree with us, for example because it evaluates thedata using a different method. FDA could also conclude that the clinical trialresults are not clinically meaningful, that there were human errors in theconduct of the clinical trial, or that for some other reason the clinical trialresults are inadequate to support approval of cintredekin besudotox. Even ifFDA agrees that the results from the PRECISE trial demonstrate a statisticallysignificant difference, FDA may require statistically significant results in asecond Phase III trial before it will approve cintredekin besudotox. Even if webelieve that we have submitted all of the data and information necessary tosatisfy FDA requirements for approval of a BLA, there is a risk that FDA willrequire additional data and information that we are unable to provide. Finally,even if the results are statistically significant, adverse safety findings inthe PRECISE trial could delay or prevent regulatory approval.

Even if the results ofthe PRECISE trial are statistically significant, prior to commercialization ofcintredekin besudotox in the United States, we will have to submit, and FDAwill have to approve, a BLA for cintredekin besudotox. FDA approval iscontingent 

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on many factors, including its evaluation of ourclinical trial results, its assessment of the remaining portions of our BLA,and its inspection of facilities where cintredekin besudotox is manufactured.If FDA does not approve the BLA, if FDA approval is delayed, or if FDA requiresadditional clinical testing or other information, our ability to achieverevenues from product sales will be impaired and our stock price would bematerially and adversely affected.

Even though FDA hasawarded orphan drug designation to cintredekin besudotox, a competitor couldobtain orphan drug designation for the same drug for the same indication andcomplete its clinical trials before we complete ours. FDA could approve thatcompetitor’s product first and give it seven years of market exclusivity. Inthis case, we might not be allowed to market our product in the United Statesfor seven years. This would have a material adverse effect on our business. Thelaw would permit FDA to approve our product during the seven years if certainconditions were met, but there is no assurance we could satisfy theseconditions. We might be able to market the product outside the United States,if certain conditions were met, but there is no guarantee that we would be ableto satisfy those conditions. The export process can be complex, and there areno assurances that export would be permitted or that another country wouldaccept the product. Even if FDA approves cintredekin besudotox as an orphandrug and awards it seven years of exclusivity, the law permits FDA, in certainsituations, to approve a competitor’s product. This could have a materialadverse effect on the commercial success of our product.

**Because many of our drug productcandidates are in clinical development, there is a high risk that further developmentand testing will demonstrate that our drug product candidates are notapprovable or suitable for commercialization, which could cause our business tosuffer.**

None of our drug productcandidates has received regulatory approval for commercial sale. Before we canobtain regulatory approval for the commercial sale of any of our drug productcandidates, we must demonstrate through pre-clinical testing and clinicaltrials that the drug product candidate is safe and effective. Conductingpre-clinical and clinical testing is a lengthy, expensive, and uncertainprocess and may take several years or more. Success in pre-clinical testingdoes not assure success in clinical trials, and positive results in early phaseclinical trials do not assure a positive outcome in later trials.

Clinical development ofany of our drug product candidates, including, but not limited to cintredekinbesudotox, may be curtailed, redirected, delayed, or eliminated at any time forany of the following reasons or for other reasons:

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

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

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

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

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

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

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

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

·       ourinability to adequately follow patients after treatment; and

·       delaysin importing or exporting clinical trial materials.

A delay or termination ofany of our clinical trials would have an adverse effect on our business. If anyof our clinical trials is unsuccessful, this could preclude us from obtainingregulatory approval, which would have an adverse effect on our business. If anyof our clinical trials is perceived as unsuccessful by FDA or physicians, ourbusiness, financial condition, and operations would be harmed.

**Our business is subject to extensivegovernmental regulation, and failure to comply with those regulations can leadto unanticipated delays in product development and approval and can preventcommercialization.**

FDA regulates theresearch, development, and testing of our drug product candidates. If any ofour drug product candidates is approved for marketing and introduced into themarket, FDA will continue to regulate the manufacturing, labeling, distribution,marketing, and advertising activities of that product. Public healthauthorities in foreign countries have comparable authority. Compliance withthese requirements before and after approval is expensive and time consuming.Failure to comply can lead to regulatory action that would have a negativeimpact on our business.

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In order to market a newtherapeutic product in the United States, we must prove that the product issafe and effective and that the product is manufactured in compliance with CGMP.Completing the pre-clinical and clinical testing necessary to prove the safetyand effectiveness of a new therapeutic product, and establishing the capabilityto comply with CGMP, can take many years, be very costly, and still beunsuccessful. The results of pre-clinical testing and Phase I and II studiesare not necessarily indicative of the results in larger patient populations, asevaluated in Phase III studies.

In order to market any ofour drug product candidates, once this lengthy research and development processis completed, we will need to submit a BLA or NDA to FDA. This will need tocontain pre-clinical, clinical, manufacturing, labeling, and other information,and it must demonstrate that the drug product candidate is safe and effectivefor use in humans for each proposed indication. FDA may refuse to accept any ofour applications if it views the application as incomplete. The manufacturingfacilities must also comply with CGMP, and FDA will inspect the facility beforeit approves the application.

Even if we complete thelengthy and expensive research and development process for one of our drugproduct candidates and file a BLA or NDA seeking approval to market thecandidate, we do not know whether FDA will approve the application on a timelybasis, or at all. FDA’s review of a BLA or NDA that it accepts can take severalyears. FDA can delay, limit, or deny approval for many reasons, including if:

·       itdetermines that our drug product candidate is not safe or is not effective;

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

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

·       itchanges its approval policies or adopts new regulations; or

·       Congressamends the FDCA, the Public Health Service Act, or other applicable laws.

The process of obtainingapprovals in foreign countries is subject to uncertainty, delay, and failurefor similar reasons.

In addition, FDA (andforeign regulatory authorities) may approve a drug product candidate for fewerthan all the indications requested or require that the drug product be labeledin a way that differs from our proposed labeling. Even if FDA (or a foreignregulatory authority) approves one of our drug product candidates, it mayrequire that we perform burdensome post-marketing studies and it may imposeother burdensome requirements, including the requirement that we institute andmaintain a special risk management plan to monitor and manage potential safetyissues. These requirements could reduce or eliminate the drug product’s marketpotential.

A drug product and itsmanufacturer are subject to strict regulation after product approval by FDA andcomparable foreign authorities. FDA regulates manufacturing, labeling,distribution, and promotional activities after product approval, as docomparable foreign regulatory agencies. We must also report certain adverseevents involving our drug products to these agencies. Failure to comply withapplicable regulatory requirements can result in, among other things, productseizure, civil penalties, suspensions and withdrawals of regulatory approvals,import and export problems, product recalls, operating restrictions, andcriminal prosecution. The restriction, suspension, or revocation of regulatoryapprovals or other adverse action taken on the basis of failure to comply withapplicable regulatory requirements could have a material adverse effect on ourbusiness, financial condition, and operations.

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

**We have a history of operatinglosses, expect to continue to incur losses for the foreseeable future, and maynever be profitable.**

We have a limitedoperating history, and our operations consist primarily of the development ofour drug product candidates and the sponsorship of research and clinicaltrials. Over the past three fiscal years ended December 31, 2005, we haveincurred aggregate net losses of approximately $149.1 million. We expectto incur additional losses and, as our development efforts and clinical testingactivities continue, our losses may increase. We also expect to experiencenegative cash flows for the foreseeable future as we fund our losses andcapital expenditures. Our losses have adversely impacted, and will continue toadversely impact, our working capital, total assets and stockholders’ equity.To date, we have not sold or received approval to sell any drug productcandidates, and it is possible that revenues from drug product sales will neverbe achieved. We have generated only limited amounts of revenue from licensefees and sales of products based upon our NeoPhectinTM technology (a novel cationiccardiolipin liposome based technology), and it is possible that additionallicense revenue and/or revenue from sales of NeoPhectinTM products will continue to be of limited significance. We cannot atthis time predict when or if we will be able to develop other sources ofrevenue or when or if our operations will become 

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profitable, even if we are able to commercialize someof our drug product candidates.

**Budget constraints may force us todelay our efforts to develop certain drug product candidates in favor ofdeveloping others, which may prevent us from commercializing all drug productcandidates as quickly as possible.**

Because we are anemerging company with limited resources, and because research and developmentis an expensive process, we must regularly assess the most efficient allocationof our research and development budget. As a result, we may have to further prioritizedevelopment activities, with the possible result that we may not be able tofully realize the value of some of our drug product candidates in a timelymanner, as they would be delayed in reaching the market, if at all. Recently,we have undertaken a reprioritization of the NeoLipid® program in an effort to rationalizeour expenses, including a restructuring of our workforce and a reduction inresearch and development spending not related to our lead drug productcandidate, cintredekin besudotox. If we are not successful in maintaining theplanned level of spending, our efforts to commercialize cintredekin besudotoxmay be delayed. Additionally, the reduction in spending on our other drugproduct candidates could delay our commercialization efforts and negativelyimpact our strategy to diversify our development risk across a broad portfolioof drug product candidates.

**Competition in the biopharmaceuticalfield is intense and subject to rapid technological change. Our principalcompetitors have substantially greater resources to develop and market productsthat may be superior to ours.**

If we obtain regulatoryapproval for any of our drug product candidates, the extent to which theyachieve market acceptance will depend, in part, on competitive factors.Competition in our industry is intense, and it is increased by the rapid paceof technological development. Existing drug products or new drug productsdeveloped by our competitors may be more effective or have fewer side effects,or may be more effectively marketed and sold, than any that we may develop.Each of our principal competitors has substantially greater research anddevelopment capabilities and experience and greater manufacturing, marketing,financial, and managerial resources than we do. Competitive drug compounds mayrender our technology and drug product candidates obsolete or noncompetitiveprior to our recovery of research, development, or commercialization expensesincurred through sales of any of our drug product candidates. The FDA’s policyof granting “fast track” approval for cancer therapies may also expedite the regulatoryapproval of our competitors’ drug product candidates.

Each of the drug productcandidates currently in clinical development will face competition from drugproducts currently on the market or under development. The following tablelists our current principal competitors and their products which compete withthe listed drug product candidates we currently have under development:
| **Our drug  product candidate** | ** ** | **Principal competitor**  | ** ** | **Competitor’s product** |
|---------------------------------|------------|---------------------------|------------|-------------------------------|
| Cintredekin  besudotox          |       | MGI PHARMA, Inc.     |       | Gliadel® Wafer           |
| LEP-ETU                         |       | Bristol-Myers Squibb Co.  |       | Taxol®(1)                |
| LE-SN38                         |       | Pfizer Inc.               |       | Camptosar®               |
| LErafAON                        |       | Isis Pharmaceuticals Inc. |       | Antisense products(2)         |

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

(2)            Thereare currently no antisense products available on the market for the treatmentof cancer, but Isis Pharmaceuticals, Genta Incorporated, and others aredeveloping such products.

We also compete withother drug development companies for licenses to novel technologies as well asfor collaborations with large pharmaceutical and other companies.

**Our stock price has been and islikely to continue to be volatile, and an investment in our common stock coulddecline in value.**

The stock market hasexperienced significant price and volume fluctuations, which often has beenunrelated to the operating performance of particular companies. In addition,the market price of our stock has been highly volatile and is likely tocontinue to be so. For example, during 2004, the market price of our common stockfluctuated between $22.70 and $4.66 per share. During 2005, the market price ofour common stock fluctuated between $15.47 and $7.16 per share.

The following factors,among others, could have a significant impact on the market price of our stock:

·                    thesuccess or failure of our clinical trials, including, but not limited to, thePRECISE trial involving our lead compound, cintredekin besudotox, or those ofour competitors;

·                    announcementsof technological innovations or new drug products by us or our competitors;

·                    litigation,including, but not limited to, current class action lawsuits and resolution ofthe ongoing SEC investigation of the Company;

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·                    actualor anticipated fluctuations in our financial results;

·                    ourability to obtain financing, when needed;

·                    economicconditions in the US and abroad;

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

·                    adverseregulatory actions or decisions;

·                    lossesof key management;

·                    changinggovernmental regulations;

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

·                    developmentsor disputes concerning patents or other proprietary rights;

·                    productor patent litigation; and

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

Additionally, volatilityor a lack of positive performance in our stock price may adversely affect ourability to retain key employees, all of whom have been granted stock options.

These factors andfluctuations, as well as political and market conditions, may materiallyadversely affect the market price of our common stock.

**We are currently named as a defendantin a number of securities class action lawsuits. The volatility of our stockincreases the risk that additional securities class action litigation could beinstituted against us in the future.**

Securities class actionlitigation is often brought against a company following periods of volatilityin the market price of its securities. We, along with certain of our officers,are currently named as defendants in a number of class action lawsuits whichhave been consolidated for trial and are currently pending in the federaldistrict court for the Northern District of Illinois, and each of which allegesvarious violations of the federal securities laws in connection with certain ofour public statements as they relate to our LEP drug product candidate. We maybe named as a defendant in similar litigation in the future. While we arevigorously defending this litigation, this litigation has resulted, and can beexpected to continue to result, in substantial costs and in a diversion ofmanagement’s attention and our resources, which could harm our business andfinancial condition, as well as the market price of our stock. Moreover, it mayresult in an adverse judgment against us or a settlement, either of which couldrequire us to make a payment to the plaintiffs to the extent a possible paymentexceeds or is not covered by our insurance.

**The SEC has initiated aninvestigation of the Company. We believe that this investigation was initiatedas a consequence of our arbitration proceeding, now concluded, involvingPharmacia’s development of LEP and LED and the class action lawsuits involvingour public statements regarding LEP.**

On March 26, 2004,we received a letter from the Securities and Exchange Commission stating thatthe SEC is conducting a formal investigation of the Company. The SEC stated inits letter that it had made no determination of any violation of law by theCompany or any individual at this time. Previously, this matter had been thesubject of an informal SEC inquiry. We have fully cooperated with the SEC. Webelieve the investigation is an outgrowth of the arbitration claim filed by theCompany against Pharmacia (now Pfizer) regarding the development of our LEP andLED drug product candidates, which was concluded in April 2004, and theongoing class action lawsuits which have been filed against us relating topublic statements regarding the development of LEP. We cannot predict withcertainty the direction the investigation will take or its ultimate outcome,and therefore are unable to determine whether the results of the investigationwill have a material adverse impact on our results of operations and financialposition.

**We will need to raise additionalcapital in the future. If additional capital is not available, we may have tocurtail or cease operations.**

We estimate that as of March31, 2006, our then existing cash reserves, should be sufficient to finance ouroperations at current and projected levels of development and general corporateactivity approximately through the fourth quarter 2007. We can offer noassurance that we will be able to generate revenues from product sales in thenear term or in the future, at a rate sufficient to fund our operations. Eventhough we were successful in raising additional capital in January 2006,we will need additional future financing depending on a number of factors,including, but not limited to, the following:

·       ourdegree of success in commercializing our drug product candidates;

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

·       apossible obligation to pay damages arising from the ongoing consolidated classaction lawsuit or fines arising from the SEC investigation, to the extent thesepossible damages or fines exceed, or are not covered by, our insurance;

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

·       emergenceof competing technologies and other adverse market developments;

·       changesin or terminations of our existing licensing arrangements;

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

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

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

Additional financing maynot be available when we need it or be on terms acceptable to us. If adequatefinancing is not available, we may be required to delay, scale-back, oreliminate certain of our research and development programs, to relinquishrights to some of our technologies or products, or to grant licenses to thirdparties to commercialize products or technologies that we would otherwise seekto develop ourselves. We could also be required to cease operations. Ifadditional capital is raised through the sale of equity, our stockholders’ownership interest could be diluted and such securities may have rights,preferences, or privileges superior to those of our other stockholders. Theterms of any debt securities we may sell to raise additional capital may placerestrictions on our operating activities. Failure to secure additionalfinancing may cause us to delay or abandon some or all of our development programs.

**We depend on third parties for avariety of functions, including the research and development, manufacturing,clinical testing, and regulatory compliance of our drug product candidates. Noassurance can be given that these third parties arrangements will allow us tosuccessfully develop and manufacture and market our drug product candidates.**

We do not have theinternal infrastructure to conduct clinical trial management or certain otheraspects of clinical testing ourselves. As of March 31, 2006, we had 96full-time employees. On April 28, 2006, we reduced our workforce by a total of22 employees (approximately 23%) consisting of 20 employees from our researchand development groups and 2 employees from the administrative group. We relyon third parties to perform a variety of functions with respect to the clinicaldevelopment of our drug product candidates, including clinical trialmanagement. If we develop additional drug product candidates with commercialpotential, we may have to either hire additional personnel skilled in clinicaltesting or engage third parties to perform such services.

We have engaged PPD tooversee our PRECISE trial for cintredekin besudotox. Our agreement with PPDobligates us to compensate PPD on a monthly basis plus make milestone paymentsas the trial progresses. For assistance in the management and testing for ourPhase I and Phase II clinical trials we have engaged Research SolutionsIncorporated and Prologue Research International, Inc. on a per studybasis. To oversee data management in our clinical trials we have contracted, ona per study basis, with Advanced Clinical Services. To conduct our large animaltesting, we have engaged, again on a per study basis, Southern ResearchInstitute.

While we have beensatisfied with the performance of these various organizations, we do notdirectly control them. We depend on these organizations to apply theappropriate expertise and resources to expeditiously and competently performthe services for which they have been retained. If any of these third partieswith whom we contract breaches its agreement with us or fails to comply with anapplicable government regulation, we might be required to find a satisfactoryalternative service provider. In addition, our drug development efforts couldbe delayed or impaired. We are aware of at least 25 other entities that couldoffer similar services to those offered by each of PPD Development, ResearchSolutions, and Advanced Clinical Services and three other entities offeringservices similar to those provided by Southern Research Institute. Wefrequently change vendors and consider such items as price, vendor capabilitiesto meet our needs, and ease of transition in choosing new vendors.

In order to commercializeour drug product candidates successfully, we, or third parties with whom wecontract, must be able to manufacture products in commercial quantities incompliance with FDA’s CGMP requirements at acceptable costs and in a timelymanner. We do not currently have CGMP manufacturing capacity for any of thedrug product candidates we are developing. Currently, all of our liposomecompounds are produced at the Center for Advanced Drug Development, which isaffiliated with the University of Iowa Pharmacy School. The Center hasindicated that it is currently able to meet our needs for research and clinicaltrials, but we cannot be sure that it will be able to meet our needs in atimely manner or on a cost-effective basis in the future. If the Center wereunable to meet our needs in the future, we cannot be sure that suitablealternatives could be found in a timely manner, or at all. In addition, we havean agreement with Diosynth RTP, Inc., pursuant to which this companyproduces cintredekin besudotox in the quantities required to support our PhaseIII clinical trial and to manufacture the initial batches of this drug productcandidate that would be necessary to support a BLA to market the product.Diosynth has provided us with quantities of cintredekin besudotox that webelieve will allow us to complete the clinical testing of that drug productcandidate and we believe that they will be able to provide us with sufficientquantities of cintredekin besudotox to support our initial commercialrequirements, if cintredekin besudotox is eventually approved.

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While we have beensatisfied with the performance of both the Center for Advanced Drug Developmentand Diosynth, if either were to breach its agreement with us or fail to complywith any applicable governmental requirement, such actions could delay or impairour drug development and/or BLA or NDA submission efforts and we may berequired to find a satisfactory alternative supplier. Though we are currentlyaware of at least two alternative manufacturers who might be able to supply uswith our requirements for drug product candidates, if we were unable to quicklyreach an agreement with these manufacturers, this could be expected to resultin delays in the development and potential approval by FDA of our drug productcandidates, particularly for cintredekin besudotox.

We also in-licensetechnology from governmental and academic institutions in order to minimize ourinvestment in basic research, and we enter into collaborative arrangements withcertain of these entities with respect to research and development of our drugproduct candidates. At this time we have a research agreement in place withFDA. The research agreement with FDA obligates us to fund research efforts atFDA relating to cintredekin besudotox through April 2006 and we expect torenew at contract expiration. We had a research agreement with Georgetown thatobligated us to fund research efforts through February 28, 2005. We didnot renew the research agreement with Georgetown. No assurance can be giventhat we will enter into more of these relationships, that we will be able tomaintain or renew the research agreement with FDA, that this relationship willprovide benefits to us, or that we will be able to establish new relationshipson beneficial terms, without undue delays or expenditures.

**If we, or our suppliers, fail tocomply with FDA and other government regulations, our manufacturing operationscould be interrupted, and our drug product development, future sales, andprofitability would suffer.**

All new drugs, includingour drug product candidates under development, are subject to extensive andrigorous regulation by FDA and comparable foreign authorities. Theseregulations govern, among other things, the development, pre-clinical andclinical testing, manufacturing, labeling, storage, pre-market approval,advertising, promotion, sale, and distribution of our drug product candidates.We rely on third parties to perform a variety of functions, including researchand development, clinical trial management and testing, and manufacturing ofour drug product candidates. We currently obtain the necessary raw materialsfor our drug product candidates, as well as certain services, such as testing,from third parties. We currently contract with suppliers and service providersthat are required to comply with strict standards established by us. Certainsuppliers and service providers are required to follow GLP, GCP, and CGMPrequirements and are subject to routine unannounced periodic inspections by FDAand by certain state and foreign regulatory agencies for compliance with thoserequirements and other applicable regulations. There can be no assurance thatFDA and other regulatory agencies will find the manufacturing process orfacilities or other operations of our suppliers and other service providers tobe in compliance with GLP, GCP, CGMP or other applicable requirements.

While to the best of ourknowledge, none of our principal suppliers or service providers has been foundto be out of compliance with GLP, GCP, CGMP, or other applicable requirementswith respect to the goods or services they provide to us, failure of any of ourprincipal third party suppliers or service providers to maintain satisfactorycompliance with applicable requirements could have a material adverse effect onour ability to develop, market and distribute our drug product candidates inthe future and, in the most serious cases, could result in the issuance ofwarning letters, seizure or recall of drug products, criminal prosecution,civil penalties or closure of such manufacturing facilities until compliance isachieved.

**We do not have sales, marketing, ordistribution experience, which means we must either enter into agreements withthird parties to market or co-promote our drug product candidates or developmarketing expertise ourselves.**

We have no experience insales, marketing, or distribution. To date, our focus has been on research anddevelopment, and we currently do not have internal sales, marketing, ordistribution resources. If we receive the required regulatory approvals, we couldelect to market and sell our drug product candidates through distribution,co-marketing, co-promotion, or licensing arrangements with third parties, as wehave elected to do with our non-drug NeoPhectinTM products, which are being soldthrough one independent distributor in addition to direct sales to customers.If we elect to market our drug product candidates directly, significantadditional expenditures and management resources will be required to develop aninternal marketing or sales force. We have no experience in establishing ormaintaining an effective sales or marketing effort. If we decide to performsales and marketing activities ourselves, we could face a number of additionalrisks, including, but not limited to:

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

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

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

On the other hand, to theextent that we enter into arrangements with third parties for the marketing andsale of our drug product candidates, any revenues we receive will depend primarilyon the efforts of these third parties, and those revenues may be lower than ifwe marketed our drug products directly. In addition, we may not be successfulin entering into sales and distribution relationships with third parties and,even if we are successful, we will not control the amount and timing ofmarketing resources such third parties devote to our drug product candidates.

There can be no assurancethat we would be able to establish an effective marketing or sales force shouldwe choose to do so. 

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The inability to successfully employ qualifiedmarketing and sales personnel or to develop other sales and marketingcapabilities through third parties would be harmful to our overall businessoperations.

**Our lack of operating experience maycause us difficulty in managing our growth.**

We have no experience inselling pharmaceutical or other products or in manufacturing or procuring drugproducts in commercial quantities in compliance with FDA rules, and we haveonly limited experience in negotiating, establishing and maintainingcollaborative relationships and conducting later stage phases of the regulatoryapproval process. Our ability to manage our growth, if any, will require us toimprove and expand our management and our operational and financial systems andcontrols. If our management is unable to manage growth effectively, ourbusiness and financial condition would be adversely affected. In addition, ifrapid growth occurs, it may strain our operational, managerial and financialresources, which are limited.

**We depend on intellectual propertyrights licensed from third parties. If we fail to meet our obligations underour license agreements, or if technology licensed to us is subject to therights of others, we could lose our rights of exclusivity of use to keytechnologies on which our business depends.**

Our business depends onour technology, which is based in part on patents and patent applicationslicensed from third parties. Those third-party license agreements imposeobligations on us, such as payment obligations and obligations to diligentlypursue development of commercial products under the licensed rights. Ourlicense agreement regarding cintredekin besudotox requires us to engage inclinical trials of the compound in patients with renal cell carcinoma. Previoustrials demonstrated that cintredekin besudotox is toxic in those patients.However, we have instead focused on developing this compound for treatingpatients with glioblastoma multiforme. We have informed the governmental agencyfrom which we licensed these patents of this change, and we received noobjections to it.

Because of our dependenceon intellectual property rights licensed to us by third parties, any adversedevelopment in our relationship with these licensors, including a disputeregarding our rights under the agreements or the grant of rights by ourlicensors to others, could materially and adversely affect our right tocommercialize the products we are developing or preclude others fromcommercializing these products.

If a licensor believesthat we have failed to meet our obligations under a license agreement, thelicensor could seek to limit or terminate our licensed rights, which could leadto costly and time-consuming litigation and, potentially, a loss of the licensedrights. During the period of any such litigation, our ability to carry out thedevelopment and commercialization of potential products could be significantlyand negatively affected. If our licensed rights were restricted or ultimatelylost, our ability to continue our business based on the affected technologyplatform would be severely adversely affected.

We depend in large parton our licensors to have and maintain the patent rights licensed to us. Whereour licensors cannot license technologies to us to the exclusion of thirdparties, our competitive position could be impaired. In this regard, weunderstand that co-rights to the technologies exclusively licensed to us by NIHrelating to cintredekin besudotox are claimed by one of the inventors, who hassubsequently entered into an agreement assigning such rights as he may have toa third party. We are in the process of determining the nature of his claimedrights and whether or not this assignment is valid. Although we have beengranted “orphan drug” status with respect to the use of cintredekin besudotoxfor malignant gliomas (a class of brain tumors which includes glioblastomamultiforme), and are thus potentially eligible to receive orphan drugexclusivity upon approval, in the event it were to be determined at a futuredate that we do not have exclusive rights to the technology licensed to us byNIH, we may be unable to preclude third parties during or after any period oforphan drug exclusivity from commercializing a drug based on cintredekinbesudotox for other indications, which could cause our business to suffer. Inorder to receive orphan drug exclusivity, we must be the first cintredekinbesudotox product approved for malignant glioma. We are currently unaware ofanyone else developing a cintredekin besudotox based drug for the treatment ofmalignant glioma, and believe that significant hurdles exist to bringing such aproduct forward to compete with our drug product candidate. If we receiveorphan drug exclusivity, it would prevent FDA for a period of seven years fromapproving another sponsor’s marketing application for the same drug for thoseorphan indications, except that a subsequent applicant could still be approvedif it demonstrated clinical superiority to our product. Other applicants couldalso receive approval of compounds other than cintredekin besudotox formalignant glioma, which would compete with our product, or could receiveapproval of cintredekin besudotox for other uses, in which case the competingcintredekin besudotox products, if suitable, could be prescribed by physiciansoutside their FDA approvals for malignant glioma and harm our business. Inaddition, it should be noted that, even if it were determined at a future datethat we do not have exclusivity with respect to the patents and patentapplications licensed from NIH, we have also filed various additional patentapplications related to the methods of administration and use of cintredekinbesudotox which are not part of the NIH patents. While we believe that patentsthat may eventually be granted under these patent applications would provide uswith additional exclusivity of use for cintredekin besudotox, these patentapplications are still pending, may not be granted, and are subject to therisks described herein relating to patents in general.

**Our inability to adequately protectour proprietary technologies could harm our competitive position and have amaterial adverse effect on our business.**

The success of ourbusiness depends, in part, on our ability to obtain patents and maintainadequate protection of our intellectual 

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property for our proprietary technology and productsin the United States and other countries. The laws of some foreign countries donot protect proprietary rights to the same extent as the laws of the UnitedStates, and many companies have encountered significant problems in protectingtheir proprietary rights in these foreign countries. These problems can becaused, for example, by a lack of rules and processes allowing formeaningful defense of intellectual property rights. If we do not adequatelyprotect our intellectual property, competitors may be able to use ourtechnologies and impair our competitive position, with the result that ourbusiness and operating results could be harmed.

The patent positions ofpharmaceutical companies, including our patent positions, are often uncertainand involve complex legal and factual questions. We will be able to protect ourproprietary rights from unauthorized use by third parties only to the extentthat our proprietary technologies are covered by valid and enforceable patentsor are effectively maintained as trade secrets. We apply for patents coveringour technologies and drug product candidates, as we deem appropriate.Currently, we either own or have obtained licenses to more than 50 UnitedStates patents and patent applications relating to our technology, compounds,and drug product candidates, many of which have foreign counterparts either asissued patents or pending patent applications. However, we may not obtainpatents on all inventions for which we seek patents, and any patents we obtainmay be challenged and may be narrowed in scope or extinguished as a result ofsuch challenges. Our existing patents and any future patents we obtain may notbe sufficiently broad to prevent others from practicing our technologies orfrom developing competing products. Others may independently develop similar oralternative technologies or design around our patented technologies or drugproduct candidates. These companies would then be able to develop, manufacture,and sell products, which compete directly with our drug product candidates. Inthat case, our revenues and operating results would decline.

We rely upon trade secretprotection for certain of our confidential information, including certain ofour trade secrets, know-how, technology advances and processes. While we havetaken measures to protect our confidential information, and to date have notexperienced any difficulties in maintaining the confidentiality of our information,these measures may not provide adequate protection for our trade secrets,know-how or other confidential information in the future. We seek to protectour confidential information by entering into confidentiality agreements withemployees, collaborators, and consultants. Nevertheless, employees,collaborators, or consultants may still disclose or misuse our confidentialinformation, and we may not be able to meaningfully protect our trade secrets.In addition, others may independently develop substantially equivalentinformation or techniques or otherwise gain access to our trade secrets.Disclosure or misuse of our confidential information would harm our competitiveposition and could cause our revenues and operating results to decline.

**We may be sued for infringing on theintellectual property rights of others.**

Our commercial successalso depends in part on ensuring that we do not infringe the patents orproprietary rights of third parties. The biotechnology industry has produced aproliferation of patents, and it is not always clear to industry participants,including us, which patents cover various types of products. The coverage ofpatents is subject to interpretation by the courts, and the interpretation isnot always uniform. While we have not been sued for infringing the intellectualproperty rights of others, there can be no assurance that the drug productcandidates that we have under development do not or will not infringe on thepatent or proprietary rights of others. Third parties may assert that we areemploying their proprietary technology without authorization. We know ofpatents issued to third parties relating to antisense and oligonucleotidetechnology, including patents about which such third parties have communicatedwith us suggesting possible infringement, but the claims of which we believe wedo not infringe or are invalid. Moreover, United States patent applicationsfiled in recent years are confidential for 18 months, while olderapplications are not published until the patent issues. Further, someapplications are kept secret during the entire length of their pendency byrequest of the applicant in special circumstances. As a result, there may bepatents of which we are unaware, and avoiding patent infringement may be difficult.Patent holders sometimes send communications to a number of companies inrelated fields, suggesting possible infringement, and we, like a number ofbiotechnology companies, have received this type of communication. If we aresued for patent infringement, we would need to demonstrate that we either donot infringe the patent claims of the relevant patent and/or that the patentclaims are invalid, which we may not be able to do. Proving invalidity, inparticular, is difficult since it requires a showing of clear and convincingevidence to overcome the presumption of validity enjoyed by issued patents.Parties making claims against us may be able to obtain injunctive or otherequitable relief that could effectively block our ability to further develop, commercializeand sell products, and such claims could result in the award of substantialdamages against us. In the event of a successful claim of infringement againstus, we may be required to pay damages and obtain one or more licenses fromthird parties. We may not be able to obtain these licenses at a reasonablecost, if at all. In that event, we could encounter delays in productintroductions while we attempt to develop alternative methods or products or berequired to cease commercializing affected products and our operating resultswould be harmed.

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

**We may in the future be a party topatent litigation, which could be expensive and divert our management’sattention.**

The field ofbiotechnology has been characterized by extensive litigation regarding patentsand other intellectual property rights, 

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and companies in the industry have used intellectualproperty litigation to gain a competitive advantage. We may become a party topatent infringement claims and litigation or interference proceedings declaredby the US Patent and Trademark Office to determine the priority of inventions.The defense and prosecution of these matters are both costly and timeconsuming. We may need to commence proceedings against others to enforce ourpatents, trade secrets or other know-how or defend against claims ofinfringement asserted against us, which would require investigation anddetermination of the enforceability, scope and validity of the respectiveproprietary rights. These proceedings could result in substantial expense to usand significant diversion of efforts by our technical and management personnel.

**If we lose key management personnelor are unable to attract and retain the talent required for our business, ourbusiness could be harmed.**

We are highly dependenton the principal members of our management staff, including, but not limitedto, our President and Chief Executive Officer, Mr. Guillermo A. Herrera.The principal members of our management and scientific staff acceptedemployment on the basis of written offers which set forth the salary andbenefits to be provided, including, but not limited to, salary continuationpayments upon termination of employment. Only Mr. Herrera has anemployment contract with us. We do not have key man insurance on any of ourmanagement. If we were to lose the services of Mr. Herrera, or othermembers of our management staff, and were unable to replace them, our productdevelopment and the achievement of our strategic objectives could be delayed.In addition, our success will depend on our ability to attract and retainqualified commercial, scientific, technical, and managerial personnel. While wehave not experienced unusual difficulties to date in recruiting and retainingpersonnel, there is intense competition for qualified staff and no assurancecan be given that we will be able to retain existing personnel or attract andretain qualified staff in the future.

**The demand for our drug productcandidates, if any, may be adversely affected by health care reform andpotential limitations on third-party reimbursement.**

In recent years, therehave been numerous proposals to change the health care system in the US. Someof these proposals have included measures that would limit or eliminatepayments for medical procedures and treatments or subject the pricing ofpharmaceutical products to government control. We cannot predict the effectthat health care reforms may have on our business, and it is possible that suchreforms will hurt our business. In addition, in both the US and elsewhere,sales of prescription pharmaceutical products are dependent in part on theavailability of reimbursement to the consumer from third party payors, such asgovernment and private insurance plans. Third party payors are increasinglychallenging the prices charged for medical products and services with respectto new drug products in particular. If we succeed in bringing any of our drugproduct candidates to the market, we cannot be certain that our products willbe considered cost effective or that reimbursement to the consumer will beavailable or will be sufficient to allow us or our collaborators to sell ourproducts on a competitive basis.

In addition, many healthmaintenance organizations and other third party payors use formularies, orlists of drugs for which coverage is provided under a health care benefit plan,to control the costs of prescription drugs. Each payor that maintains a drugformulary makes its own determination as to whether a new drug will be added tothe formulary and whether particular drugs in a therapeutic class will havepreferred status over other drugs in the same class. This determination ofteninvolves an assessment of the clinical appropriateness of the drug andsometimes the cost of the drug in comparison to alternative products. We cannotbe assured that:

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

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

·       theformulary decisions will be conducted in a timely manner.

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

**Physicians, patients, payors, or themedical community in general may be unwilling to accept, utilize, or recommendany of our drug products, and the failure to achieve market acceptance willharm our business.**

Even if approved formarketing, our drug products may not achieve market acceptance. The degree ofmarket acceptance of our drug products will depend upon a number of factors,including:

·       theestablishment and demonstration in the medical community of the safety andclinical efficacy of our drug products and their potential advantages overexisting therapeutic products, including non-liposomal forms of the activeagents included in our drug products; and

·       pricingand reimbursement policies of government and third party payors such asinsurance companies, health maintenance organizations and other planadministrators.

**Material weaknesses or deficienciesin our internal control over financial reporting could harm stockholder andbusiness confidence in our financial reporting, our ability to obtain financing,and other aspects of our business.**

**As of March 31 2006, managementconcluded that a control deficiency with respect to the review and verificationof the accuracy of the calculation estimating the fair value of non-employeestock options constituted a material weakness in internal control overfinancial reporting.  A material weaknessis a control deficiency, or combination of control deficiencies that results inmore than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected.  This control deficiency resulted in anadjustment to the unaudited interim condensed consolidated financial statementsfor the quarter ended March 31, 2006 affecting derivative financial instrumentsand change in fair value of derivative financial instruments.**

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**Management is in the process ofreviewing and, as necessary, revising its policies and procedures with respectto its controls over the review and verification of the accuracy of thecalculation estimating the fair value of non-employee stock options to ensurethat all reasonable steps will be taken to correct this material weakness.  The deficiency will not be consideredremediated until the new internal controls are operational for a period of timeand are tested, and management has concluded that the controls are operatingeffectively.  Until it is remediated, theidentified control deficiency could result in a misstatement in the derivativefinancial instruments and change in fair value of derivative financialinstruments balances that would not be prevented or detected.  While management believes it has or will takethe appropriate steps to remediate this control deficiency, we may not be ableto remediate the identified control deficiency prior to management’s assessmentand the audit of our assessment as of December 31, 2006.  A failure on our part to properly remediatethe control deficiency could materially and adversely affect our business, ourfinancial condition and the market value of our securities.  In addition, our ability to obtain additionalfinancing could be materially or adversely affected.**

Internal control over financial reporting can provideonly reasonable and not absolute assurance that deficiencies or weaknesses areidentified. Additionally, potentialcontrol deficiencies that are not yet identified could emerge and internalcontrols that are currently deemed to be in place and operating effectively aresubject to the risk that those controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate. Identification and corrections of these types ofpotential control deficiencies could have a material impact on our business,financial position, results of operations, and disclosures.

**Our investments could lose marketvalue and consequently harm our ability to fund continuing operations.**

The primary objective ofour investment activities is to preserve principal while at the same timemaximizing yields without significantly increasing risk. To achieve thisobjective, we maintain our portfolio of cash, cash equivalents and short-terminvestments in a variety of securities, including government and corporateobligations and money market funds. The market values of these investments mayfluctuate due to market conditions and other conditions over which we have nocontrol. Fluctuations in the market price and valuations of these securitiesmay require us to record losses due to impairment in the value of thesecurities underlying our investment. This could result in future charges toour earnings. All of our investment securities are denominated in US dollars.

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

**We handle hazardous materials andmust comply with environmental laws and regulations, which can be expensive andrestrict how we do business. We could also be liable for damages, penalties, orother forms of censure if we are involved in a hazardous waste spill or otheraccident.**

Our research anddevelopment processes involve the controlled storage, use, and disposal ofhazardous materials and biological hazardous materials. We are subject tofederal, state, and local laws and regulations governing the use, manufacture,storage, handling, and disposal of hazardous materials and certain wasteproducts. Although we believe that our safety procedures for handling anddisposing of these hazardous materials comply with the standards prescribed bylaw and regulation, the risk of accidental contamination or injury fromhazardous materials cannot be completely eliminated. In the event of anaccident, even by a third party, we could be held liable for any damages thatresult, and such liability could exceed our current general liability insurancecoverage of $1,000,000 and our financial resources. In the future, we may notbe able to maintain insurance on acceptable terms, or at all. We could also berequired to incur significant costs to comply with current or futureenvironmental laws and regulations.

**We may have product liabilityexposure, and insurance against such claims may not be available to us atreasonable rates or at all.**

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

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**Anti-takeover provisions could make athird party acquisition of us or the removal of our board of directors ormanagement more difficult.**

In June 2003, weadopted a stockholder rights plan that provided for the issuance of rights topurchase shares of Series A Participating Preferred Stock (“Series APreferred”) of the Company. Under the plan, we distributed one preferred sharepurchase right for each outstanding share of common stock. Each purchase rightentitles the holder to purchase from the Company one one-thousandth (1/1000th)of a share of Series A Preferred at a price of $112.00 per share, subjectto adjustment. The rights become exercisable, with certain exceptions, ten businessdays after any party, without prior approval of our Board of Directors,acquires, or announces an offer to acquire, beneficial ownership of 15% or moreof our common stock. An exception to this policy exists in the case of ourlargest shareholder, Dr. John N. Kapoor, who is permitted to acquire up to30% of our common stock without triggering the rights issuance. In the eventthat any party acquires 15% or more of our common stock (other than Dr. Kapoorfor whom the threshold is 30%), we are acquired in a merger or other businesscombination, or 50% or more of our assets are sold after the time that therights become exercisable, the rights provide that each right holder willreceive, upon exercise, shares of the common stock of the surviving or acquiringcompany, as applicable, having a market value of twice the exercise price ofthe right. The stockholder rights plan may discourage or prevent certain typesof transactions involving an actual or potential change in control, whichtransactions may be beneficial to our shareholders, by causing substantialdilution to a party that attempts to acquire us on terms not approved by ourBoard of Directors. In addition, Section 203 and other provisions of theDelaware General Corporation Law as well as provisions of our charter andby-laws could make a takeover of us or the removal of the members of the boardof directors or management more difficult.

**The issuance of preferred stock couldadversely affect the holders of our common stock.**

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

**If there are substantial sales ofcommon stock, the market price of our common stock could decline.**

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

**Item 2.**                          UnregisteredSales of Equity Securities and Use of Proceeds

**                                                              **None

**Item 3.**                          DefaultsUpon Senior Securities

**                                                              **None

**Item 4.**                          Submissionof Matters to a Vote of Security Holders

**                                                              **None

**Item 5.**                          OtherInformation

**                                                              **None

**Item6.**                          Exhibits

| Exhibit 31.1 |   | Certification of the Chief Executive Officer                          |
|-------------------|--------|-----------------------------------------------------------------------|
|              |   |                                                                  |
| Exhibit 31.2 |   | Certification of the Chief Financial Officer                          |
|              |   |                                                                  |
| Exhibit 32.1 |   | Certification pursuant to section 906 of the  Sarbanes-Oxley Act |
|              |   |                                                                  |
| Exhibit 32.2 |   | Certification pursuant to section 906 of the  Sarbanes-Oxley Act |

 

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**SIGNATUREPAGE**

**Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.**
|                          |     |     |     | NEOPHARM, INC.                                                                             |
|--------------------------|----------|----------|----------|--------------------------------------------------------------------------------------------|
| Date: May 15,  2006 |     | By:      |     | /s/ Lawrence A. Kenyon                                                                     |
|                     |     |     |     | Lawrence A. Kenyon,                                                                        |
|                     | * * | * * | * * | *Chief Financial Officer  (Principal Accounting Officer and  Principal Financial Officer)* |

 

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