** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 
| **ý**                                                                                                                                                                                           | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**         |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                           | ** **                                                                                          |
| **For Quarterly Period Ended June 30, 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 filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 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 large accelerated filer” in Rule 12b-2 of the ExchangeAct. (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-2 of theExchange Act).  Yes   o  No  ý

As of July 31,2006, the number of shares outstanding of each of the issuer’s classes ofcommon stock was as follows:

 
| Title of each class                | ** ** | **Number of shares outstanding** |
|------------------------------------|------------|----------------------------------|
| Common Stock ($.0002145 par value) |       | 27,877,247                       |

 

 

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NEOPHARM, INC.

FORM 10-QINDEX
| PART I. FINANCIAL  INFORMATION |
|--------------------------------|
|                           | Item 1. | Financial Statements |
|                           |   | Condensed  Consolidated Balance Sheets as of June 30, 2006 (unaudited) and  December 31, 2005 |
|                           |   | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2006 and 2005 (unaudited) |
|                           |   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 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**
| ** **                                                                                                                                | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                | ** ** | **(Unaudited)**             | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                |       |                        |       |                            |       |
| Current assets:                                                                                                                           |       |                        |       |                            |       |
| Cash and cash  equivalents                                                                                                                |       | $                           | 3,140,021  |                            | $          | 1,486,172 |   |
| Short-term  investments                                                                                                                   |       | 47,441,193                  |       | 28,776,020                      |       |
| Trade accounts  receivable, net                                                                                                           |       | 4,025                       |       | 1,285                           |       |
| Inventories                                                                                                                               |       | 4,950                       |       | 5,677                           |       |
| Prepaid expenses                                                                                                                          |       | 392,595                     |       | 727,432                         |       |
| Other  receivables                                                                                                                        |       | 16,226                      |       | 155                             |       |
| Total current  assets                                                                                                                     |       | 50,999,010                  |       | 30,996,741                      |       |
| Fixed assets, net                                                                                                                         |       | 1,753,802                   |       | 2,157,507                       |       |
| Other assets                                                                                                                              |       | 213,271                     |       | 215,737                         |       |
| Total assets                                                                                                                              |       | $                           | 52,966,083 |                            | $          | 33,369,985 |   |
|                                                                                                                                      |       |                        |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                            |       |                        |       |                            |       |
| Current liabilities:                                                                                                                      |       |                        |       |                            |       |
| Obligations  under capital lease                                                                                                          |       | $                           | 28,954     |                            | $          | — |   |
| Accounts payable                                                                                                                          |       | 1,002,138                   |       | 683,168                         |       |
| Accrued clinical  trial expense                                                                                                           |       | 3,591,746                   |       | 5,369,507                       |       |
| Accrued  compensation                                                                                                                     |       | 1,635,259                   |       | 1,888,534                       |       |
| Other accrued  expenses                                                                                                                   |       | 1,213,024                   |       | 1,447,265                       |       |
| Derivative  financial instruments                                                                                                         |       | 23,880                      |       | —                          |       |
| Deferred and  unearned revenue                                                                                                            |       | 500                         |       | —                          |       |
| Total current  liabilities                                                                                                                |       | 7,495,501                   |       | 9,388,474                       |       |
|                                                                                                                                      |       |                        |       |                            |       |
| Obligations under  capital lease                                                                                                          |       | 120,619                     |       | —                          |       |
| Deferred revenue                                                                                                                          |       | 2,000,000                   |       | 2,000,000                       |       |
| Deferred rent                                                                                                                             |       | 48,714                      |       | 36,187                          |       |
| Derivative financial  instruments                                                                                                         |       | 457,158                     |       | —                          |       |
|                                                                                                                                      |       |                        |       |                            |       |
| 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: 27,877,247 and 23,740,051  shares issued and outstanding, respectively |       | 5,981                       |       | 5,092                           |       |
| Additional paid-in  capital                                                                                                               |       | 288,333,183                 |       | 249,964,947                     |       |
| Accumulated deficit                                                                                                                       |       | (245,495,073                | )          | (228,024,715                    | )          |
| Total  stockholders’ equity                                                                                                          |       | 42,844,091                  |       | 21,945,324                      |       |
| Total liabilities and  stockholders’ equity                                                                                          |       | $                           | 52,966,083 |                            | $          | 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 and Six Months Ended June 30, 2006 and 2005**(Unaudited)
| ** **                                                | ** ** | **Three-Month Periods Ended** | ** ** | **Six-Month Periods Ended** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                | ** ** | **June 30, 2006**             | ** ** | **June 30, 2005**           | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Collaboration revenue                                     |       | $                                       | —     |                                  | $          | 435,000 |   | $ | — |   | $ | 500,000 |   |
| Product revenue                                           |       | 8,670                                   |       | 19,600                                |       | 10,280 |   | 25,900 |   |
| Total revenue                                             |       | 8,670                                   |       | 454,600                               |       | 10,280 |   | 525,900 |   |
|                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Expenses:                                                 |       |                                    |       |                                  |       |   |   |   |   |
| Cost of product  revenue                                  |       | 657                                     |       | 1,060                                 |       | 727 |   | 1,350 |   |
| Research and  development                                 |       | 6,037,143                               |       | 7,960,917                             |       | 11,880,902 |   | 16,034,678 |   |
| Selling,  general, and administrative                     |       | 4,495,843                               |       | 3,051,288                             |       | 7,541,399 |   | 6,284,597 |   |
| Change in fair  value of derivative financial instruments |       | (627,545                                | )          | —                                |       | (1,170,673 | ) | — |   |
| Employee  termination costs                               |       | 570,253                                 |       | —                                |       | 570,253 |   | — |   |
| Recovery of note  receivable                              |       | —                                  |       | (2,500,000                            | )          | — |   | (2,500,000 | ) |
| Total expenses                                            |       | 10,476,351                              |       | 8,513,265                             |       | 18,822,608 |   | 19,820,625 |   |
| Loss from operations                                      |       | (10,467,681                             | )          | (8,058,665                            | )          | (18,812,328 | ) | (19,294,725 | ) |
|                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Interest income, net                                      |       | 676,284                                 |       | 401,364                               |       | 1,341,970 |   | 773,151 |   |
| Net loss                                                  |       | $                                       | (9,791,397 | )                                     | $          | (7,657,301 | ) | $ | (17,470,358 | ) | $ | (18,521,574 | ) |
| Net loss per share —                                 |       |                                    |       |                                  |       |   |   |   |   |
| Basic and  diluted                                        |       | $                                       | (0.35      | )                                     | $          | (0.32 | ) | $ | (0.63 | ) | $ | (0.79 | ) |
| Weighted average shares  outstanding —               |       |                                    |       |                                  |       |   |   |   |   |
| Basic and diluted                                         |       | 27,798,475                              |       | 23,561,539                            |       | 27,559,480 |   | 23,515,755 |   |

 

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 FlowsSix Months Ended June 30, 2006 and 2005**(Unaudited)
| ** **                                                                   | ** ** | **Six Months Ended** | ** **  |
|------------------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                                   | ** ** | **June 30, 2006**    | ** **  | **June 30, 2005** | ** ** |
| Cash flows from  operating activities:                                       |       |                           |        |   |   |
| Net loss                                                                     |       | $                              | (17,470,358 | ) | $ | (18,521,574 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                           |        |   |   |
| Depreciation and  amortization                                               |       | 676,404                        |        | 680,095 |   |
| Stock-based  compensation expense                                            |       | 1,036,223                      |        | 361,779 |   |
| Change in fair value of  derivative financial instruments                    |       | (1,170,673                     | )           | — |   |
| Loss on retirement of  equipment and furniture                               |       | 8,541                          |        | 4,963 |   |
| Changes in assets and  liabilities:                                          |       |                           |        |   |   |
| Decrease in  current assets                                                  |       | 301,580                        |        | 212,533 |   |
| Decrease in  other assets                                                    |       | 2,466                          |        | — |   |
| Decrease in  other current liabilities                                       |       | (1,946,307                     | )           | (248,877 | ) |
| Increase in  deferred and unearned revenue                                   |       | 500                            |        | 2,000,000 |   |
| Increase in  deferred rent                                                   |       | 12,527                         |        | — |   |
| Net cash and cash  equivalents used in operating activities                  |       | (18,549,097                    | )           | (15,511,081 | ) |
|                                                                         |       |                           |        |   |   |
| Cash flows from  investing activities:                                       |       |                           |        |   |   |
| Proceeds from sales of  marketable securities                                |       | 22,150,000                     |        | 19,500,000 |   |
| Purchase of marketable  securities                                           |       | (40,800,000)                   |        | (56,050,000 | ) |
| Purchase of equipment  and furniture                                         |       | (120,145                       | )           | (69,680 | ) |
|                                                                         |       |                           |        |   |   |
| Net cash and cash  equivalents used in investing activities                  |       | (18,770,145                    | )           | (36,619,680 | ) |
|                                                                         |       |                           |        |   |   |
| Cash flows from  financing activities:                                       |       |                           |        |   |   |
| Proceeds from issuance  of common stock                                      |       | 38,731,386                     |        | — |   |
| Proceeds from exercise  of stock options                                     |       | 253,227                        |        | 778,925 |   |
| Repayment of capital  lease obligation                                       |       | (11,522                        | )           | — |   |
| Net cash and cash equivalents  provided by financing activities              |       | 38,973,091                     |        | 778,925 |   |
|                                                                         |       |                           |        |   |   |
| Net increase  /(decrease) in cash and cash equivalents                       |       | 1,653,849                      |        | (51,291,827 | ) |
| Cash and cash  equivalents, beginning of period                              |       | 1,486,172                      |        | 52,736,320 |   |
| Cash and cash  equivalents, end of period                                    |       | $                              | 3,140,021   |   | $ | 1,444,493 |   |
|                                                                         |       |                           |        |   |   |
| Supplemental disclosure  of cash paid for:                                   |       |                           |        |   |   |
| Interest                                                                     |       | $                              | 4,239       |   | $ | — |   |
| Income taxes                                                                 |       | $                              | —      |   | $ | — |   |

 

Supplementalschedule of non-cash investing and financing activities:

During the sixmonths ended June 30, 2006, the Company entered into a capital lease obligationfor office equipment of $161,095.

During the sixmonths ended June 30, 2005, the Company issued 23,692 shares of the Company’scommon 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 FINANCIAL STATEMENTS(unaudited)**

**Note 1 Basis of Presentation**

The financialinformation herein is unaudited.  Thebalance sheet as of December 31, 2005 is derived from audited financialstatements.

The accompanyingunaudited condensed consolidated financial statements of NEOPHARM, Inc. andsubsidiary (the “Company”) have been prepared in accordance with U.S. generallyaccepted accounting principles (“GAAP”) for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.Accordingly, they do not contain all of the information and notes required byU.S. GAAP for complete financial statements. In the opinion of the Company, theaccompanying unaudited condensed consolidated interim financial statementscontain all adjustments (consisting of normal recurring adjustments) necessaryto present fairly the Company’s financial position as of June 30, 2006 and theresults of its  operations for the threeand six months ended June 30, 2006 and 2005, and their cash flows for the sixmonths ended June 30, 2006 and 2005.  Theresults of operations for the three and six months ended June 30, 2006 are notnecessarily indicative 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 Limitedwas created 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 financial statements and notes included in the Company’s2005 Annual Report on Form 10-K filed with the Securities and ExchangeCommission (“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 those estimates.

Certain amounts in2005 have been reclassified to conform to the current year presentation.  In particular, the Company classifiesinvestments in auction rate certificates as short-term investments, which hadpreviously been classified as a cash equivalent.  This reclassification affected theclassification of cash flows from investing activities on the ConsolidatedStatements of Cash Flows for the six months ended June 30, 2005 which reflectspurchases of marketable securities of $56,050,000 and proceeds from sales ofmarketable securities of $19,500,000, 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”), whichrequires the recognition of compensation expense related to the fair value ofthe Company’s stock-based compensation awards effective January 1, 2006.  Prior to the adoption of SFAS 123R, theCompany accounted for stock-based awards to directors, officers, and employees,using the intrinsic value method in accordance with Accounting Principles BoardOpinion No. 25 (“APB 25”) as allowed under Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).Under the intrinsic value method, compensation expense is measured on the dateof grant if the current market price of the underlying stock exceeded theexercise price or when the number of shares and exercise price are known ifboth are not determinable at the date of grant. Compensation expense for fixed stock options was recognized ratably overthe vesting period.  SFAS 123 establishedaccounting and disclosure requirements using a fair value method of accountingfor stock-based employee compensation plans. 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 this transition method, compensationcost recognized in the 2006 condensed consolidated statements of operationsincludes: a) compensation cost 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 cost for the fair valuefor all share-based awards granted or modified subsequent to January 1,2006.  In conjunction with the adoptionof SFAS No. 123R, the Company has adopted a policy of recognizing compensationcost on a straight-line basis.  Under thepro forma disclosure requirements of SFAS No. 123, in prior periods, theCompany recognized costs on a straight-line basis and considered the effect offorfeitures in the period an award was cancelled.

InFebruary 2006, the FASB issued SFAS No. 155, *Accounting forCertain Hybrid Financial Instruments, an amendment of FASB StatementsNo. 133 and 140*, to simplify and make more consistent theaccounting for certain financial instruments. SFAS No. 155 applies to allfinancial instruments acquired or issued after the beginning of an entity’sfirst fiscal year that begins after 

6

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September 15, 2006 withearlier application allowed. The adoption of SFAS No. 155 is not expectedto have a material impact on the Company’s consolidated financial position orresults of operations.

In June 2006, the FASB issued FASB Interpretation No.48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes,an interpretation of FASB Statement No. 109.*  This interpretation is effective for fiscalyears beginning after December 15, 2006 and clarifies the accounting foruncertainty in income taxes by prescribing a recognition threshold andmeasurement attribute for financial statement recognition and measurement of atax position taken or expected to be taken in a tax return as well as providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. Adoption of FIN 48 is not expected to have a material impact on theCompany’s consolidated financial position or results of operations.

**Note 2 Loss Per Share**

The followingtable sets forth the computation of basic and diluted net loss per share:

|                                      | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Numerator:                           |       |                             |       |                           |       |   |   |   |   |
| Net loss                             |       | $                                | (9,791,397 | )                              | $          | (7,657,301 | ) | $ | (17,470,358 | ) | $ | (18,521,574 | ) |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Denominator:                         |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding  |       | 27,798,475                       |       | 23,561,539                     |       | 27,559,480 |   | 23,515,755 |   |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Loss per share -  basic and diluted  |       | $                                | (0.35      | )                              | $          | (0.32 | ) | $ | (0.63 | ) | $ | (0.79 | ) |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Potential common  share equivalents: |       |                             |       |                           |       |   |   |   |   |
| Stock options                        |       | 3,867,619                        |       | 3,470,759                      |       | 3,867,619 |   | 3,470,759 |   |

 

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 describedbelow.  Amounts recognized in thecondensed consolidated financial statements with respect to this plan are asfollows:

|                                                            | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
|                                                       |       |                             |       |                           |       |   |   |   |   |
| Research and  development                                  |       | $                                | 220,415    |                           | $          | — |   | $ | 387,602 |   | $ | — |   |
| General and  administrative                                |       | 244,279                          |       | 209,060                        |       | 648,621 |   | 361,779 |   |
|                                                       |       |                             |       |                           |       |   |   |   |   |
| Total cost of  share-based payment plans during the period |       | $                                | 464,694    |                           | $          | 209,060 |   | $ | 1,036,223 |   | $ | 361,779 |   |

 

No amounts of share-basedcompensation cost have been capitalized into inventory or other assets duringthe three and six months ended June 30, 2006 or 2005.

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

|                                                                                                        | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                             | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
| Net loss as  reported                                                                                  |       | $                                | (7,657,301 | )                              | $          | (18,521,574 | ) |
|                                                                                                   |       |                             |       |                           |       |
| Add: stock-based  compensation expense included in reported net loss                                   |       | 209,060                          |       | 361,779                        |       |
|                                                                                                   |       |                             |       |                           |       |
| Less: total  stock-based compensation expense determined under fair value based method for  all awards |       | (406,185                         | )          | (606,854                       | )          |
|                                                                                                   |       |                             |       |                           |       |
| Pro forma net  loss                                                                                    |       | $                                | (7,854,426 | )                              | $          | (18,766,649 | ) |

 

7

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| Basic and  diluted loss per common share |   |   |   |   |   |
|------------------------------------------|--------|--------|--------|--------|--------|
| As reported                              |   | $      | (0.32  | )      | $      | (0.79 | ) |
| Pro forma                                |   | $      | (0.33  | )      | $      | (0.80 | ) |

 

Until June 19,2006, the Company maintained the 1998 Equity Incentive Plan (the “1998 Plan”),which replaced all prior equity incentive plans.  The 1998 Plan, provided for the grant ofawards (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 awardswere generally granted with an exercise price equal to the closing price of theCompany’s common stock at the date of grant, but may have been granted with anexercise price of not less than 85% of the fair market value of the Company’scommon stock.  Option awards typicallyvested based upon continuous service in increments of 25% of the total grant onthe first four anniversaries of the original grant and are exercisable as theoptions vest.  Option awards typicallyhave 10-year contractual terms. Nonvested stock awards granted to non-employee directors of the Company typicallyvested after a service period of 1 year. Option and nonvested stock awards provide for accelerated vesting ifthere is a change in control (as defined in the 1998 Plan).  Although the 1998 Plan provided for the grantof performance units and performance shares, the Company did not grant thesetypes of awards.

On April 26, 2006, theBoard of Directors of the Company adopted the NEOPHARM, Inc. 2006 EquityIncentive Plan (the “2006 Plan”) which was approved by the stockholders at the2006 Annual Meeting on June 19, 2006.  Nofurther awards will be made under the 1998 Plan.  The 2006 Plan provides for the grant ofawards (options, nonvested stock, performance units or performance shares) toemployees, directors and consultants to acquire up to 1,000,000 shares of theCompany’s common stock.  No more than500,000 shares of common stock may be issued as restricted stock awards or asbonus stock awards.  Option awards aregenerally granted with an exercise price equal to the mean between the lowestand highest reported sale prices of the Company’s common stock on the date ofgrant, but shall not be granted with an exercise price of less than 85% of thefair market value of the Company’s common stock at the date of grant.  Option awards typically vest based uponcontinuous service in increments of 25% of the total grant on the first fouranniversaries of the original grant and are exercisable as the options vest,subject to the Company’s policies in effect from time to time concerningtransactions by employees in the Company’s securities. Option awards typicallyhave a 10-year contractual term.  Nonvestedstock awards are granted to non-employee directors of the Company and typicallyvest after a service period of 1 year. Option and nonvested stock awards provide for accelerated vesting ifthere is a change in control (as defined in the 2006 Plan).  Although the 2006 Plan provides for the grantof performance units and performance shares, the Company has not made grants ofthese types of awards.  As of June 30,2006, 941,917 shares were available for issuance under the 2006 Plan.

OnJune 19, 2006, the Company’s shareholders approved the 2006 Employee StockPurchase Plan (the “Purchase Plan”) in which eligible employees of the Companymay purchase shares of common stock at quarterly intervals, through payrolldeductions. The purchase price per share is 85% of the closing price of thecommon stock on (i) the first business day of the plan period or(ii) the purchase date, whichever closing price is less. The Purchase Planimposes a limitation upon a participant’s right to acquire common stock ifimmediately after or prior to purchase the employee owns 5% or more of thetotal combined voting power or value of the Company’s common stock.   The Purchase Plan allows for the purchase ofan aggregate of 100,000 shares of common stock by eligible employees.  Each year the Company will make offerings toemployees to purchase shares of common stock under the Purchase Plan.  16,163 shares were purchased on June 30, 2006,resulting in compensation expense of $12,922 during the three months ended June30, 2006.  As of June 30, 2006,approximately 83,837 shares were available for issuance under the PurchasePlan.

Thefollowing is a summary of activity relating to option awards to employeesduring the six months ended June 30, 2006:

|                                  | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding -  beginning of year |       | 3,571,132  |       | $                                      | 13.07      |                                                |       |                                |       |   |
| Granted                          |       | 317,400    |       | $                                      | 11.90      |                                                |       |                                |       |   |
| Exercised                        |       | —     |       | $                                      | 0.00       |                                                |       |                                |       |   |
| Forfeited/expired/cancelled      |       | (216,988   | )          | $                                      | 9.60       |                                                |       |                                |       |   |

 

8

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| Outstanding -  end of period                                      |   | 3,671,544 |   | $      | 13.18  |   | 4.26   |   | $      | 283,511 |   |
|-------------------------------------------------------------------|--------|-----------|--------|--------|--------|--------|--------|--------|--------|---------|--------|
|                                                              |   |      |   |   |   |   |   |   |   |
| Exercisable -  end of period                                      |   | 2,724,648 |   | $      | 14.44  |   | 2.51   |   | $      | 283,511 |   |
|                                                              |   |      |   |   |   |   |   |   |   |
| Weighted-average fair  value of options granted during the period |   |      |   | $      | 7.76   |   |   |   |   |    |

 

No options were granted tonon-employee directors during the six months ended June 30, 2006.

Asof June 30, 2006, the Company expects to recognize approximately $4.4 millionof unrecognized compensation cost related to stock options over aweighted-average period of 2.1 years.

Duringthe six months ended June 30, 2005, the Company granted 516,085 options with aweighted average grant date fair value of $7.12.  211,512 options were exercised during the sixmonths ended June 30, 2005 with an aggregate intrinsic value of approximately$1,416,471.

InJune 2005, the Company granted 36,010 shares of nonvested common stock tonon-employee directors of the Company with a weighted average grant date fairvalue of $9.76.  On June 16, 2006, all36,010 shares vested.  On June 19, 2006,58,083 nonvested shares of common stock were granted to non-employee directorsof the Company with a weighted average grant fair value of $6.37.  As of June 30, 2006, there were 58,083nonvested shares outstanding, with $357,825 of remaining unrecognizedcompensation expense to be recognized over a weighted average period of 11.6months.

Through2000, the Company granted option awards to certain non-employees.  Upon the adoption of SFAS No. 123R, theseawards were required to be classified as a liability and are subject to theprovisions of SFAS No. 133, *Accounting forDerivative 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.  This model requires the input of subjectiveassumptions that will usually have a significant impact on the fair valueestimate.  The weighted-average estimatedfair value of employee stock options granted during the three and six monthsended June 30, 2006 were $3.93 and $7.76 per share, respectively, using theBlack Scholes model with the following weighted-average assumptions:

|                           | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| Expected  volatility      |       | 71.0                             | %          | 71.31                          | %          |
| Risk-free  interest rate  |       | 4.97                             | %          | 4.42                           | %          |
| Expected term  (in years) |       | 6.25                             |       | 6.25                           |       |
| Expected dividend yield   |       | 0.0                              | %          | 0.0                            | %          |

 

The Company based thecalculation of expected volatility on the historic volatility of the Company’scommon stock.  The Company based therisk-free interest rate on the U.S. Treasury yield curve in effect at the timeof option grant, and the expected term of options was determined using the SAB107 “Safe Harbor.”  Assumptions used inthe Black-Scholes option-pricing model for calculating the weighted averagefair value of $5.73 for options granted in fiscal year 2005 were as follows:expected volatility was 70.46%, weighted average risk-free interest rate was4.25%, weighted average expected term was 6.25 years, and expected dividendyield 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 $741,507 and $104,305 as of June 30, 2006 and December 31, 2005,respectively. The carrying value of these investments approximates their fairmarket value due to their short maturity and liquidity.

**Note 5Short-term Investments**

9

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Short-terminvestments represent investments in auction rate certificates and have beenclassified as available-for-sale. Short-term investments as of June 30, 2006and December 31, 2005 are summarized as follows:

|                            | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| State government  agencies |       | $                           | 47,350,000 |                            | $          | 28,700,000 |   |
| Total                      |       | $                           | 47,350,000 |                            | $          | 28,700,000 |   |

 

Included with thecarrying value of the investments is accrued interest income receivable of$91,193 and $76,020 as of June 30, 2006 and December 31, 2005,respectively.

Short-terminvestments are stated at cost, which approximates fair value due to theirvariable interest rates, which typically reset every 7 to 35 days. As ofJune 30, 2006, the Company’s investments in auction rate certificates havecontractual maturities of greater than ten years. Despite the long-term natureof their stated contractual maturities, the Company has demonstrated theability to liquidate these securities as needed. Accordingly, as thesesecurities represent the investment of cash, which is available for operations,they have been classified as a current asset on the accompanying CondensedConsolidated Balance Sheets.

**Note 6Inventory**

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

Inventory at June30, 2006 and December 31, 2005 consisted of the following:

|                              | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
|                         |       |                        |       |                            |       |
| Finished goods  on hand      |       | $                           | 4,911      |                            | $          | 5,677 |   |
| Inventory  subject to return |       | 39                          |       | —                          |       |
|                         |       |                        |       |                            |       |
|                         |       | $                           | 4,950      |                            | $          | 5,677 |   |

 

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

**Note 7Fixed 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 and six months endedJune 30, 2006 was $341,932 and $676,404, respectively.  Total depreciation and amortization expensefor the three and six months ended June 30, 2005 was $342,267 and $680,095,respectively.  During the six monthsended June 30, 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 carryingamount of an asset exceeds its estimated future cash flows, an impairmentcharge is recognized by the amount by which the carrying amount of the assetexceeds the fair value of the asset.

**Note 8Capital Lease**

Minimum futurelease payments under capital lease as of June 30, 2006 for each of the nextfive years and in the aggregate are as follows:

| For the period July 1, 2006  through December 31, 2006 |   | $ | 18,912 |   |
|--------------------------------------------------------|--------|---|--------|--------|
| For the year ending  December 31, 2007                 |   | $ | 37,824 |   |
| For the year ending  December 31, 2008                 |   | $ | 37,824 |   |
| For the year ending  December 31, 2009                 |   | $ | 37,824 |   |
| For the year ending  December 31, 2010                 |   | $ | 37,824 |   |
| Subsequent to  2010                                    |   | $ | 3,152  |   |

 

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|                                     |   |   |    |
|------------------------------------------|--------|--------|---------|
| Total minimum  lease payments            |   | $      | 173,360 |   |
| Less amount  representing interest       |   | 23,787 |    |
| Present value of  minimum lease payments |   | $      | 149,573 |   |

** **

**Note 9Derivative Financial Instruments**

Through 2000, theCompany granted common stock options to certain non-employees, as compensationassociated with research and development activities.  As of January 1, 2006, the effective date ofSFAS No. 123R, options granted to certain non-employees, to purchase 234,025shares of the Company’s common stock, were fully vested and unexercised.  Upon adoption of SFAS No. 123R, thesenon-employee common stock options were required to be classified as a liabilityand became subject to the provisions of SFAS No. 133, which requires thesenon-employee options to be accounted for as a derivative instrument.

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 value of the non-employeeoptions is remeasured each reporting period and the change in estimated fairvalue is recorded as a component of loss from operations in the accompanyingcondensed consolidated statements of operations.  Accordingly, as of March 31, 2006, theCompany remeasured and calculated the estimated fair value of the outstandingnon-employee options to be $1,108,583 and recorded the change in fair value of$543,128.  As of June 30, 2006, 196,075options remained outstanding and the Company remeasured and calculated theestimated fair value of these outstanding non-employee options to be $481,038and recorded the change in fair value of $627,545.

The Company usesthe Black-Scholes option-pricing model to estimate the fair value of thenon-employee option grants.  As of June30, 2006, the remaining contractual terms of the outstanding non-employeeoptions granted ranged from 1.5 months to 42.8 months.  Other option pricing model inputs weredetermined based upon the remaining contractual terms of the non-employeeoptions at the date of measurement for initial classification as a liability asof January 1, 2006 and the remeasurement of estimated fair value as of eachreporting period.

**Note 10Employee Termination Costs**

The Companyreduced its workforce by a total of 22 employees in April 2006, consisting of20 employees from its research and development groups and 2 employees from theadministrative group.  Terminatedemployees were eligible to receive up to three months severance, 50% payout ofthe 2006 bonus plan, two months of medical insurance coverage as well asoutplacement services.  All $570,253 ofemployee termination costs were expensed during the three months ended June 30,2006.  $43,194 of employee terminationcosts accrued during the three months ended June 30, 2006 remained unpaid as ofJune 30, 2006.  The Company anticipatesthe remaining accrual to be paid during the third quarter of 2006.

**Note11 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.

The Companymaintains a Stockholder Rights Plan whereby rights to purchase shares of SeriesA Participating Preferred Stock become exercisable by the Company’sstockholders after any non-excluded party acquires, or announces an intentionto acquire, 15% or more of the Company’s outstanding common stock.

**Note 12Revenue Recognition**

The Company recognizesrevenue when persuasive evidence of an arrangement exists, delivery hasoccurred or services have been rendered, the price is fixed or determinable,and collectibility is reasonably assured.

For product 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 have beengranted an unconditional right of return is currently being recognized when theright of return has expired, which occurs upon the earlier of shipment of theproduct by the distributor to an end user or expiration of the right of return,which is 60-180 days depending upon the distributor. The Company warrants itsproducts in a manner consistent with industry standards and has not incurredany warranty costs related to the sale of NeoPhectinTM.

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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 ofaccounting.

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 inJanuary 2005 and is entitled to receive future additional fees, milestonepayments and royalties.  Nippon isresponsible for all development costs in Japan. The Company has agreed to provide or arrange for contract manufacture ofa commercial supply of CINTREDEKIN BESUDOTOX upon receipt of marketing approvalby Nippon.  The up-front nonrefundablefee received by the Company will be recognized ratably as revenue once thegeneral criteria for revenue recognition have been met for the unit ofaccounting to which the fee has been allocated.

**Note 13 Commitments**

On June 7,2006, Mr. Lawrence A. Kenyon notified the Company that he would resign asthe Company’s Executive Vice President, Chief Financial Officer and Secretary,effective as of August 31, 2006. On June 13, 2006, the Company enteredinto a separation agreement and release of all claims (the “SeparationAgreement”) with Mr. Kenyon.  Pursuant tothe Separation Agreement, which is scheduled to take effect upon Mr. Kenyon’stermination of employment with the Company on August 31, 2006, for a period ofnine (9) months after the effective date of the Separation Agreement, Mr.Kenyon will be eligible to receive salary continuation based upon his currentmonthly salary of $17,500, payment or reimbursement for medical and dentalcoverage for Mr. Kenyon and his family, and options previously granted toMr. Kenyon will continue to vest. The salary continuation and otherbenefits are subject to forfeiture if Mr. Kenyon provides services to certaincompeting businesses without the Company’s consent.  In exchange for those benefits, and again fora period of nine (9) months after his resignation becomes effective, Mr. Kenyonwill provide consulting services to the Company and has agreed to abide bycertain non-compete, non-solicitation and confidentiality provisions.  The Separation Agreement also contains amutual release of all claims by the parties.

On May 2, 2006,Dr. Imran Ahmad resigned as the Company’s Executive Vice President and ChiefScientific Officer.  Upon hisresignation, in accordance with the terms of his offer letter, dated June 12,2000, Dr. Ahmad began receiving twelve months salary continuance based upon hismonthly salary of $18,917 in effect as of the date of his resignation.  Additionally, the Company agreed to pay$20,000 of his 2006 bonus.

**Note 14Contingencies**

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 fromSeptember 25, 2000 through April 19, 2002 as they relate to theCompany’s LEP drug product candidate. The original lawsuits also named as individualdefendants John N. Kapoor, the Chairman of the Company, 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 theseClass Action Suits was filed on April 26, 2002 and all of theClass Action Suits have been filed in the United States District Court forthe Northern District of Illinois, Eastern Division. On September 16,2002, a consolidated amended complaint was filed against the Company in thismatter. The amended complaint shortened the class period to October 31,2001 through April 19, 2002, removed Dr. Rahman as a defendant, andadded Dr. Imran Ahmad, the Company’s former Chief Scientific Officer andExecutive Vice President of Research and Development, as a defendant. OnNovember 4, 2002, the Company moved to have the complaint dismissed. TheCompany’s motion to dismiss was granted in part and denied in part inFebruary 2003. Dr. Kapoor was dismissed from the lawsuit at thattime. In November 2004, the plaintiffs filed a motion to amend and amotion for summary adjudication. The motion to amend seeks to again makeDr. Kapoor a defendant, and realleges that certain pre-class periodstatements are actionable. The motion for summary adjudication asks theCourt to rule that certain statements made in the arbitration award between theCompany and Pharmacia (now Pfizer) be deemed facts established in thisproceeding. The Company filed oppositions to both motions. The Court has notyet ruled on the motions. No trial date has been set and discovery isongoing.  The Company intends tovigorously defend each and every claim in the Class Action Suits.Management is unable to estimate the potential outcome or a range of possiblelosses, if any. In addition, 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 

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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.

The pharmaceuticalindustry has traditionally experienced difficulty in maintaining productliability insurance coverage at desired levels. To date, no significant productliability suit has ever been filed against the Company. However, if a suit wasfiled and a judgment entered against the Company, it could have a materialadverse effect upon the Company’s operations and financial position. While theCompany maintains insurance to cover the use of its drug product candidates inclinical trials, the Company does not maintain insurance covering the sale ofits drug product candidates nor is there any assurance that it will be able toobtain or maintain such insurance on acceptable terms or with adequate coverageagainst potential liabilities.

**Note 15 Subsequent Event**

 

On August 8, 2006the Company announced Ronald E. Pauli will join the Company on August 28, 2006 as an Executive Vice President,and will assume the position of Chief Financial Officer and CorporateSecretary, effective September 1, 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 are madepursuant to the safe harbor provisions of the Private Securities LitigationReform Act of 1995.  The Company cautionsreaders that important factors may affect the Company’s actual results andcould cause such results to differ materially from forward-looking statementsmade by or on behalf of the Company. 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 IL13-PE38QQR (“CINTREDEKINBESUDOTOX” ), including the PRECISE trial, the possible filing of a BiologicsLicense Application (“BLA”) forapproval of CINTREDEKIN BESUDOTOX from the FDA, the marketing of non-drug productssuch as NeoPhectinTM and NeoPhectin-ATTM, the performance of third partycontractors, uncertainty regarding the outcome of class action litigationagainst the Company, resolution of the ongoing SEC investigation, unexpectedadverse side effects or inadequate therapeutic efficacy of the Company’s drugcandidates that could slow or prevent products coming to market, theuncertainty of patent protection for the Company’s intellectual property ortrade secrets, the ability of the Company to raise additional funds on termsacceptable to the Company and other factors referenced under “Risk Factors” inthe Company’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2005 and in Item 1A, “Risk Factors” in Part II of thisQuarterly Report on Form 10-Q.

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.  The results discussed below are notnecessarily indicative of the results to be expected in any futureperiods.  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. As of June 30,2006, we had 70 full time employees and conducted operations at twolocations.  We are currentlyconsolidating our operations to our corporate headquarters in Waukegan,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 tocontinue to incur losses for the foreseeable future as we continue our researchand development activities, which include the sponsorship of human clinical trialsfor our drug product candidates.  Untilwe are able to consistently generate revenue through the sale of drug ornon-drug products, we anticipate that we will be required to fund thedevelopment of our pre-clinical compounds and drug product candidates primarilyby other means, including, but not limited to, licensing the development rightsto some of our drug product candidates to third parties, collaborating withthird parties to develop formulations of their compounds using our technology,or selling Company issued securities.

In thequarter ended June 30, 2006, management’s efforts were primarily devoted todeveloping a commercial strategy for CINTREDEKIN BESUDOTOX, preparing for apotential submission of a BLA for CINTREDEKIN BESUDOTOX, planning the furtherdevelopment of our NeoLipid® liposomal drug product candidates and reducingexpenses in an effort to conserve the amount of cash used in operations.

We completedpatient enrollment in the Phase III PRECISE clinical trial for CINTREDEKINBESUDOTOX in December 2005.  In June2006, the independent Data Monitoring Committee (“iDMC”) for the PRECISE trialmet, analyzed, and reviewed the data for the PRECISE trial interim efficacyanalysis after 160 patient deaths, and recommended that the PRECISE trialcontinue to the final efficacy analysis at 215 deaths.  The final efficacy analysis is the nextmilestone for PRECISE and is currently expected to occur in the first quarterof 2007.  We are currently preparing tosubmit the BLA to FDA to seek marketing approval of CINTREDEKIN BESUDOTOX, inthe event that the PRECISE trial achieves its endpoint of a statisticallysignificant improvement in overall survival compared to Gliadel®.  However, there can be no assurance that the PRECISEtrial will meet its endpoint in the time anticipated, that the FDA will approvethe BLA or that the FDA will not require additional data or testing.  Additionally, enrollment has now beencompleted, pending drug safety assessment, in our Phase I clinical trial ofCINTREDEKIN BESUDOTOX for malignant glioma patients at initial diagnosis.

InApril 2006, we reprioritized our NeoLipid® platform and strategy to focus ourdevelopment efforts on the two most promising drug product candidates in theplatform, LEP-ETU and LE-SN38.  Duringthe second quarter of 2006, we initiated enrollment in a Phase II clinicaltrial for LE-SN38 in metastatic colorectal cancer patients.  Additionally, we are preparing our LEP-ETUPhase III clinical trial plans for review by the FDA later this year.  Pre-clinical work continues on our earlierstage liposomal formulations of the anti-cancer agents docetaxel andgemcitabine, while the LErafAON program is on hold pending analysis of the datagathered in Phase I.

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InApril 2006, in an effort to further reduce our operating expenses, we completeda reduction in workforce of approximately 23% that is expected to reduce ourpayroll costs in the second half of 2006. It is difficult to predict with any certainty the timing of and totalestimated costs to complete development of drug product candidates in earlystage, or Phase I, clinical development, as well as the estimated date suchdrug product candidates would be available for sale, if approved by the FDA. Anumber of factors contribute to this uncertainty, including: side effectsencountered in early stage clinical trials, ability to scale up manufacturingfor commercial supply, and the fact that the size and scope of pivotal PhaseIII clinical trials are unknown until sufficient data is available to present aPhase III plan to the FDA for approval. In addition, our drug productcandidates are required to be approved by the FDA after completing Phase IIIclinical trials before we can sell the drugs to generate revenue and,potentially, realize net cash inflows. Because our lead product candidate,CINTREDEKIN BESUDOTOX, has now completed enrollment in the Phase IIIPRECISE study, we estimate that we will incur further direct expenses ofapproximately $2 million to close out the study. Additional clinical trialexpenses are expected to be incurred for CINTREDEKIN BESUDOTOX as we conductother clinical trials to investigate its potential use 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 theCINTREDEKIN BESUDOTOX BLA submission.

Thetable below includes a summary of identified direct project costs incurred todate for our clinical research and development projects. Generally, identifiedproject costs include expenses incurred specifically for clinical trials andpre-clinical studies we conduct, and exclude expenses incurred for salariespaid to our professional staff, overhead expenses for our former Lake Forestfacility and our current Waukegan facility and general laboratory supplies usedin our research, which are included with non-project specific.

| Research Project                    | ** ** | **Total Direct Costs  Incurred in  Current Quarter** | ** ** | **Total Direct Costs  Incurred Year   to Date** | ** ** | **Total Direct Costs  Incurred Since  Beginning of Project** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| CINTREDEKIN  BESUDOTOX                   |       | $                                                                        | 3,530,580  |                                                                     | $          | 5,677,393                                                                             |       | $ | 60,402,459 |   |
| LEP-ETU                                  |       | 30,514                                                                   |       | 615,239                                                                  |       | 7,322,209                                                                             |       |
| LE-SN38                                  |       | 86,425                                                                   |       | 121,819                                                                  |       | 5,095,527                                                                             |       |
| LErafAON                                 |       | 24,140                                                                   |       | 79,235                                                                   |       | 7,816,917                                                                             |       |
| Non-project  specific                    |       | 2,365,484                                                                |       | 5,387,216                                                                |       | N/A                                                                                   |       |
| Total research and  development expenses |       | $                                                                        | 6,037,143  |                                                                     | $          | 11,880,902                                                                            |       | N/A |   |
|                                          |            |                                                                          |            |                                                                          |            |                                                                                       |            |  |  |  |

 

**Results of Operations — ThreeMonths Ended June 30, 2006 vs. Three Months Ended June 30, 2005.**

The Companyrecorded product revenue of $8,670 for the three months ended June 30, 2006 ascompared to $19,600 for the three months ended June 30, 2005.  The sole source of product revenue in bothperiods was from sales of NeoPhectinTM and NeoPhectin-ATTM.  During the three month period ended June 30,2005, we also recognized $435,000 of revenue from collaboration fees receivedin 2005.

Generally, theresults of operations for the three months ended June 30, 2006 reflect theeffects of the completion of enrollment in the PRECISE trial in the fourthquarter of 2005 and our efforts to begin developing a strategy to commercializeCINTREDEKIN BESUDOTOX in the event it is approved.  Accordingly, the mix in expenses has begun tochange which reflects our transition into a fully integrated biopharmaceuticalcompany in the process of preparing for the potential commercial launch of itsfirst product.

Research anddevelopment expense for the three months ended June 30, 2006 decreased byapproximately $1.9 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 $4.5 million for thethree months ended June 30, 2006 and approximately $3.1 million for the threemonths ended June 30, 2005.  Commercialoperation expenses increased by approximately $1.0 million during the threemonths ended June 30, 2006 compared to the prior year, as we began to developour commercialization strategy for CINTREDEKIN BESUDOTOX. Compensation expensefor the three months ended June 30, 2006 increased by approximately $0.4million as compared to the three months ended June 30, 2005 as a result ofaccruing termination benefits due to the announced resignation of our CFO, Mr. LawrenceA. Kenyon in June 2006 and our Chief Scientific Officer, Dr. Imran Ahmad, inMay 2006.

TheCompany recorded a benefit of $0.6 million relating to the change in theestimated fair value of derivative financial instruments for the three monthsended June 30, 2006 as a result of the requirements to account for optionspreviously granted to non-employees as derivative financial instruments uponthe adoption of SFAS No. 123R.

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Approximately$0.6 million in employee termination costs were incurred during the threemonths ended June 30, 2006 as a result of a workforce reduction completed inApril 2006.  A total of 22 employees wereterminated, including 20 employees in our research and development groups and 2employees from our selling, general and administrative group.  We expect to incur no additional employeetermination costs for this workforce reduction.

On May16, 2005, we accepted $2.5 million as payment in full for all outstandingprincipal and interest due and owing on a promissory note that we hadpreviously determined to be impaired.  Asa result of the payment, we recorded a $2.5 million benefit as Recovery of NoteReceivable during the three months ended June 30, 2005.

TheCompany generated interest income on cash and investments of approximately $0.6million and $0.4 million for the three months ended June 30, 2006 and 2005,respectively.  The increase in interestincome during the period was primarily due to an increase in average cash andshort-term investment balances as a result of the public stock offeringcompleted in January 2006, in addition to increases in short-term interestrates.

**Resultsof Operations — Six Months Ended June 30, 2006 vs. Six Months Ended June 30,2005.**

The Companyrecorded product revenue of $10,280 for the six months ended June 30, 2006 ascompared to $25,900 for the six months ended June 30, 2005.  The sole source of product revenue in bothperiods was from sales of NeoPhectinTM andNeoPhectin-ATTM.  During the six month period ended June 30,2005, we also recognized $500,000 of revenue from collaboration fees receivedin 2005.

Generally, theresults of operations for the six months ended June 30, 2006 reflect theeffects of the completion of enrollment in the PRECISE trial in the fourth quarterof 2005 and our efforts to begin developing a strategy to commercializeCINTREDEKIN BESUDOTOX in the event it is approved.  Accordingly, the mix in expenses has begun tochange which reflects our transition into a fully integrated biopharmaceuticalcompany in the process of preparing for the potential commercial launch of itsfirst product.

Research anddevelopment expense for the six months ended June 30, 2006 decreased byapproximately $4.2 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 $7.5 million for thesix months ended June 30, 2006 and approximately $6.3 million for the sixmonths ended June 30, 2005.  Commercialoperation expenses increased by approximately $1.5 million, during the sixmonths ended June 30, 2006 compared to the prior year, as we began to develop acommercialization strategy for CINTREDEKIN BESUDOTOX.  Stock based compensation expense associatedwith options granted to employees increased approximately $0.3 million as aresult of the Company’s adoption of SFAS No. 123R in 2006.  In addition, the Company incurredapproximately $0.5 million in product licensing milestone expenses during thesix months ended June 30, 2005 that were not incurred during the six monthsended June 30, 2006.

TheCompany recorded a benefit of $1.2 million relating to the change in theestimated fair value of derivative financial instruments for the six monthsended June 30, 2006 as a result of the requirements to account for optionspreviously granted to non-employees as derivative financial instruments uponthe adoption of SFAS No. 123R.

Approximately$0.6 million in employee termination costs were incurred during the six monthsended June 30, 2006 as a result of a workforce reduction completed in April2006.  A total of 22 employees wereterminated, including 20 employees in our research and development groups and 2employees from our selling, general and administrative group.  We expect to incur no additional employeetermination costs for this workforce reduction.

On May16, 2005, we accepted $2.5 million as payment in full for all outstandingprincipal and interest due and owing on a promissory note that we hadpreviously determined to be impaired.  Asa result of the payment, we recorded a $2.5 million benefit as Recovery of NoteReceivable during the six months ended June 30, 2005.

TheCompany generated interest income on cash and investments of approximately $1.3million and $0.8 million for the six months ended June 30, 2006 and 2005,respectively.  The increase in interestincome during the period was primarily due to an increase in average cash andshort-term investment balances as a result of the public stock offeringcompleted in January 2006, in addition to increases in short-term interest rates.

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**Liquidityand Capital Resources**

Our primary source ofcash has been 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.

As of June 30, 2006, wehad approximately $3.1 million in cash and cash equivalents and$47.4 million in short-term investments. We currently believe that ourcash, cash equivalents and short-term investments on hand at June 30, 2006 cansupport our activities into 2008 at current and projected levels of developmentand general corporate activity.  Thisestimate reflects the effects of the NeoLipid® platform reprioritization thatis expected 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 June 30,2006:

|                                                       | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                      | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Operating leases                                      |       | $                                         | 760,264    |   | $ | 422,858 |   | $ | 335,358 |   | $ | 2,048 |   | $ | — |   |
| Capital lease                                         |       | 173,360                                   |       | 37,824 |   | 75,648 |   | 59,888 |   | — |   |
| Clinical trial  monitoring (CRO) agreements (1)       |       | 564,076                                   |       | 564,076 |   | — |   | — |   | — |   |
| License  agreements—milestone based payments (2) |       | 2,050,000                                 |       | 300,000 |   | 900,000 |   | — |   | 850,000 |   |
| Total                                                 |       | $                                         | 3,547,700  |   | $ | 1,324,758 |   | $ | 1,311,006 |   | $ | 61,936 |   | $ | 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 payment obligations are contingent upon successfullyreaching objectively determinable stages in the development of drug productcandidates. The Company has estimated the period the payment may be due, if atall, based upon its expectations of the timeline for continued successfuldevelopment of the drug product candidates.

**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.

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*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. Significant judgmentsare required to estimate the generation of future taxable income and the timingof the reversal of deferred tax liabilities.

*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 Companyaccounts for stock-based compensation in accordance with SFAS No. 123R, *Share-Based Payment*. Under the fair valuerecognition provisions of this statement, we measure stock-based compensationcost at the grant date based upon the fair value of the award and recognize thecost of awards that are expected to ultimately vest as expense over therequisite service period. Management judgment and the use of estimates arerequired in determining the inputs to an option pricing model used to estimatefair value of stock-based awards. Management judgment and the use of estimatesare also required in estimating the number of stock-based awards that willultimately vest. Additionally, management judgment and the use of estimates maybe required in determining the requisite service period over which to recognizethe 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 in collaboration and license agreements with third parties that containmultiple deliverables. Under the provisions of EITF 00-21, a determination mustbe made on each contract as to whether a deliverable constitutes a separateunit of accounting. The amount of revenue to be recognized is based on the fairvalue for each unit of accounting within the arrangement. Management’s judgmentis required to determine, based upon the facts and circumstances of eacharrangement, whether or not each deliverable has standalone value and whetheror not there exists a sufficient level of objective and reliable evidence offair value of the undelivered items. Additionally, units of accounting may bedelivered over an indeterminate period of time. Management judgment is requiredto estimate the period over which recognition of allocated revenue occurs.

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

As ofJune 30, 2006, we were exposed to market risks, primarily changes in U.S.interest rates. As of June 30, 2006, we held total cash and cash equivalents of$3,140,021 and short-term investments in auction rate certificates of$47,441,193.  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 June 30, 2006, adecrease in interest rates of 1.0% would cause a corresponding decrease in ourannual interest income of approximately $506,000.

**Item 4 — Controls and Procedures**

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As of June 30,2006, we carried out an evaluation, under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures. Based on that evaluation, our management, including the Chief ExecutiveOfficer and Chief Financial Officer, have concluded, as a result of thematerial weakness in internal control over financial reporting discussed below,our disclosure controls and procedures were not effective to ensure thatinformation required to be disclosed by us in the reports we file or submitunder the Exchange Act is recorded, processed, summarized, accumulated,communicated and reported, within the time periods specified in the Securitiesand Exchange Commission’s rules and forms.

In May 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 weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.  This control deficiencyresulted in an adjustment to the unaudited interim condensed consolidatedfinancial statements for the quarter ended March 31, 2006 affecting derivativefinancial instruments and the change in fair value of derivative financialinstruments.

Management has revisedits policies and procedures with respect to its controls over the review andverification of the accuracy of the calculation estimating the fair value ofnon-employee stock options to ensure that all reasonable steps will be taken tocorrect this material weakness.  As part of the remediation process,additional reviews and controls were implemented by management over the reviewand verification of the accuracy of the calculation estimating the fair valueof non-employee stock options. The deficiency will not be considered remediateduntil the new internal controls are operational for a period of time and aretested and management has concluded that the controls are operatingeffectively. Until it is remediated, the identified control deficiency couldresult in a misstatement in the derivative financial instruments and the changein fair value of derivative financial instruments balances that would not beprevented or detected.

There have been nosignificant changes in our internal control over financial reporting thatoccurred during the three months ended June 30, 2006, other than controlsestablished to remediate the identified material weakness described above, thathave materially 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 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 fromSeptember 25, 2000 through April 19, 2002 as they relate to theCompany’s LEP drug product candidate. The original lawsuits also named asindividual defendants John N. Kapoor, the Chairman of the Company, JamesM. Hussey, the Company’s former President and CEO, and Dr. Aquilur Rahman,a former director and executive officer of the Company. The first of theseClass Action Suits was filed on April 26, 2002 and all of theClass Action Suits have been filed in the United States District Court forthe Northern District of Illinois, Eastern Division.  On September 16, 2002, a consolidatedamended complaint was filed against the Company in this matter. The amendedcomplaint shortened the class period to October 31, 2001 throughApril 19, 2002, removed Dr. Rahman as a defendant, and addedDr. Imran Ahmad, the Company’s former Chief Scientific Officer andExecutive Vice President of Research and Development, as a defendant. OnNovember 4, 2002, the Company moved to have the complaint dismissed. TheCompany’s motion to dismiss was granted in part and denied in part inFebruary 2003. Dr. Kapoor was dismissed from the lawsuit at thattime. In November 2004, the plaintiffs filed a motion to amend and amotion for summary adjudication. The motion to amend seeks to again makeDr. Kapoor a defendant, and realleges that certain pre-class periodstatements are actionable. The motion for summary adjudication asks theCourt to rule that certain statements made in the arbitration award between theCompany and Pharmacia (now Pfizer) be deemed facts established in thisproceeding. The Company filed oppositions to both motions. The Court has notyet ruled on the motions. No trial date has been set and discovery isongoing.  The Company intends tovigorously defend each and every claim in the Class Action Suits.Management is unable to estimate the potential outcome or a range of possiblelosses, if any. In addition, 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.

**Item 1A.****                                                RiskFactors**

You should carefullyconsider the following risk factors, in addition to the other information setforth in this document as well as other information 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 are 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, although theclinical development program for one of these products is on hold pending ouranalysis of the data gathered in Phase I. Each candidate is the subject of aneffective IND that we filed with FDA. The protocols for any clinical trials weperform under these INDs must have institutional review board (“IRB”) approval,and the trials must comply with FDA’s good clinical practices (“GCP”) and otherregulations. There is no assurance that the clinical trials we may seek toconduct under these INDs will obtain IRB approval. There is also no assurancethat FDA will allow us to continue the clinical trials that we have begun. FDAmay suspend a clinical trial at any time if the agency believes that thepatients participating in the study are or will be exposed to unacceptablehealth risks. FDA may also terminate an IND and require the sponsor to end allclinical trials under that IND, if it finds deficiencies in the IND or in theconduct of a trial under the IND.  An IRBalso may suspend or terminate a clinical trial. 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 guaranteethat clinical studies, if performed, will demonstrate the safety and efficacyof any drug product candidate we have in development.

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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 anyof our drug product candidates in any country, or that any approval we obtainwill be on commercially viable terms. We have yet to submit an application formarketing approval for any of the drug product candidates we currently haveunder development. We cannot predict with certainty if or when we might submitany of these drug product candidates for regulatory review. We cannot assureyou that once we submit a drug product candidate for review, FDA or any otherregulatory agency will approve that product 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 theproduct.  FDA may also withdraw itsapproval of the product if it determines, based on other information, that theproduct does not present an acceptable balance of benefits and risks

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 we believe haspotential to be used as a treatment for malignant glioma. InSeptember 1997, we exclusively licensed worldwide rights to CINTREDEKINBESUDOTOX from the NIH and FDA. Our Phase I clinical trials to date involvingthis drug product candidate have enrolled approximately 100 patients. On thebasis of our preliminary Phase I clinical trial findings for this drug productcandidate, we initiated the PRECISE trial, a pivotal Phase III multi-center,multi-national clinical trial that enrolled a total of 294 patients, of whom,in accordance with the trial protocol, approximately 196 patients were randomlyselected to receive CINTREDEKIN BESUDOTOX. While a final efficacy analysis iscurrently expected early in 2007, there are no assurances that CINTREDEKINBESUDOTOX will prove to be safe and effective or receive regulatory approvalfor any indication.

We also have three otherdrug product candidates in clinical development for the treatment of variouscancers: LE-SN38, LEP-ETU, and LErafAON. We have initiated enrollment, currently ongoing, in a Phase II clinicaltrial for LE-SN38.  We have completed twoPhase I clinical trials and we are currently planning a Phase III clinicaltrial for LEP-ETU .  The LErafAON programis on hold pending our analysis of the data gathered in Phase I.  There are no assurances that any of thesedrug product candidates will proceed to the next phase of clinical development,or prove to be safe and effective, or that any of them will receive regulatoryapproval for the treatment of the indications which we may pursue.

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 maynever be 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, andsuccessful commercialization. Development, approval, and successful commercializationof new 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 thePRECISE trial for patients suffering from first recurrent glioblastomamultiforme tumors. 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. While the final efficacy analysis for the PRECISE Trial is expected inearly 2007, the results from this clinical trial may not demonstrate astatistically significant difference. If the results from the PRECISE trial donot demonstrate a statistically significant difference, FDA could determinethat additional clinical trials are necessary, which could delay or evenprevent approval 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 may evaluate 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 

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trial results are inadequate to support approval ofCINTREDEKIN BESUDOTOX. Even if FDA agrees that the results from the PRECISEtrial demonstrate a statistically significant difference, FDA may requirestatistically significant results in a second Phase III trial before it willapprove CINTREDEKIN BESUDOTOX. Even if we believe that we have submitted all ofthe data and information necessary to satisfy FDA requirements for approval ofthe BLA, there is a risk that FDA will require additional data and informationthat we are unable to provide. Finally, even if the results are statisticallysignificant, adverse safety findings in the PRECISE trial could delay orprevent 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.  A BLA is a lengthy, complex submission toFDA, which must comply in format and content with elaborate and detailed FDArequirements.  We have never submitted aBLA before.  FDA may refuse to accept aBLA for filing if it is incomplete.  Thelength and outcome of FDA’s review of the BLA is uncertain.  FDA approval is contingent on many factors,including its evaluation of our preclinical and clinical trial results, itsassessment of the manufacturing process we propose as well as the process controls,its review of our drug substance specifications and proposed analyticalprocedures, the data we provide on the drug’s stability, and its inspection ofthe facilities where CINTREDEKIN BESUDOTOX is manufactured.  FDA may ask an advisory committee for itsrecommendations on the BLA, and we cannot predict the outcome of the advisorycommittee process.

We rely heavily on thirdparties with respect to, among other things, the production and testing ofCINTREDEKIN BESUDOTOX.  We have engagedseveral third parties to perform services, including: PPD Development, LP("PPD") to oversee the PRECISE trial; Advance Clinical Services tooversee data management; and Diosynth RTP, Inc. ("Diosynth") tomanufacture drug product.  The failure ofany of these third parties to fulfill their contractual obligations orotherwise perform key tasks appropriately or in a timely manner, or theirfailure to comply with applicable government regulations, could require theCompany to seek alternative third parties to fulfill these functions and couldslow the filing of the BLA, preclude its timely approval or even preclude itsapproval altogether.  For example, aspart of the work that will be required to support a BLA for CINTREDEKINBESUDOTOX, we have contracted with Diosynth to assist in the development ofmanufacturing processes in connection with the scale-up of manufacturing ofCINTREDEKIN BESUDOTOX from preclinical testing and clinical development tocommercial-scale operations, including the preparation and filing of documentsfor process development, method development, and process validation.  These programs must be developed incompliance with applicable government regulations, including FDA’s current goodmanufacturing practice (cGMP) requirements for biological products, which areextremely complex and require considerable time, resources, and ongoinginvestment to comply with.  Manufacturingestablishments, including contract manufacturers such as Diosynth, are subjectto inspections by the FDA for compliance with cGMP.  Any errors or omissions in completing theprocess or method development or process validation, if not promptly correctedby the Company and/or Diosynth, could delay our BLA filing.  If FDA approval is delayed, FDA requiresadditional clinical testing or other information, or FDA does not approve theBLA, our ability to achieve revenues from product sales will be impaired andour stock price would be materially 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 furtherdevelopment and testing will demonstrate that our drug product candidates arenot approvable or suitable for commercialization, which could cause ourbusiness to suffer.**

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 of anyof 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, 

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or a clinical hold placed upon 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 health authorities in foreign countries have comparable authority.Compliance with these requirements before and after approval is expensive andtime consuming. Failure to comply can lead to regulatory action that would havea negative impact on our business.

In order to market a newtherapeutic product in the United States, we must prove that the product issafe and effective for its intended uses and that the product is manufacturedin compliance with CGMP. Completing the pre-clinical and clinical testingnecessary to prove the safety and effectiveness of a new therapeutic product,and establishing the capability to comply with CGMP, can take many years, bevery costly, and still be unsuccessful. The results of pre-clinical testing andPhase I and II studies are not necessarily indicative of the results in largerpatient populations, as evaluated 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 may 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, on commercially viable terms, or at all. FDA’s review of a BLA or NDAthat it accepts can take several years.  FDA can delay, limit, or denyapproval for many reasons, including if:

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

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

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

·       itchanges its approval policies or adopts new regulations; or

·       Congressamends the 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 impose otherburdensome 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 certainadverse events and manufacturing issues involving our drug products to theseagencies.  Application holders mustsubmit new or supplemental applications and obtain FDA approval for certainchanges to the approved product, product labeling or manufacturingprocess.  In addition to FDArequirements, sales, marketing and scientific/education grant programs mustcomply with the anti-fraud and abuse provision of the Social Security Act, theFalse Claims 

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Act and similar state laws, each as amended.  Pricing and rebate programs must comply withthe Medicaid rebate requirements of the Omnibus Budget Reconciliation Act of1990, and the Veteran’s Health Care Act of 1992, each as amended.  If products are made available to authorizedusers of the Federal Supply Schedule of the General Services Administration,additional laws and requirements apply. All of these activities are also potentially subject to federal andstate consumer protection and unfair competition laws.

Failure to comply withapplicable legal and regulatory requirements can result in, among other things,product seizure, civil penalties, suspensions and withdrawals of regulatoryapprovals, import and export problems, product recalls, operating restrictions,and criminal prosecution. The restriction, suspension, or revocation ofregulatory approvals or other adverse action taken on the basis of failure tocomply with applicable regulatory requirements could have a material adverseeffect on our business, 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 experience negativecash flows for the foreseeable future as we fund our losses and capitalexpenditures. Our losses have adversely impacted, and will continue toadversely impact, our working capital, total assets and stockholders’ equity.To date, we have not sold or received approval to sell any drug productcandidates, and it is possible that revenues from drug product sales will neverbe achieved. 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 expected that additionallicense revenue and/or revenue from sales of NeoPhectinTM products will continue to be of limited significance. We cannotat this time predict when or if we will be able to develop other sources ofrevenue or when or if our operations will become profitable, even if we areable to commercialize some of 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 furtherprioritize development activities and may not be able to fully realize thevalue of some of our drug product candidates in a timely manner, as they willbe delayed in reaching the market, if at all. We recently completed areprioritization of the NeoLipid® program in an effort to substantiallydecrease our expenses, including a restructuring of our workforce and areduction in research and development spending not related to our lead drugproduct candidate, CINTREDEKIN BESUDOTOX. If we are not successful inmaintaining the planned level of spending, our efforts to commercializeCINTREDEKIN BESUDOTOX may be delayed. Additionally, the reduction in spendingon our other drug product candidates could delay our commercialization effortsand negatively impact our strategy to diversify our development risk across abroad portfolio of 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 and developmentcapabilities and experience and greater manufacturing, marketing, financial,and managerial resources than we do. Competitive drug compounds may render ourtechnology and drug product candidates obsolete or noncompetitive prior to ourrecovery of research, development, or commercialization expenses incurredthrough sales of any of our drug product candidates. The FDA’s policy ofgranting “fast track” approval for cancer therapies may also expedite theregulatory approval 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:

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| **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)             This product iscurrently off-patent and generics are available.

(2)             There are currentlyno antisense products available on the market for the treatment of cancer, butIsis Pharmaceuticals, Genta Incorporated, and others are developing suchproducts.

Additionally, other drugcompanies are currently conducting clinical trials which are in various stages,for numerous drug compounds that, if ultimately approved for marketing, couldbe competitive with our drug product candidates, including, but not limited to,clinical trials involving drug compounds for the treatment of glioblastomamultiforme which, if approved, could compete with CINTREDEKIN BESUDOTOX, if itis eventually approved for the treatment of that disease.

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 have beenunrelated to the operating performance of particular companies. In addition,the market price of our common stock has been highly volatile and is likely tocontinue to be so. For example, during the first six months of 2006, the marketprice of our common stock fluctuated between $12.47 and $4.47 per share. During2005, the market price of our common stock fluctuated between $15.47 and $7.16per 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;

·                     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 current orformer officers, are currently named as defendants in a number of class actionlawsuits which have been consolidated for trial and are currently pending inthe U.S. District Court for the Northern District of Illinois, and each ofwhich 

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alleges various violations of the federal securitieslaws in connection with certain of our public statements as they relate to ourLEP drug product candidate. We may be named as a defendant in similarlitigation in the future. While we are vigorously defending this litigation,this litigation has resulted, and can be expected to continue to result, insubstantial costs and in a diversion of management’s attention and ourresources, which could harm our business and financial condition, as well asthe market price of our stock. Moreover, it may result in an adverse judgmentagainst us or a settlement, either of which could require us to make a paymentto the plaintiffs to the extent a possible payment exceeds or is not covered byour 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 ofJune 30, 2006, our then existing cash reserves, should be sufficient to financeour operations at current and projected levels of development and generalcorporate activity into 2008. We can offer no assurance that we will be able togenerate revenues from product sales in the near term or in the future, at arate sufficient to fund our operations. Even though we were successful inraising additional capital in January 2006, we will need additional futurefinancing depending on a number of factors, including, but not limited to, thefollowing:

·       ourdegree of success in commercializing our drug product candidates;

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

·       apossible obligation to pay damages arising from the ongoing consolidated classaction lawsuit 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 we may receive from future collaborators, if any;

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

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

Additional financing maynot be available when we need it or be on terms acceptable to us. If adequatefinancing is not available, we may be required to delay, scale-back, oreliminate certain of our research and development programs, to 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 developmentprograms.

**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, 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 June 30, 2006, we had 70full-time employees.  On April 28, 2006,we announced a reprioritization program and reduced our workforce by a total of22 employees (approximately 23%) consisting of 20 employees from our researchand 

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development groups and 2 employees from theadministrative group. We therefore rely on third parties to perform a varietyof functions with respect to the clinical development of our drug productcandidates, including clinical trial management. If we develop additional drugproduct candidates with commercial potential, we will have to either hireadditional personnel skilled in clinical testing or engage third parties toperform 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.  We have engagedother companies on a per study basis for assistance in the management andtesting for our Phase I and Phase II clinical trials. To oversee datamanagement in our clinical trials we have contracted, on a per study basis,with Advanced Clinical Services. To conduct our large animal testing, we haveengaged, again on a per study basis, Southern Research Institute.

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 and AdvancedClinical Services and three other entities offering services similar to thoseprovided by Southern Research Institute. We frequently change vendors andconsider such items as price, vendor capabilities to meet our needs, and easeof 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 ofthe drug 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.

We have an agreement withDiosynth RTP, Inc., pursuant to which this company produces CINTREDEKINBESUDOTOX in the quantities required to support our Phase III clinical trialand to manufacture the initial batches of this drug product candidate thatwould be necessary to support a BLA to market the product. Diosynth hasprovided us with quantities of CINTREDEKIN BESUDOTOX that we believe will allowus to complete the clinical testing of that drug product candidate and webelieve that they will be able to provide us with sufficient quantities ofCINTREDEKIN BESUDOTOX to support our initial commercial requirements, ifCINTREDEKIN BESUDOTOX is eventually approved.

If either the Center forAdvanced Drug Development or Diosynth RTP, Inc. were to breach its agreementwith us or fail to comply with any applicable governmental requirement, suchactions could delay or impair our drug development and/or BLA or NDA submissionefforts and we might be required to find a satisfactory alternative supplier.Though we are currently aware of at least two alternative manufacturers whomight be able to supply us with our requirements for our drug productcandidates, if we were unable to quickly reach an agreement with thesemanufacturers, this could be expected to result in delays in the development,filing for approval, 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 obligated us to fund research efforts atFDA relating to CINTREDEKIN BESUDOTOX through April 2006 and we arecurrently in contract negotiations to renew the research agreement with FDA. Wehad a research agreement with Georgetown that obligated us to fund research effortsthrough February 28, 2005. We did not renew the research agreement withGeorgetown.  No assurance can be given that we will enter into more ofthese relationships, that we will be able to maintain or renew the researchagreement with FDA, that this relationship will provide benefits to us, or thatwe will be able to establish new relationships on beneficial terms, withoutundue delays or expenditures.

**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.  Wecurrently obtain the necessary raw materials for our drug product candidates,as well as certain services, such as testing, from third parties. We currentlycontract with suppliers and service providers that are required to comply withstrict standards established by us. Certain suppliers and service providers arerequired to follow GLP, 

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GCP, and CGMP requirements and are subject to routineunannounced periodic inspections by FDA and by certain state and foreignregulatory agencies for compliance with those requirements and other applicableregulations. There can be no assurance that FDA and other regulatory agencieswill find the manufacturing process or facilities or other operations of oursuppliers and other service providers to be in compliance with GLP, GCP, CGMP,or other applicable requirements.

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

**We 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, wecould elect to market and sell our drug product candidates throughdistribution, co-marketing, co-promotion, or licensing arrangements with thirdparties, as we have elected to do with our non-drug NeoPhectinTM products, which are being soldthrough one independent distributor in addition to direct sales with 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 dependprimarily on the efforts of these third parties, and those revenues may belower than if we marketed our drug products directly. In addition, we may notbe successful in entering into sales and distribution relationships with thirdparties and, even if we are successful, we will not control the amount andtiming of marketing resources such third parties devote to our drug productcandidates.

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

**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 treating patients withglioblastoma multiforme. We have informed the governmental agency from which welicensed these patents of this change, and we received no objections 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 from 

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commercializing 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 thelicensed rights. During the period of any such litigation, our ability to carryout the development and commercialization of potential products could besignificantly and negatively affected. If our licensed rights were restrictedor ultimately lost, our ability to continue our business based on the affectedtechnology platform would be 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.

We have been granted“orphan drug” status with respect to the use of CINTREDEKIN BESUDOTOX formalignant gliomas (a class of brain tumors which includes glioblastomamultiforme), and we are thus potentially eligible to receive orphan drugexclusivity upon approval.  In order toreceive orphan drug exclusivity, we must be the first CINTREDEKIN BESUDOTOXproduct approved for malignant glioma. If we receive orphan drug exclusivity, it would prevent FDA for a periodof seven years from approving another sponsor’s marketing application for thesame drug for the same indication, except that a subsequent applicant with thesame drug could be approved if it demonstrated its product were clinicallysuperior to our product or if we were unable to manufacture sufficient suppliesof product.   If it were determined thatwe do not have exclusive rights to the technology licensed to us by NIH, wemight be unable to preclude third parties - during or after any period oforphan drug exclusivity - from commercializing a drug based on CINTREDEKINBESUDOTOX for other indications. Competing CINTREDEKIN BESUDOTOX products, if suitable, could be prescribedby physicians for malignant glioma, even though not FDA-approved for thatuse.  This could cause our business tosuffer.  Moreover, if it were determinedthat we do not have exclusive rights to the technology licensed to us by NIH, athird party might be able to develop a CINTREDEKIN BESUDOTOX based drug for thetreatment of malignant glioma.  If thiscompetitor completed its clinical trials before we complete ours, FDA couldapprove that competitor’s product first and give it seven years of marketexclusivity.  In such a case, we mightnot be allowed to market our product in the United States for seven years.  Further, even if we receive seven years ofmarket exclusivity, other applicants could receive approval of compounds otherthan CINTREDEKIN BESUDOTOX for malignant glioma, which would compete with ourproduct.

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

In May of 2006, we entered into a licenseagreement with PHS, on behalf of NIH, for a non-exclusive license to the Company of rights to use a patentedprocess for Convection Enhanced Delivery (“CED”).  As the licenseagreement did not permit sublicensing of the Company’s rights, the Company hasbeen negotiating with PHS to obtain such rights, but has not yet agreed toterms.  Should the Company be unable to obtain sublicensing rights for thetechnology, the Company’s ability to utilize these CED rights in connectionwith the Company’s CINTREDEKIN BESUDOTOX would be not be restricted, but couldimpact our ability to sublicenseour technology in the future.

**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 property for our proprietary technologyand products in the United States and other countries. The laws of some foreigncountries do not protect proprietary rights to the same extent as the laws ofthe United States, and many companies have encountered significant problems inprotecting their proprietary rights in these foreign countries. These problemscan be caused, 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 as issuedpatents or pending patent applications. However, we may not obtain patents onall inventions for which we seek patents, and any patents we obtain may bechallenged and may be narrowed in scope or extinguished as a result of suchchallenges. Our existing patents and any future patents we obtain may not besufficiently broad to prevent others from practicing our technologies or fromdeveloping 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 not 

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experienced any difficulties in maintaining theconfidentiality of our information, these measures may not provide adequateprotection for our trade secrets, know-how or other confidential information inthe future. We seek to protect our confidential information by entering intoconfidentiality agreements with employees, collaborators, and consultants.Nevertheless, employees, former employees, collaborators, or consultants maystill disclose or misuse our confidential information, and we may not be ableto meaningfully protect our trade secrets. In addition, others mayindependently develop substantially equivalent information or techniques orotherwise gain access to our trade secrets. Disclosure or misuse of ourconfidential information would harm our competitive position and could causeour 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 or proprietaryrights 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 oligonucleotide technology,including patents about which such third parties have communicated with ussuggesting possible infringement, but the claims of which we believe we do notinfringe or are invalid. Moreover, United States patent applications filed inrecent years are confidential for 18 months, while older applications arenot published until the patent issues. Further, some applications are keptsecret during the entire length of their pendency by request of the applicantin special circumstances. As a result, there may be patents of which we areunaware, and avoiding patent infringement may be difficult. Patent holderssometimes send communications to a number of companies in related fields,suggesting possible infringement, and we, like a number of biotechnology companies,have received this type of communication. If we are sued for patentinfringement, we would need to demonstrate that we either do not infringe thepatent claims of the relevant patent and/or that the patent claims are invalid,which we may not be able to do. Proving invalidity, in particular, is difficultsince it requires a showing of clear and convincing evidence to overcome thepresumption of validity enjoyed by issued patents. Parties making claimsagainst us may be able to obtain injunctive or other equitable relief thatcould effectively block our ability to further develop, commercialize and sellproducts, and such claims could result in the award of substantial damagesagainst us. In the event of a successful claim of infringement against us, wemay be required to pay damages and obtain one or more licenses from thirdparties. We may not be able to obtain these licenses at a reasonable cost, ifat all. In that event, we could encounter delays in product introductions whilewe attempt to develop alternative methods or products or be required to ceasecommercializing affected products and our operating results would be harmed.

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

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

**If we lose 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 accepted employmenton the basis of written offers which set forth the salary and benefits to beprovided, including, but not limited to, salary continuation payments upontermination of employment. Only Mr. Herrera has an employment contractwith us. We do not have key man insurance on any of our management. If we wereto lose the services of Mr. Herrera, or other members of our managementstaff, and were unable to replace them, our product development and theachievement of our strategic objectives could be delayed. In addition, oursuccess will depend on our ability to attract and retain qualified commercial,scientific, technical, and managerial personnel. While we have not experiencedunusual difficulties to date in recruiting and retaining personnel, there isintense competition for qualified staff and no assurance can be given that wewill be able to retain existing personnel or attract and retain 

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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 increasingly challengingthe prices charged for medical products and services with respect to new drugproducts in particular. If we succeed in bringing any of our drug productcandidates to the market, we cannot be certain that our products will beconsidered 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 over existingtherapeutic products, including non-liposomal forms of the active agentsincluded 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 obtainfinancing, and other aspects of our business.**

As of June 30, 2006,management concluded that a control deficiency with respect to the review andverification of the accuracy of the calculation estimating the fair value ofnon-employee stock options constituted a material weakness in internal controlover financial reporting.  A material weakness is a control deficiency, orcombination of control deficiencies that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.  This control deficiencyresulted in an adjustment to the unaudited interim condensed consolidatedfinancial statements for the quarter ended March 31, 2006 affecting derivativefinancial instruments and change in fair value of derivative financialinstruments.

Management has revisedits policies and procedures with respect to its controls over the review andverification of the accuracy of the calculation estimating the fair value ofnon-employee stock options to ensure that all reasonable steps will be taken tocorrect 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, the identified control deficiencycould result in a misstatement in the derivative financial instruments andchange in fair value of derivative financial instruments balances that wouldnot be prevented or detected.  While management believes it has taken theappropriate steps to remediate this control deficiency, we may not be able toremediate the identified control deficiency prior to management’s assessmentand the audit of our assessment as of December 31, 2006.  A failure on ourpart to properly remediate the control deficiency could materially andadversely affect our business, our financial condition and the market value ofour securities.  In addition, our ability to obtain additional financingcould be materially or adversely affected.

Internal control overfinancial reporting can provide only reasonable and not absolute assurance thatdeficiencies or weaknesses 

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are identified. Additionally, potential controldeficiencies that are not yet identified could emerge and internal controlsthat are currently deemed to be in place and operating effectively are subjectto the risk that those controls may become inadequate because of changes inconditions, or that the degree of compliance with the policies or proceduresmay deteriorate. Identification and corrections of these types of potentialcontrol deficiencies could have a material impact on our business, financialposition, results of operations, and disclosures.

** Our investments could lose market value andconsequently 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 securitiesmay produce less income than expected if interest rates decrease. Due in partto these factors, our investment income may fall short of expectations or wemay suffer losses in principal if securities are sold that have declined inmarket value due to changes in interest rates.

**We handle 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 could have a material adverse effecton our business.

**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, tenbusiness days after any party, without prior approval of our Board ofDirectors, acquires, or announces an offer to acquire, beneficial ownership of15% or more of our common stock. An exception to this policy exists in the caseof our largest shareholder, Dr. John N. Kapoor, who is permitted toacquire up to 30% of our common stock without triggering the rights issuance.In the event that any party acquires 15% or more of our common stock (otherthan Dr. Kapoor for whom the threshold is 30%), we are acquired in amerger or other business combination, or 50% or more of our assets are soldafter the time that the rights become exercisable, the rights provide that eachright holder will receive, upon exercise, shares of the common stock of thesurviving or acquiring company, as applicable, having a market value of twicethe exercise price of the right. The stockholder rights plan may discourage orprevent certain types of transactions involving an actual or potential changein control, which transactions may be beneficial to our shareholders, bycausing substantial dilution to a party that attempts to acquire us on termsnot approved by our Board of Directors. In addition, Section 203 and otherprovisions of the Delaware General Corporation Law as well as provisions of ourcharter and by-laws could make a takeover of us or the removal of the membersof the board of directors or management more 

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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 statements registeringshares issuable pursuant to our equity compensation plans. Any sales byexisting stockholders or holders of options may have an adverse effect on ourability 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**

OnJune 19, 2006, the Company held its Annual Meeting of Stockholders to vote onthe matters listed below.  All of the matters voted on at the AnnualMeeting were approved the Company’s stockholders at the Annual Meeting.

1.     To elect eightdirectors to serve until the 2007 Annual Meeting of Stockholders.

 Withrespect to the election for directors, the votes were as follows:

|                       | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Withheld** | ** ** |
|-----------------------|------------|--------------------|------------|------------------------|------------|-------------------------|------------|
| Frank C. Becker       |       | 20,662,708         |       | —                 |       | 759,091                 |       |
| Ronald G. Eidell      |       | 15,787,266         |       | —                 |       | 5,634,533               |       |
| Bernard A. Fox        |       | 20,826,648         |       | —                 |       | 595,151                 |       |
| Paul E. Freiman       |       | 16,474,656         |       | —                 |       | 4,947,143               |       |
| Erick E. Hanson       |       | 20,765,695         |       | —                 |       | 656,104                 |       |
| Guillermo A.  Herrera |       | 20,881,563         |       | —                 |       | 540,236                 |       |
| John N. Kapoor        |       | 20,641,157         |       | —                 |       | 780,642                 |       |
| Kaveh T. Safavi       |       | 20,824,047         |       | —                 |       | 597,752                 |       |

 

2.               To approve adoptionof the NEOPHARM, Inc. 2006 Employee Stock Purchase Plan.

| Votes For | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|----------------|------------|------------------------|------------|-------------|------------|--------------------|------------|
| 12,389,848     |       | 514,590                |       | 31,629      |       | 8,485,732          |       |

 

3.               To approve adoptionof the NEOPHARM, Inc. 2006 Equity Incentive Plan.

| Votes For | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|----------------|------------|------------------------|------------|-------------|------------|--------------------|------------|
| 11,681,849     |       | 1,206,723              |       | 47,495      |       | 8,485,732          |       |

 

4.               To ratify theappointment of KPMG LLP as the Company’s independent registered publicaccounting firm for 2006.

| Votes For | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|----------------|------------|------------------------|------------|-------------|------------|--------------------|------------|
| 21,366,217     |       | 25,888                 |       | 29,694      |       | —             |       |

 

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**Item 5.****                                                         OtherInformation**

None

**Item 6.****                                                           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: August 9, 2006 | By:            | /s/ Lawrence A. Kenyon |
|                 |           | Lawrence A. Kenyon, |
|                 |           | *Chief Financial Officer  (Principal Accounting Officer and  Principal Financial Officer)* |

 

 

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