**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **ý**                                                                                                                                                                                                                                                                 | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EX­CHANGE ACT OF  1934.**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                       |
| **For  the quarterly period ended June 30, 2003**                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                       |
| **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 0-18006**                                                                                                                                                                                                                                        |

 

**THE IMMUNE RESPONSE CORPORATION**

(Exact Name of Registrant as Specified in its Charter)

 

| **Delaware**                                                      |   | **33-0255679**                        |
|-------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of   Incorporation or Organization) |   | (IRS Employer  Identification Number) |

 

**5931 Darwin Court, Carlsbad, CA  92008**

(Address of PrincipalExecutive Offices)

(Zip Code)

 

**Telephone (760) 431-7080**

(Registrant’s TelephoneNumber, Including Area Code)

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

Yes o    No ý

 

Indicate the number of shares outstanding of each of the Issuer’sclasses of common stock, as of the latest practicable date.

 

As of July 29, 2003,  32,275,526shares of common stock were outstanding.

 

 

----

 

**THE IMMUNE RESPONSE CORPORATION**

 

**FORM 10-Q**

 

**QUARTERLY REPORT**

 

 

**TABLE OF CONTENTS**

 
| PART I - FINANCIAL  INFORMATION |                                                                                        |
|---------------------------------|---------------------------------------------------------------------------------------------|
|                            |                                                                                        |   |
| Item 1.                         | Financial Statements (unaudited)                                                            |
|                            |                                                                                        |   |   |
|                            |                                                                                        | Condensed Consolidated Balance Sheets | 3 |
|                            |                                                                                        | Condensed Consolidated  Statements of Operations | 4 |
|                            |                                                                                        | Condensed  Consolidated Statements of Cash Flows | 5 |
|                            |                                                                                        | Condensed  Consolidated Statements of Stockholders' Equity | 6 |
|                            |                                                                                        | Notes to Condensed Consolidated  Financial Statements | 7 |
|                            |                                                                                        |
| Item  2.                        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 20 |
|                            |                                                                                        |
| Item  3.                        | Quantitative  and Qualitative Disclosures about Market Risk                                 | 40 |
|                            |                                                                                        |
| Item  4.                        | Controls  and Procedures                                                                    | 41 |
|                            |                                                                                        |
| PART II - OTHER INFORMATION     |                                                                                        |
|                            |                                                                                        |
| Item 1.                         | Legal Proceedings                                                                           | 42 |
|                            |                                                                                        |
| Item 2.                         | Changes in Securities and Use of  Proceeds                                                  | 42 |
|                            |                                                                                        |
| Item  4.                        | Submission  of Matters to a Vote of Security Holders                                        | 43 |
|                            |                                                                                        |
| Item  5.                        | Other  Information                                                                          | 43 |
|                            |                                                                                        |
| Item  6.                        | Exhibits  and Reports on Form 8-K                                                           | 44 |
|                            |                                                                                        |
| Signature                       | 45                                                                                          |
|                                 |                                                                                             |  |  |  |

 

2

----

 

**THEIMMUNE RESPONSE CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(inthousands, except share and per share amounts)

 
|                                                                                                                                                                          |   | **June 30,  2003** |   | **December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|------------------------|--------|
|                                                                                                                                                                          |   | **(unaudited)**    |   |                   |   |
| **Assets**                                                                                                                                                                    |   |               |   |                   |   |
| Current assets:                                                                                                                                                               |   |               |   |                   |   |
| Cash and cash equivalents                                                                                                                                                     |   | $                  | 1,302  |                   | $      | 3,939 |   |
| Marketable securities - available-for-sale                                                                                                                                    |   | 2                  |   | 2                      |   |
| Other current assets                                                                                                                                                          |   | 845                |   | 420                    |   |
| Total current assets                                                                                                                                                          |   | 2,149              |   | 4,361                  |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Property and equipment, net                                                                                                                                                   |   | 5,711              |   | 6,483                  |   |
| Licensed technology, net                                                                                                                                                      |   | 2,472              |   | 2,825                  |   |
| Deposits and other assets ($600 restricted as security for letter of  credit)                                                                                                 |   | 858                |   | 896                    |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Total assets                                                                                                                                                                  |   | $                  | 11,190 |                   | $      | 14,565 |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| **Liabilities and Stockholders’ Equity (Deficit)**                                                                                                                       |   |               |   |                   |   |
| Current liabilities:                                                                                                                                                          |   |               |   |                   |   |
| Accounts payable                                                                                                                                                              |   | $                  | 1,358  |                   | $      | 1,326 |   |
| Accrued expenses                                                                                                                                                              |   | 1,206              |   | 1,014                  |   |
| Short-term unsecured promissory notes, net of discount of $314                                                                                                                |   | 686                |   | —                 |   |
| Short-term convertible notes payable, related party                                                                                                                           |   | 3,899              |   | —                 |   |
| Current portion of equipment notes payable                                                                                                                                    |   | 280                |   | 724                    |   |
| Capital lease liability                                                                                                                                                       |   | 36                 |   | 217                    |   |
| Current portion of deferred revenue                                                                                                                                           |   | 56                 |   | 56                     |   |
| Total current liabilities                                                                                                                                                     |   | 7,521              |   | 3,337                  |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Convertible notes payable, related party, net of discount of $6,789  and $10,848 and plus accrued interest of $312 and $594 at 2003 and 2002,  respectively                   |   | 3,069              |   | 3,487                  |   |
| Equipment notes payable, net of current portion                                                                                                                               |   | —             |   | 141                    |   |
| Accrued excess lease costs                                                                                                                                                    |   | 1,178              |   | 637                    |   |
| Long-term deferred revenue, net of current portion                                                                                                                            |   | 351                |   | 378                    |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Total liabilities                                                                                                                                                             |   | 12,119             |   | 7,980                  |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Commitments, contingencies and subsequent events                                                                                                                              |   |               |   |                   |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Stockholders’ equity (deficit):                                                                                                                                          |   |               |   |                   |   |
| Preferred stock, 5,000,000 shares authorized; 0 shares issued and  outstanding                                                                                                |   | —             |   | —                 |   |
| Common stock, $.0025 par value, 170,000,000 shares authorized; 21,628,390  and 19,670,729 shares issued and outstanding at June 30, 2003 and December  31, 2002, respectively |   | 54                 |   | 49                     |   |
| Warrants                                                                                                                                                                      |   | 13,734             |   | 13,684                 |   |
| Additional paid-in capital                                                                                                                                                    |   | 257,537            |   | 250,656                |   |
| Accumulated other comprehensive income                                                                                                                                        |   | 2                  |   | 2                      |   |
| Accumulated deficit                                                                                                                                                           |   | (272,256           | )      | (257,806               | )      |
| Total stockholders’ equity (deficit)                                                                                                                                     |   | (929               | )      | 6,585                  |   |
|                                                                                                                                                                          |   |               |   |                   |   |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                     |   | $                  | 11,190 |                   | $      | 14,565 |   |

 

See accompanying notes.

 

3

----

 

**THE IMMUNE RESPONSE CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(inthousands, except per share amounts)

(unaudited)

 
|                                                                                                                                  |   | **Three months ended June 30,** |   | **Six months ended June 30,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                                                                                                  |   | **2003**                        |   | **2002**                      |   | **2003** |   | **2002** |   |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Revenues:                                                                                                                             |   |                            |   |                          |   |   |   |   |   |
| Contract research revenue                                                                                                             |   | $                               | 7      |                          | $      | 7 |   | $ | 14 |   | $ | 14 |   |
| Licensed research revenue                                                                                                             |   | 7                               |   | 4                             |   | 24 |   | 6 |   |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
|                                                                                                                                  |   | 14                              |   | 11                            |   | 38 |   | 20 |   |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Expenses:                                                                                                                             |   |                            |   |                          |   |   |   |   |   |
| Research and development                                                                                                              |   | 2,527                           |   | 3,753                         |   | 5,004 |   | 7,561 |   |
| General and administrative                                                                                                            |   | 2,348                           |   | 1,233                         |   | 3,383 |   | 2,380 |   |
| Exit and disposal related costs                                                                                                       |   | 1,005                           |   | —                        |   | 1,290 |   | — |   |
| Collaborative contract costs                                                                                                          |   | —                          |   | 2,360                         |   | — |   | 2,360 |   |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
|                                                                                                                                  |   | 5,880                           |   | 7,346                         |   | 9,677 |   | 12,301 |   |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Other revenue and expense:                                                                                                            |   |                            |   |                          |   |   |   |   |   |
| Investment income                                                                                                                     |   | 3                               |   | 8                             |   | 11 |   | 22 |   |
| Interest expense - including non-cash accretion of $3,028 and $576  for three months and $4,130 and $828 for six months, respectively |   | (3,398                          | )      | (774                          | )      | (4,822 | ) | (1,146 | ) |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Net loss                                                                                                                              |   | $                               | (9,261 | )                             | $      | (8,101 | ) | $ | (14,450 | ) | $ | (13,405 | ) |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Loss per share - basic and diluted                                                                                                    |   | $                               | (0.46  | )                             | $      | (0.91 | ) | $ | (0.72 | ) | $ | (1.50 | ) |
|                                                                                                                                  |   |                            |   |                          |   |   |   |   |   |
| Weighted average number of shares outstanding                                                                                         |   | 20,203,965                      |   | 8,951,287                     |   | 19,938,820 |   | 8,922,317 |   |

 

See accompanying notes.

 

4

----

 

**THE IMMUNE RESPONSE CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(inthousands)

(unaudited)

 
|                                                                         |   | **Six months ended June 30,** |    |
|------------------------------------------------------------------------------|--------|-------------------------------|---------|
|                                                                         |   | **2003**                      |    | **2002** |   |
| Operating activities:                                                        |   |                          |    |   |   |
| Net loss                                                                     |   | $                             | (14,450 | ) | $ | (13,405 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                          |    |   |   |
| Depreciation and amortization                                                |   | 1,001                         |    | 1,128 |   |
| Operating expenses accrued or paid with common stock                         |   | 136                           |    | — |   |
| Operating expenses paid with warrants                                        |   | 20                            |    | — |   |
| Stock option adjustments                                                     |   | 1,323                         |    | — |   |
| Collaborative contract costs                                                 |   | —                        |    | 2,360 |   |
| Deferred revenue                                                             |   | (27                           | )       | 229 |   |
| Accrued excess lease costs                                                   |   | 541                           |    | — |   |
| Long-term accrued interest                                                   |   | 523                           |    | 193 |   |
| Accretion of convertible notes and short-term unsecured notes                |   | 4,130                         |    | 828 |   |
| Gain on sale of assets                                                       |   | (46                           | )       | — |   |
| Changes in operating assets and liabilities:                                 |   |                          |    |   |   |
| Other current assets                                                         |   | (209                          | )       | 438 |   |
| Accounts payable                                                             |   | 32                            |    | (10 | ) |
| Accrued expenses                                                             |   | (28                           | )       | 36 |   |
| Net cash used in operating activities                                        |   | (7,054                        | )       | (8,203 | ) |
|                                                                         |   |                          |    |   |   |
| Investing activities:                                                        |   |                          |    |   |   |
| Sale of marketable securities, net                                           |   | —                        |    | 251 |   |
| Purchase of property and equipment                                           |   | (26                           | )       | — |   |
| Proceeds from sale of equipment                                              |   | 196                           |    | — |   |
| Other assets                                                                 |   | 38                            |    | (38 | ) |
| Net cash provided by investing activities                                    |   | 208                           |    | 213 |   |
|                                                                         |   |                          |    |   |   |
| Financing activities:                                                        |   |                          |    |   |   |
| Principal payments under equipment notes and capital leases payable          |   | (766                          | )       | (342 | ) |
| Proceeds from issuances of convertible notes payable and warrants            |   | —                        |    | 7,000 |   |
| Proceeds from issuance of short-term convertible notes payable               |   | 3,899                         |    | — |   |
| Proceeds from short-term unsecured promissory notes                          |   | 1,000                         |    | — |   |
| Net proceeds from common stock purchases through employee plans              |   | 76                            |    | 9 |   |
| Net cash provided by financing activities                                    |   | 4,209                         |    | 6,667 |   |
|                                                                         |   |                          |    |   |   |
| Net decrease in cash and cash equivalents                                    |   | (2,637                        | )       | (1,323 | ) |
| Cash and cash equivalents at beginning of year                               |   | 3,939                         |    | 2,430 |   |
| Cash and cash equivalents at end of period                                   |   | $                             | 1,302   |   | $ | 1,107 |   |
|                                                                         |   |                          |    |   |   |
| Supplemental disclosure of cash flow information:                            |   |                          |    |   |   |
| Interest paid                                                                |   | $                             | 105     |   | $ | 125 |   |
|                                                                         |   |                          |    |   |   |
| Supplemental disclosure of noncash investing and financing activities:       |   |                          |    |   |   |
| Convertible notes payable converted into common stock                        |   | $                             | 4,195   |   | $ | — |   |
| Common stock issued for long-term accrued interest upon conversion of  notes |   | $                             | 805     |   | $ | — |   |
| Common stock issued for consulting contracts                                 |   | $                             | 102     |   | $ | — |   |
| Value allocated to common stock issued as debt discount                      |   | $                             | 385     |   | $ | — |   |
| Warrants issued for consulting contracts                                     |   | $                             | 50      |   | $ | — |   |
| Unrealized loss on marketable securities                                     |   | $                             | —  |   | $ | (18 | ) |
| Common stock issued for collaborative contracts                              |   | $                             | —  |   | $ | 2,360 |   |

 

See accompanying notes.

 

5

----

 

**THEIMMUNE RESPONSE CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYAND COMPREHENSIVE LOSS**

(in thousands)

(unaudited)

 
|                                                                                       |   | **Common Stock** |   |       |   | **Additional********Paid-in** |   | **Accumulated********Other********Comprehensive** |   | **Accumulated**   |    | **Total********Stockholders’** |   | **Comprehensive** |   |
|--------------------------------------------------------------------------------------------|--------|------------------|--------|------------|--------|-------------------------------|--------|---------------------------------------------------|--------|-------------------|---------|-------------------------------------|--------|-------------------|--------|
|                                                                                       |   | **Shares**       |   | **Amount** |   | **Warrants**                  |   | **Capital**                                       |   | **Income (Loss)** |    | **Deficit**                         |   | **Equity**        |   | **Income (Loss)** |   |
| Balance at December 31, 2001                                                               |   | 8,893            |   | $          | 89     |                          | $      | 1,131                                             |   | $                 | 238,819 |                                | $      | 20                |   | $ | (226,971 | ) | $ | 13,088 |   |   |   |
|                                                                                       |   |             |   |       |   |                          |   |                                              |   |              |    |                                |   |              |   |   |   |
| Issuance of common stock and warrants in private placement,net of issuance costs of $1,523 |   | 7,262            |   | 18         |   | 4,064                         |   | 822                                               |   | —            |    | —                              |   | 4,904             |   |   |   |
| Conversion of convertible notes into private placement                                     |   | 2,260            |   | 6          |   | 1,265                         |   | 729                                               |   | —            |    | —                              |   | 2,000             |   |   |   |
| Beneficial inducement cost for convertible notes convertedinto private placement           |   | —           |   | —     |   | —                        |   | 3,200                                             |   | —            |    | —                              |   | 3,200             |   |   |   |
| Issuance of placement agent option in private placement                                    |   | —           |   | —     |   | 1,148                         |   | (1,148                                            | )      | —            |    | —                              |   | —            |   |   |   |
| Warrants issued in conjunction with convertible notes                                      |   | —           |   | —     |   | 6,076                         |   | —                                            |   | —            |    | —                              |   | 6,076             |   |   |   |
| Convertible notes discount                                                                 |   | —           |   | —     |   | —                        |   | 5,421                                             |   | —            |    | —                              |   | 5,421             |   |   |   |
| Reclassification for stock split                                                           |   | —           |   | (67        | )      | —                        |   | 67                                                |   | —            |    | —                              |   | —            |   |   |   |
| Issuance of common stock for collaborative contract costs                                  |   | 1,000            |   | 2          |   | —                        |   | 2,358                                             |   | —            |    | —                              |   | 2,360             |   |   |   |
| Issuance of common stock for consulting contract                                           |   | 250              |   | 1          |   | —                        |   | 378                                               |   | —            |    | —                              |   | 379               |   |   |   |
| Issuance of common stock for employee stock plans                                          |   | 6                |   | —     |   | —                        |   | 10                                                |   | —            |    | —                              |   | 10                |   |   |   |
| Change in unrealized gain on marketable securities                                         |   | —           |   | —     |   | —                        |   | —                                            |   | (18               | )       | —                              |   | (18               | )      | $ | (18 | ) |
| Net loss                                                                                   |   | —           |   | —     |   | —                        |   | —                                            |   | —            |    | (30,835                             | )      | (30,835           | )      | (30,835 | ) |
| Balance at December 31, 2002                                                               |   | 19,671           |   | 49         |   | 13,684                        |   | 250,656                                           |   | 2                 |    | (257,806                            | )      | 6,585             |   | $ | (30,853 | ) |
|                                                                                       |   |             |   |       |   |                          |   |                                              |   |              |    |                                |   |              |   |   |   |
| Conversion of convertible notes into common stock                                          |   | 1,614            |   | 4          |   | —                        |   | 4,996                                             |   | —            |    | —                              |   | 5,000             |   |   |   |
| Warrants issued in conjunction with consulting contract                                    |   | —           |   | —     |   | 32                            |   | —                                            |   | —            |    | —                              |   | 32                |   |   |   |
| Issuance of common stock  and  warrant for debt discount                              |   | 167              |   | 1          |   | 18                            |   | 384                                               |   | —            |    | —                              |   | 403               |   |   |   |
| Issuance of common stock for consulting contract                                           |   | 74               |   | —     |   | —                        |   | 102                                               |   | —            |    | —                              |   | 102               |   |   |   |
| Issuance of common stock for employee stock plans                                          |   | 102              |   | —     |   | —                        |   | 76                                                |   | —            |    | —                              |   | 76                |   |   |   |
| Intrinsic valuation for repriced employee stock options                                    |   | —           |   | —     |   | —                        |   | 1,107                                             |   | —            |    | —                              |   | 1,107             |   |   |   |
| Variable accounting for options granted to nonemployees                                    |   | —           |   | —     |   | —                        |   | 216                                               |   | —            |    | —                              |   | 216               |   |   |   |
| Change in unrealized gain on marketable securities                                         |   | —           |   | —     |   | —                        |   | —                                            |   | —            |    | —                              |   | —            |   | $ | — |   |
| Net loss                                                                                   |   | —           |   | —     |   | —                        |   | —                                            |   | —            |    | (14,450                             | )      | (14,450           | )      | (14,450 | ) |
| Balance at June 30, 2003                                                                   |   | 21,628           |   | $          | 54     |                          | $      | 13,734                                            |   | $                 | 257,537 |                                | $      | 2                 |   | $ | (272,256 | ) | $ | (929 | ) | $ | (14,450 | ) |

 

See accompanying notes.

 

6

----

 

**THE IMMUNE RESPONSE CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**June 30,2003**

**(Unaudited)**

 

**1.****                                      Basisof Presentation**

 

The condensed consolidated financial statements of The Immune ResponseCorporation and its wholly owned subsidiary (“the Company”) for the three andsix months ended June 30, 2003 and 2002 are unaudited.  All significant intercompany accounts andtransactions have been eliminated in consolidation.  These financial statements reflect all adjustments, consisting ofonly normal recurring adjustments which, in the opinion of management, are necessaryto fairly present the consolidated financial position of the Company as of June30, 2003, and the consolidated results of operations of the Company for thethree and six months ended June 30, 2003 and 2002.  The results of operations for the three and six months ended June30, 2003 are not necessarily indicative of the results to be expected for theyear ended December 31, 2003.  For morecomplete financial information, these consolidated financial statements and thenotes thereto should be read in conjunction with the consolidated auditedfinancial statements for the year ended December 31, 2002 included in theCompany’s Form 10-K filed with the Securities and Exchange Commission.

 

In October 2002, the Company’s Board of Directors formally declared aone-for-four reverse stock split of issued and outstanding shares of commonstock.  The Company’s stockholdersauthorized the reverse split at their annual meeting held in June 2002.  All common share balances and net loss pershare amounts presented in these financial statements have been retroactivelyadjusted to reflect the reverse stock split.

 

Certain reclassifications have been made to conform prior periodfinancial information to the current presentation.  These reclassifications had no effect on reported income orlosses.

 

**2.****                                      Organization,liquidity and going concern**

 

*Organization*

 

The Immune Response Corporation (the “Company”), a Delawarecorporation, is a biopharmaceutical company developing a therapeutic vaccinefor the treatment of HIV infection.  Wehave developed REMUNE**®**,an immune-based therapy, to induce specific immune responses for the treatmentof HIV.  We also have created sixdistinct therapeutic vaccines in various stages of development for autoimmunediseases and cancer and have established an extensive patent portfolio spanningfour different technologies with a total of 173 patents issued to us worldwide.

 

As part of our restructuring program announced in September 2002, wehave ceased development of all therapeutic vaccines other than Remune**®**.  During May2003, we disposed of excess assets, and we are negotiating an early leasetermination for our former vacated headquarters facility resulting in exit anddisposal related costs of approximately $1.3 million recognized as of June 30, 2003,including an estimate of approximately $700,000 of additional costs accrued fora potential settlement of a claim filed by the landlord for breach of contractunder the lease.  See Notes 11 and 14.

 

*Liquidity and going concern*

 

The condensed consolidated financial statements have been preparedassuming that the Company will continue as a going concern.  The Company has operating and liquidityconcerns due to historically reporting significant net losses and negative cashflows from operations.  As of June 30,2003 and December 31, 2002, the Company had a working capital deficiency of$5.4 million and working capital of $1.0 million, respectively, and anaccumulated deficit of $272.3 million and $257.8 million, respectively.

 

During June 2003, Cheshire Associates, LLC (“Cheshire”) exercised itsoption to convert $4.2 million of principal on notes issued to it in November2001, February 2002, part of the principal of the May 2002 note and all accruedand unpaid interest of $.8 million into 1,613,572 shares of our commonstock.  Cheshire is an affiliate of oneof our directors and principal stockholder, Mr. Kevin Kimberlin.  The balance of the May 2002 note and allaccrued and unpaid interest thereon was transferred to two new notes in theapproximate amounts of $2.4 million and $1.4 million, respectively.  During July 2003, the note in the amount of$2.4 million was cancelled as payment for the aggregate 

 

7

----

 

exercise price of Class A warrants to purchase 1,774,888 shares and anadditional 887,444 incentive shares of our common stock in connection with theJuly 7, 2003 incentive share offering described below.

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire. The Company issued an additional 3,496,118 shares equal to one halfshare of common stock for each Class A warrant exercised as an incentive toinduce holders of the Class A warrants to exercise their Class A warrants andto allow the Company to obtain a “lock-up” on the shares of common stock issuedto the holders of such exercised Class A warrants in the December 2002 unitoffering and the shares of the common stock issued upon the exercise of theClass A warrants (including the additional one half share of common stock),prohibiting the sale of such common stock for 270 days, with the “lock-up” periodexpiring on April 4, 2004. The incentive shares issued as part of the offeringrepresent an inducement to participate in the voluntary exercise and willresult in a charge to our statement of operations for beneficial inducementcost in the third quarter of 2003.

 

 

On July 30, 2003 the Company exercised its option to redeem theremaining outstanding Class A warrants on September 3, 2003. If all theoutstanding Class A warrants are exercised, the Company would receive grossproceeds of approximately $3.4 million. The Company anticipates that theaggregate proceeds from the exercise of the Class A warrants, together with theexercise of the Class A warrants on July 7, 2003, will be sufficient to fundour planned operations, including necessary capital expenditures and newclinical trials, into the first quarter of 2004.

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued to itbetween January 1, 2003 and July 7, 2003 into shares of Series A ConvertiblePreferred Stock.  The Series AConvertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

Notwithstanding the exercise of the Class A warrants, we will continueto have limited cash resources. Although our management recognizes the need to secure additionalfinancing and currently is exploring its options, there can be no assurancethat we will be successful in consummating any such transaction or, if we doconsummate such a transaction, that the terms and conditions will not beunfavorable to us. The failure by us to obtain additional financing before thefirst quarter of 2004 (assuming the exercise of all the remaining Class Awarrants), will have a material adverse effect on us and likely result in ourinability to continue as a going concern. Our independent auditors haveconcluded that there is substantial doubt as to our ability to continue as agoing concern for a reasonable period of time, and have modified their reportin the form of an explanatory paragraph describing the events that have givenrise to this uncertainty regarding our 2002 annual consolidated financialstatements.

 

These factors, among others, raise substantial doubt about theCompany’s ability to continue as a going concern.  The consolidated financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might resultshould the Company be unable to continue as a going concern.

 

**3.****                                      Netloss per share**

 

Basic and diluted net loss per share is computed using the weightedaverage number of common shares outstanding during the period.  Potentially dilutive securities are excludedfrom the diluted net loss per share calculation, as the effect would beantidilutive.  Potentially dilutiveshares not included are 3.6 million shares for outstanding employee stockoptions, 10.7 million shares issuable under convertible notes payable, relatedparty, 9.8 million shares issuable under warrants outstanding,9.5 million shares issuable under A warrants outstanding and1.5 million shares issuable under an option issued to the placement agentfor the private offering in December 2002.

 

8

----

 

**4.****                                   Comprehensiveloss**

 

The Company accounts for comprehensive income in accordance with FASNo. 130, “Reporting Comprehensive Income.” The components of comprehensive loss are as follows:

 
|                                          |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **(in thousands)**                            |   | **2003**                          |   | **2002**                        |   | **2003** |   | **2002** |   |
| Net loss                                      |   | $                                 | (9,261 | )                               | $      | (8,101 | ) | $ | (14,450 | ) | $ | (13,405 | ) |
| Net unrealized  loss on marketable securities |   | —                            |   | (5                              | )      | — |   | (18 | ) |
| Comprehensive  loss                           |   | $                                 | (9,261 | )                               | $      | (8,106 | ) | $ | (14,450 | ) | $ | (13,423 | ) |

 

**5.****                                      Recentaccounting pronouncements**

 

In August 2001, the Financial Accounting Standards Board, FASB, issuedFAS No. 143, “Accounting for Asset Retirement Obligations.”  This statement addresses financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs.  It applies to all entities and legalobligations associated with the retirement of long-lived assets that resultfrom the acquisition, construction, development and/or normal operation oflong-lived assets, except for certain obligations of lessees.  This statement amends FAS No. 19,“Financial Accounting and Reporting by Oil and Gas Producing Companies,” andwas effective for financial statements issued for fiscal years beginning afterJune 15, 2002.  The adoption of FASNo. 143 did not have a material impact on the Company’s consolidatedfinancial position or results of operations.

 

In June 2002, the FASB issued FAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities.” FAS No. 146 addresses accounting and reporting for costs associatedwith exit or disposal activities and nullifies Emerging Issues Task Force IssueNo. 94-3, “Liability Recognition for Certain Employee Termination Benefitsand Other Costs to Exit an Activity (Including Certain Costs Incurred in aRestructuring).”  FAS No. 146requires that a liability for a cost associated with an exit or disposalactivity be recognized and measured initially at fair value when the liabilityis incurred.  FAS No. 146 iseffective for exit or disposal activities that are initiated afterDecember 31, 2002.  See Note 2 forcurrent and estimated costs from the exit and disposal of our vacatedheadquarters facility including ongoing negotiations regarding early leasetermination.

 

In November 2002, the FASB issued Interpretation No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others,” which disclosures are effectivefor financial statements issued after December 15, 2002.  While the Company has various guaranteesincluded in contracts in the normal course of business, primarily in the formof indemnities, these guarantees would only result in immaterial increases infuture costs, but do not represent significant commitments or contingentliabilities of the indebtedness of others. The adoption of this statement did not have a material impact on theCompany’s financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, "Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity," which establishes standards for the classification andmeasurement of certain financial instruments with characteristics of bothliability and equity. This statement is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective for theCompany on July 1, 2003. We do not expect the adoption of SFAS No. 150 to havea material effect on our consolidated financial statements.

 

**6.****                                      Licensedtechnology**

 

In December 1999, the Company entered into a technology licensingagreement with Connetics Corporation (“Connetics”) and XOMA, (US) LLC(“XOMA”).  The agreement assignedexclusive rights to T cell receptor (“TCR”), intellectual property (issuedpatents and know-how) to the Company in exchange for approximate value of$4.9 million comprised of $500,000 in cash, 62,500 shares of common stock,$945,000 of short-term license contract payable and $2,664,000 of a potentialcontingent stock liability.  Theagreement also requires the Company to make royalty payments on future sales ofproducts, if any, related to the TCR intellectual property to Connetics, XOMAand Dr. Arthur Vandenbark, one of the inventors of the assignedtechnology.  The purchased technologydid not include any FDA approved products. The agreement terminates when the patent expires in 2014.  The Company owns additional TCR-relatedintellectual property and intends to carry forward development of pharmaceuticalproducts for the treatment of multiple sclerosis and other autoimmune diseasesusing the technology.

 

In accordance with FAS No. 144, the Company had identifiedlicensed technology totaling $2.8 million at December 31, 2002 aslong-lived assets subject to annual impairment review.  Given the current financial status of theCompany, its historical losses and the indeterminable outcome of thedevelopment and approval of its products, there is substantial uncertainty asto the Company’s ability to recover its investment in these long-lived assetsthrough the generation of net future cash flows.  In light of this uncertainty, the Company obtained an independentthird-party appraisal of these long-lived assets in the first quarter of2003.  As a result of such appraisal,licensed technology did not require an impairment charge for the year endedDecember 31, 2002.

 

9

----

 

The Company capitalized the purchase cost to licensed technology.  The license contract was paid in full inOctober 2000 by four quarterly installments of $250,000 beginning in January2000.  The contingent stock liabilitywas settled in March 2000.  Noadditional shares of common stock were required to be issued pursuant to thevaluation contingency terms of the agreement.

 

**7.****                                      Equipmentnotes payable**

 

In June 2002, the Company restructured its equipment loans withTransamerica Technology Finance Corporation (“Transamerica”).  As a result of the loan restructuring, theCompany cured the existing default under those loans and limited thecircumstances which could serve as the basis for any future default by theCompany.  Pursuant to the agreementssigned with Transamerica, the Company paid Transamerica $200,000 upon theclosing of the December 2002 private placement.

 

During May 2003, the Company held an auction to sell excess assetsassociated with our vacated headquarters facility located in Carlsbad,California.  Transamerica was paid$187,000 of total auction proceeds.  InJuly 2003, the Company paid $200,000, the second milestone payment, as a resultof the exercise of the Class A warrants. In August 2003, the loans were paid in full with a final payment of$35,000.  See Note 14.  The total amount owed to Transamerica as ofJune 30, 2003 and December 31, 2002 was approximately $280,000 and$865,000, respectively.

 

**8.****                                      Convertiblenotes payable, related party**

 

In November 2001, the Company entered into the Note Purchase Agreementand Intellectual Property Security Agreement with an accredited investor.  The investor, Kevin Kimberlin Partners, L.P.(“KKP”), is an affiliate of Kevin Kimberlin, a director and majorstockholder of the Company. Subsequently, the Note Purchase Agreement has been amended to add otheraffiliates and/or related parties of Kevin Kimberlin as investors.  These affiliated investors include OshkimLimited Partnership (“Oshkim”), The Kimberlin Family 1998 Irrevocable Trust(“KFIT”) and Cheshire.  Since November2001 through December 31, 2002, the Company has privately placed a totalof $15.7 million in convertible notes and warrants.  In December 2002, $2.0 million of thenotes were converted into the Company’s private placement of common stock andwarrants.  In June 2003, $4.2 million ofthe notes plus $0.8 million of accrued interest were converted into theCompany’s common stock, which leaves a remaining balance of $9.5 million and$13.7 million of convertible notes and warrants at June 30, 2003 andDecember 31, 2002, respectively. Subsequent to June 30, 2003, a $2.4 million note was cancelled aspayment for the aggregate exercise price for Class A warrants exercised byCheshire as part of the incentive share offering.  See Note 14.

 

The Company used substantially all of the net proceeds from thesetransactions for product development, working capital and other generalcorporate purposes.  The Company filed aRegistration Statement on Form S-3 with the SEC to cover the resale of theunderlying shares of common stock, which was declared effective on June 23,2003.

 

All the notes bear interest at a fixed rate of 8% per year and aresecured by the intellectual property of the Company.  The notes have a three-year maturity from the date of originalissuance.  The notes are convertibleinto shares of the Company’s common stock at any time, at the option of theinvestors.  The conversion prices arebased on a percentage of the average closing bid prices of the Company’s commonstock for either a ten-day or five-day trading period ended on the daypreceding each closing.

 

Each note provides 100% warrant coverage.  The warrants are for a term of ten years.  The warrants are exercisable into shares ofthe Company’s common stock at any time, at the option of the investors.  The exercise prices are based on the averageclosing bid prices of the Company’s common stock for either a ten-day orfive-day trading period ended on the day preceding each closing.  Both the conversion prices of the notes andthe exercise prices of the warrants provide anti-dilution protection for theinvestors.

 

Following is a summary of the various terms and conversion features ofthe outstanding convertible notes payable, related party at June 30, 2003 andDecember 31, 2002:

 

10

----

 
| **Issuance   Date**     |   | **Maturity  Date** |             | **Convertible  Notes Principal** |                  | **At  Issuance** |             | **# of Days  Average  Closing   Bid** |   | **After  Dilution Adjustments** |   |
|-------------------------|--------|--------------------|------------------|----------------------------------|-----------------------|------------------|------------------|---------------------------------------|--------|---------------------------------|--------|
|                    |   |               |             |                             |                  |
|                    |   |               | **# of  Shares** |                             | **Conversion  Price** |             | **% to  Market** |                                  |   | **# of  Shares**                |   | **Conversion  Price** |   |
| 09-Nov-01               |   | 09-Nov-04          |             | $                                | 2,000,000             |             | 433,426          |                                  | $      | 4.6144                          |   | 80 | % | 10 |   | 559,706 |   | $ | 3.5733 |   |
| 14-Feb-02               |   | 14-Feb-05          |             | 2,000,000                        |                  | 429,000          |             | 4.6620                                |   | 112.5                           | %      | 5 |   | 554,292 |   | 3.6082 |   |
| 03-May-02               |   | 03-May-05          |             | 4,000,000                        |                  | 2,319,109        |             | 1.7248                                |   | 80                              | %      | 10 |   | 2,745,367 |   | 1.4570 |   |
| 12-Nov-02               |   | 12-Nov-05          |             | 4,847,608                        |                  | 4,243,354        |             | 1.1424                                |   | 80                              | %      | 10 |   | 4,704,131 |   | 1.0305 |   |
| 15-Nov-02               |   | 15-Nov-05          |             | 200,000                          |                  | 174,581          |             | 1.1456                                |   | 80                              | %      | 10 |   | 193,648 |   | 1.0328 |   |
| 20-Nov-02               |   | 20-Nov-05          |             | 200,000                          |                  | 184,638          |             | 1.0832                                |   | 80                              | %      | 10 |   | 202,613 |   | 0.9871 |   |
| 27-Nov-02               |   | 27-Nov-05          |             | 215,000                          |                  | 264,518          |             | 0.8128                                |   | 80                              | %      | 10 |   | 272,462 |   | 0.7891 |   |
| 10-Dec-02               |   | 30-Jul-05          |             | 278,320                          |                  | 187,851          |             | 1.4816                                |   | 80                              | %      | 10 |   | 217,624 |   | 1.2789 |   |
| December 31,  2002 |   |               |             | 13,740,928                       |                  | 8,236,477        |             |                                  |   |                            |   |   |   | 9,449,843 |   |   |   |
| 03-Jun-03               |   | Conversion         |             | (4,195,000                       | )                     | n/a              |             | n/a                                   |   | n/a                             |   | n/a |   | (1,247,656 | ) | $1.457 -  $3.6082 |   |
| June 30, 2003           |   |               |             | $                                | 9,545,928             |             |             |                                  |   |                            |   |   |   |   | 8,202,187 |   |   |   |
|                         |        |                    |                  |                                  |                       |                  |                  |                                       |        |                                 |        |  |  |  |  |  |  |  |  |  |

 

Following is a summary of the various terms and exercise features ofthe warrants issued in conjunction with the convertible notes payable, relatedparty at June 30, 2003 and December 31, 2002:

 
| **Issuance   Date** |   | **Expiration  Date** |             | **Fair Value  Allocated to  Warrants** |                | **At  Issuance** |             | **After  Dilution  Adjustments** |             |
|---------------------|--------|----------------------|------------------|----------------------------------------|---------------------|------------------|------------------|----------------------------------|------------------|
|                |   |                 | **# of  Shares** |                                   | **Exercise  Price** |             | **% to  Market** |                             | **# of  Shares** |   | **Exercise  Price** |   |
| 09-Nov-01           |   | 09-Nov-11            |             | $                                      | 1,076,000           |             | 433,426          |                             | $                | 5.7680 |   | 100 | % | 565,841 |   | $ | 4.4182 |   |
| 14-Feb-02           |   | 14-Feb-12            |             | 906,000                                |                | 429,000          |             | 4.1440                           |             | 100 | % | 550,599 |   | 3.2288 |   |
| 03-May-02           |   | 03-May-12            |             | 2,038,000                              |                | 2,319,109        |             | 2.1560                           |             | 100 | % | 2,820,396 |   | 1.7728 |   |
| 12-Nov-02           |   | 12-Nov-12            |             | 2,697,000                              |                | 4,243,354        |             | 1.4280                           |             | 100 | % | 4,887,883 |   | 1.2397 |   |
| 15-Nov-02           |   | 15-Nov-12            |             | 107,000                                |                | 174,581          |             | 1.4320                           |             | 100 | % | 201,191 |   | 1.2426 |   |
| 20-Nov-02           |   | 20-Nov-12            |             | 72,000                                 |                | 184,638          |             | 1.3540                           |             | 100 | % | 210,881 |   | 1.1855 |   |
| 27-Nov-02           |   | 27-Nov-12            |             | 103,000                                |                | 264,518          |             | 1.0160                           |             | 100 | % | 286,544 |   | 0.9379 |   |
| 10-Dec-02           |   | 30-Jul-12            |             | 154,000                                |                | 187,851          |             | 1.8520                           |             | 100 | % | 224,422 |   | 1.5502 |   |
|                |   |                 |             | $                                      | 7,153,000           |             | 8,236,477        |                             |             |   |   |   | 9,747,757 |   |   |   |
|                     |        |                      |                  |                                        |                     |                  |                  |                                  |                  |  |  |  |  |  |  |  |  |  |

 

The cash proceeds of the notes were allocated prorata between therelative fair values of the notes and warrants at issuance using the BlackScholes valuation model for valuing the warrants.  After allocating the proceeds between the note and warrant, aneffective conversion price was calculated for the convertible note to determinethe beneficial conversion discount for each note.  The value of the beneficial conversion discount is recorded asadditional discount to the note.  Theresultant combined discount to the note is accreted back to the note principalbalance over the three-year term of the note and recorded as interest expense.  The following is a summary of the allocationof the cash proceeds to the relative fair values of the notes and warrants andthe components of the discount recorded upon issuance of each note:

 
|                |   | **Convertible  Notes  Principal** |                                    |      |         |   |                             |   |                |   |   |   |   | **Original  Note  Balance  Net of  Discount** |   |
|---------------------|--------|-----------------------------------|-----------------------------------------|-----------|--------------|--------|----------------------------------|--------|---------------------|--------|--------|--------|--------|-----------------------------------------------|--------|
| **(in  thousands)** |   |                              |                                    |      |         |   | **Components  of Note Discount** |   |                |
|                |   |                              | **Fair Value  Allocation at  Issuance** |      | **Warrants** |   | **Beneficial  Conversion  Cost** |   | **Total  Discount** |   |   |
| **Issuance  Date**  |   |                              |                                    |      |         |   |                             |
|                |   | **Warrants**                      |                                    | **Notes** |         |   |                             |   |                |
| 09-Nov-01           |   | $                                 | 2,000                                   |      | $            | 1,076  |                             | $      | 924                 |   | $      | 1,076  |   | $                                             | 924    |   | $ | 2,000 |   | $ | — |   |
| 14-Feb-02           |   | 2,000                             |                                    | 906       |         | 1,094  |                             | 906    |                | 639    |   | 1,545  |   | 455                                           |   |
| 03-May-02           |   | 4,000                             |                                    | 2,038     |         | 1,962  |                             | 2,038  |                | 1,962  |   | 4,000  |   | 3⁄4                                        |   |
| 12-Nov-02           |   | 4,848                             |                                    | 2,697     |         | 2,151  |                             | 2,697  |                | 2,151  |   | 4,848  |   | 3⁄4                                        |   |
| 15-Nov-02           |   | 200                               |                                    | 107       |         | 93     |                             | 107    |                | 93     |   | 200    |   | 3⁄4                                        |   |
| 20-Nov-02           |   | 200                               |                                    | 72        |         | 128    |                             | 72     |                | 72     |   | 144    |   | 56                                            |   |
| 27-Nov-02           |   | 215                               |                                    | 103       |         | 112    |                             | 103    |                | 103    |   | 206    |   | 9                                             |   |
| 10-Dec-02           |   | 278                               |                                    | 154       |         | 124    |                             | 154    |                | 124    |   | 278    |   | 3⁄4                                        |   |
| 31-Dec-02           |   | 13,741                            |                                    | 7,153     |         | 6,588  |                             | 7,153  |                | 6,068  |   | 13,221 |   | 520                                           |   |
| 03-Jun-03           |   | (4,195                            | )                                       | (2,081    | )            | (2,114 | )                                | (2,081 | )                   | (1,659 | )      | (3,740 | )      | (455                                          | )      |
| 30-Jun-03           |   | $                                 | 9,546                                   |      | $            | 5,072  |                             | $      | 4,474               |   | $      | 5,072  |   | $                                             | 4,409  |   | $ | 9,481 |   | $ | 65 |   |

 

11

----

 

Convertible notes payable, related party - net as it is presented onthe balance sheet consists of the following:

 
| **(in thousands)**                                           |   | **June 30,  2003** |   | **December  31,  2002** |   |
|--------------------------------------------------------------|--------|--------------------|--------|-------------------------|--------|
|                                                         |   |               |   |                    |   |
| Convertible  notes payable, related party – face amount |   | $                  | 9,546  |                    | $      | 13,741 |   |
|                                                         |   |               |   |                    |   |
| Discount for  warrants and beneficial conversion             |   | (13,221            | )      | (13,221                 | )      |
| Discount  accreted on notes converted into private placement |   | (276               | )      | (276                    | )      |
| Accretion of  discount recorded as interest expense          |   | 6,708              |   | 2,649                   |   |
| Discount  balance, net                                       |   | (6,789             | )      | (10,848                 | )      |
|                                                         |   |               |   |                    |   |
| Long-term  accrued interest                                  |   | 312                |   | 594                     |   |
| Convertible  notes payable, related party - net              |   | $                  | 3,069  |                    | $      | 3,487 |   |

 

*December Conversion*

 

In December 2002, as part of the Private Placement (as defined below),the Company converted $2.0 million of related party convertible promissorynotes and cancelled warrants previously issued in June and July 2002.  The Company recorded a $3.2 millionbeneficial inducement cost as a result of the conversion.  The partially unpaid principal balance of$278,320 from the third note dated July 30, 2002 was reissued to Cheshireon December 10, 2002 but with all the original terms of the July 30,2002 convertible note and warrant pursuant to the amended Note PurchaseAgreement and Intellectual Property Security Agreement.  In addition, approximately $74,000 of accruedinterest for the three notes was repaid with conversion proceeds.

 

The following is a summary of the previous notes, warrants, theremaining balances and their terms, less the amounts converted into the PrivatePlacement:

 
| **Issuance  Date** |   | **Convertible  Notes  Principal &  Interest** |      | **Convertible  Notes** |    | **Warrants**     |   |
|--------------------|--------|--------------------------------------------------------|-----------|------------------------|---------|------------------|--------|
|               |   |                                                   |      |
|               |   | **# of  Shares**                                       |      | **Conversion  Price**  |    | **# of  Shares** |   | **Exercise  Price** |   |
| 24-Jun-02          |   | $                                                      | 1,000,000 |                   | 523,451 |             | $      | 1.9104 |   | 523,451 |   | $ | 2.3880 |   |
| 11-Jul-02          |   | 566,638                                                |      | 354,858                |    | 1.5968           |   | 354,858 |   | 1.9960 |   |
| 30-Jul-02          |   | 637,189                                                |      | 430,068                |    | 1.4816           |   | 430,068 |   | 1.8520 |   |
| Accrued Interest   |   | 74,493                                                 |      |                   |    |             |   |   |   |   |   |
| 10-Dec-02          |   | (2,000,000                                             | )         | (1,121,000             | )       |             |   | (1,121,000 | ) |   |   |
| 10-Dec-02          |   | $                                                      | 278,320   |                   | 187,377 |             | $      | 1.4816 |   | 187,377 |   | $ | 1.8520 |   |

 

*June 2003 Conversion*

 

In June 2003, the $4.2 million of related party convertiblepromissory notes previously issued to Cheshire in November 2001, February 2002and May 2002 were converted into common stock. The Company recorded an additional $1.9 million of non-cashaccretion for the notes, which represents beneficial conversion cost, as aresult of the conversion.  The partiallyunpaid principal balance of $3.8 million from the third note dated May 3, 2002was reissued to Cheshire as two new notes dated July 7, 2003.  The July 7, 2003 notes have all the originalterms of the May 3, 2002 convertible note which was issued pursuant to theamended Note Purchase Agreement and Intellectual Property SecurityAgreement.  The May 2002 warrants arestill outstanding and have not been affected for the June 2003 noteconversion.  In addition, approximately$805,000 of accrued interest for the three notes was repaid as part of theconversion.

 

12

----

 

 

The following is a summary of the previous notes, the remaining balanceand their terms, less the amounts converted into common stock:

 
| **Issuance   Date** |   | **Convertible  Notes  Principal &   Interest** |      | **Convertible  Notes**    |      |
|---------------------|--------|---------------------------------------------------------|-----------|---------------------------|-----------|
|                |   | **# of   Shares**                                       |      | **Conversion Price** |      |
| 09-Nov-01           |   | $                                                       | 2,000,000 |                      | 559,706   |   | $ | 3.5733 |   |
| 14-Feb-02           |   | 2,000,000                                               |      | 554,292                   |      | 3.6082 |   |
| 03-May-02           |   | 4,000,000                                               |      | 2,745,367                 |      | 1.4570 |   |
| Accrued Interest    |   | 805,000                                                 |      | 365,915                   |      | various |   |
| 03-Jun-03           |   | (5,000,000                                              | )         | (1,613,572                | )         |   |   |
| 30-Jun-03           |   | $                                                       | 3,805,000 |                      | 2,611,708 |   | $ | 1.4570 |   |

 

*Private Placement*

 

In December 2002 (the “Private Placement”), the Company completed thePrivate Placement of common stock and warrants, which raised approximately$8.4 million in gross proceeds, including $6.4 million in newinvestment proceeds and $2.0 million of non-cash proceeds converted frompreviously issued related party convertible promissory notes.  We used the net cash proceeds ofapproximately $4.9 million (net of approximately $1.5 million inissuance costs) of the offering for general corporate purposes such asresearch, development, operations, personnel and regulatory expertise and torepay a portion of our outstanding indebtedness to Transamerica FinanceCorporation.  As of June 30, 2003, wecould raise an additional $29.5 million if all of the Class Awarrants and Class B warrants issued in the offering, which are redeemableby us at $2.49 and $3.32, respectively, are exercised.  Alternatively, we could raise an additional$12.7 million if only the Class A warrants are exercised. If all ofthe Class A and Class B warrants are exercised, we estimate that the$29.5 million in proceeds would provide us with sufficient funds to fundour planned operations, including capital improvements and new clinical trialcosts, for an additional 18 months.  Ifonly the Class A warrants are exercised, we estimate that the additional$12.7 million would provide us with sufficient funds to fund our plannedoperations, including capital improvements and new clinical trial costs, intothe first quarter of 2004.  However,there can be no assurances that all of the warrants will be exercised by theinitial purchasers or by any subsequent holders.  We also issued to Spencer Trask Ventures, Inc., the placementagent for the private offering, an option to purchase 1,452,419 shares ofcommon stock and 1,452,419 Class A warrants, which are not redeemable bythe Company.  We have not included theexercise of this option and Class A warrants in the estimated proceedsdiscussed above.  As of June 30, 2003,no Class A warrants had been exercised.

 

On July 7, 2003, the Company issued shares of common stock under apartial voluntary exercise of Class A warrants as part of the incentive shareoffering. The proceeds included $6.9 million in cash and the noncashcancellation of $2.4 million of convertible notes.  Additionally on July 30, 2003 the Company exercised its option toredeem the remaining outstanding Class A warrants on September 3, 2003. If allthe outstanding Class A warrants are exercised, the Company would receive grossproceeds of approximately $3.4 million. See Note 14.

 

**9.****                                      Short-termconvertible promissory notes, related party**

 

On March 28, 2003, we issued to Cheshire a short-term convertiblepromissory note in the amount of $2.0 million, bearing interest at therate of 8% per annum due March 28, 2004 (the “March Note”). The proceeds fromthe issuance of the March Note were used to fund our operations.  The March Note is convertible into either1,626,016 shares of our common stock at a price of $1.23 per share (which wasthe closing  price of our common stockon March 27, 2003) or into the proposed offering discussed below.

 

In May 2003, we issued to Cheshire two short-term convertiblepromissory notes in the aggregate amount of $1.08 million, bearinginterest at the rate of 8% per annum due May 2004 and September 2003 (the “MayNotes”). The proceeds from the issuance of the May Notes were used to fund ouroperations.  The May Notes have aconvertible feature still to be determined in good faith negotiation prior to the120-day maturity of each note.

 

In June 2003, we issued to Cheshire a short-term convertible promissorynote in the amount of $819,000, bearing interest at the rate of 8% per annumdue October 2003 (the “June Note”).  Theproceeds from the issuance of the June note were used 

 

13

----

 

to fund our operations.  TheJune Note has a convertible feature still to be determined in good faithnegotiation prior to the 120-day maturity.

 

Alternatively, Cheshire may convert all of the above convertiblepromissory notes issued between January 1, 2003 and July 7, 2003 into shares ofSeries A Convertible Preferred Stock in connection with a proposed offering,which was approved at a special meeting of our stockholders in July 2003.  As of July 31, 2003, we have not commencedthe offering.

 

**10.****                               Short-termunsecured promissory notes**

 

In June 2003, the Company issued $1.0 million of short-term unsecuredpromissory notes to accredited investors, which bear interest at the rate of12% per annum. In conjunction with the notes, the Company issued 166,665 sharesof common stock that were given to investors. The Company recorded a discount on the loan of $385,000 as the fairvalue allocation between the stock granted and the loan principal.  The notes were repaid with interest in July2003 with proceeds from the Class A warrant incentive share offering. See Note14.

 

**11.****                               Contingencies**

 

From time to time, the Company is subject to various claims andlitigation incidental to our business activities.  Since July 2001, several complaints have been filed in the UnitedStates District Court for the Southern District of California seeking anunspecified amount of damages on behalf of an alleged class of persons, whopurchased shares of the Company’s common stock at various times betweenMay 17, 1999 and July 6, 2001. The various complaints name the Company and certain of its officers asdefendants, as well as Agouron Pharmaceuticals, Inc. and one of its officers.  The complaints allege that the Company,Agouron and/or such officers violated federal securities laws bymisrepresenting and failing to disclose certain information about the resultsof clinical trials of Remuneâ.  The complaints have been consolidated into asingle action under the name *In re Immune Response Securities Litigation*by order of the Court and a consolidated amended complaint has been filed.  The Company has not yet formally respondedto the consolidated amended complaint. Although the Company intends to vigorously defend the actions, theCompany can not now predict or determine the outcome or resolution of theseproceedings, or to estimate the amounts of, or potential range of, loss withrespect to these proceedings.  Inaddition, the timing of the final resolution of these proceedings isuncertain.  The range of possibleresolutions of these proceedings could include judgments against us or ourofficers or settlements that could require substantial payments by the Company,which could have a material adverse impact on our consolidated financialposition, results of operations and cash flows.  These proceedings also might require substantial attention of ourmanagement team and therefore divert their time and attention from our businessand operations.

 

In July 2003, Respimun Associates Ltd., our landlord, filed a complaintagainst us in Superior Court of California. The complaint alleges a breach of contract for the payment of rent atour vacated former headquarters facility in Carlsbad, California ($79,385 permonth plus late charges and other amounts). We intend to defend the claim. However, we have accrued approximately $700,000 relating to this matter,which represents management’s expectation of the minimum amount the Companywill be obligated to pay upon settlement of this matter.

 

**12.****                               Stockholders’equity**

 

In October 2002, the Company’s Board of Directors formally declared aone-for-four reverse stock split of issued and outstanding shares of commonstock.  The Company’s stockholdersauthorized the reverse split at their annual meeting held in June 2002.  All common share balances and net loss pershare amounts presented in these financial statements have been retroactivelyadjusted to reflect the reverse stock split.

* *

*Stocktransactions*

 

During June 2003, the Company converted $4.2 million of principal onnotes issued in November 2001, February 2002, part of the principal of the May2002 note and all accrued and unpaid interest of $.8 million into 1,613,572shares of our common stock by Cheshire. The balance of the May 2002 note and all accrued and unpaid interestthereon was transferred to two new notes in the approximate amounts of $2.4million and $1.4 million, respectively.

 

In June 2003, in conjunction with the issuance of $1.0 million inshort-term unsecured promissory notes issued to accredited investors, theCompany issued 166,665 shares of its common stock. The Company recorded adiscount on the loan of $385,000 as the fair value allocation between the stockgranted and the loan principal.

 

14

----

 

In June 2003,  the Company issued 74,492 shares of its common stock forconsulting services performed from August 2002 through January 2003 equal to$102,000.  For the period January 2003through June 2003, the Company accrued $77,000 for consulting services thatwill be paid in common stock.  For theperiod January 2003 through June 2003, the Company issued $49,000 in warrantsfor consulting services.

 

In December 2002, the Company completed the Private Placement, whichraised approximately $8.4 million in gross proceeds, including$6.4 million in new investment proceeds and $2.0 million of non-cashproceeds converted from previously issued related party convertible promissorynotes.  See Note 8.  The net proceeds totaled $4.9 millionafter issuance costs of approximately $1.5 million.  The Company also issued to Spencer TraskVentures, Inc., the placement agent for the Private Placement, an option topurchase 1,452,419 shares of common stock and 1,452,419 Class A warrants,which are not redeemable by the Company. As per the June 2002 agreement with Transamerica, $200,000 of theoffering proceeds were used to pay down the Long-term Equipment NotesPayable.  As of June 30, 2003, exerciseof all warrants, including those Class A and Class B warrants in theplacement agent option, would result in total proceeds of$37.8 million.  Each unit had apurchase price of $100,000 and consists of (a) 112,995 shares of commonstock and (b) 112,995 Class A warrants.  The Class A warrants are exercisable for one share of commonstock and a Class B Warrant at $1.33, a 50 percent premium to the $0.885discounted Unit Price.  The Class Bwarrants are exercisable for one share of common stock at $1.77, a 100 percentpremium to the $0.885 discounted Unit Price.

 

On July 7, 2003, the Company issued shares of common stock under apartial voluntary exercise of Class A warrants as part of the incentive shareoffering. The proceeds included $6.9 million in cash and the noncashcancellation of $2.4 million of convertible notes previously issued to Cheshireas payment for the aggregate exercise price for the purchase of 1,774,888shares and an additional 887,444 incentive shares.  The incentive shares issued as part of the offering represent aninducement to participate in the voluntary exercise and will result in a chargeto our statement of operations for beneficial inducement cost in the thirdquarter of 2003.  Additionally on July30, 2003 the Company exercised its option to redeem the remaining outstandingClass A warrants on September 3, 2003. If all the outstanding Class A warrantsare exercised, the Company would receive gross proceeds of approximately $3.4million.  See Note 14.

 

The Company’s registration statements on Forms S-1 (Registration No.333-103260) and S-3 (Registration No. 333-101856) registering the common stocksold in the Private Placement were declared effective by the SEC on June 23,2003.

 

The Company received authorization for listing of the shares of commonstock included in the units, as well as the shares of common stock underlyingthe warrants on the Nasdaq SmallCap Market. Additionally, the Company received approval for the quotation of theClass A warrants and Class B warrants on the Nasdaq SmallCap Marketunder the trading symbols “IMNRW” and “IMNRZ”, respectively.

 

*Stock-based compensation*

 

The Company accounts for stock-based compensation in accordance withAccounting Principles Board, APB, No. 25, “Accounting for Stock Issued toEmployees.”  The Company has adopted thedisclosure-only provisions of FAS No. 123 “Accounting for Stock-BasedCompensation.”  Under APB No. 25,compensation expense relating to employee stock options is determined based onthe excess of the market price of the Company’s stock over the exercise priceon the date of grant, the intrinsic value method, versus the fair value methodas provided under FAS No. 123.

 

At June 30, 2003, the Company had two stock-based employee compensationplans.  The Company accounts for theseplans under the recognition and measurement principles of APB No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations.  Generally, no stock-based employeecompensation cost is reflected in net loss for employee grants, as optionsgranted under the plans have an exercise price equal to the market value of theunderlying common stock on the date of grant. Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant date for awards for the threeand six months ended June 30, 2003 and 2002, consistent with the provisions ofFAS No. 123, the Company’s net loss and loss per share would haveincreased.

 

During April 2003, the Company repriced and accelerated the vesting ofstock options to purchase 664,007 shares previously granted to employees andoutside directors.  The weighted averageshare price was reduced from $10.04 per share to $1.12 per share.  This repricing has been expensed using theintrinsic valuation method required under APB No. 25 during the three monthsended June 30, 2003.  The Company recordedadditional employee compensation of $ 1,107,000 for the repriced options.

 

The Company also makes grants to nonemployees under the two plans.  These grants are subject to variableaccounting under FAS No. 123 and are expensed as the options vest over thecontract period.  The expenses recordedfor the three and six months ended June 30, 2003 were $115,000 and $216,000,respectively.

 

15

----

 

The following table provides information as of June 30, 2003 regardingcompensation plans (including individual compensation arrangements) under whichequity securities of The Immune Response Corporation are authorized forissuance (in thousands, except per share data):

 
| **Plan category**                                          |   | **Number of  securities to be  issued upon exercise  of outstanding  options, warrants  and rights  (a)** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights*  (b)** |   | **Number of securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))  (c)** |   |
|------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Equity compensation plans approved by security holders     |   | 2,808                                                                                                     |   | $                                                                                        | 2.80   |                                                                                                                                                      | 2,008  |   |
| Equity compensation plans not approved by security holders |   | 750                                                                                                       |   | 1.20                                                                                     |   | —                                                                                                                                                    |   |
| Total                                                      |   | 3,558                                                                                                     |   | $                                                                                        | 2.46   |                                                                                                                                                      | 2,008  |   |

 

----

*As adjusted forreverse stock split.

* *

*Stock options*

 

The Company has an approved stock option plan, the 1989 Stock Plan, togrant options to purchase common stock to employees and non-employee directorsof the Company and certain other individuals. The plan authorizes the Company to issue or grant qualified andnon-qualified options to purchase up to 2,475,000 shares of its commonstock.  As of June 30, 2003, there wereapproximately 767,000 shares available for grant.

 

Under the terms of the 1989 Stock Plan, options may be granted at notless than 100% and 85% of fair market value as of the date of grant forqualified and non-qualified options, respectively.  To date, all options have been issued at 100% of fair marketvalue.  Except for the non-employeedirectors, these options primarily become exercisable over a four-year periodfrom the date of grant.

 

Under the terms of the plan, non-qualified options will be granted tonon-employee directors at the fair market value as of the date of grant.  These options become exercisable in fourequal annual installments on each of the first four anniversaries of the dateof grant.

 

In February 2003, a new stock option plan to grant options to purchasecommon stock to employees and non-employee directors of the Company and certainother individuals was established for 3,250,000 shares, and approved by thestockholders at the Company’s Annual Meeting held May 20, 2003.  As of June 30, 2003, there wereapproximately 1,241,000 shares available for grant.

 

In addition, the Company granted options to purchase 750,000 shares ofcommon stock to John Bonfiglio, the new Chief Executive Officer hired inJanuary 2003, per an employment agreement, not subject to any equitycompensation plans.  For purposes offinancial disclosure, this agreement is treated as a third employee stockoption plan.

 

Activity with respect to the various stock plans is summarized asfollows (in thousands):

 
|                              |   | **Stock Options  Outstanding** |   | **Weighted  Average Price** |   |
|-----------------------------------|--------|--------------------------------|--------|-----------------------------|--------|
| Balance at December 31, 2001 |   | 1,399                          |   | $                           | 23.12  |   |
| Granted                           |   | 625                            |   | 2.59                        |   |
| Exercised                         |   | 3⁄4                         |   | 3⁄4                      |   |
| Cancelled                         |   | (887                           | )      | 21.70                       |   |
| Balance at December 31, 2002 |   | 1,137                          |   | 12.95                       |   |
| Granted                           |   | 2,872                          |   | 1.14                        |   |
| Repriced                          |   | 664                            |   | 1.12                        |   |
| Exercised                         |   | (103                           | )      | 1.12                        |   |
| Cancelled                         |   | (1,012                         | )      | 9.75                        |   |
| Balance at June 30, 2003          |   | 3,558                          |   | $                           | 2.46   |   |

 

16

----

 

Following is a summary of the optionsoutstanding as of June 30, 2003:

 
| **Range of  Exercise Prices** |   | **Options  Outstanding** |   | **Weighted  Average  Remaining Life  In Years** |   | **Weighted  Average  Exercise Price** |   | **Options  Exercisable** |      | **Weighted  Average  Exercise Price  of Options  Exercisable** |   |
|-------------------------------|--------|--------------------------|--------|-------------------------------------------------|--------|---------------------------------------|--------|--------------------------|-----------|----------------------------------------------------------------|--------|
| $0.95 - $1.00                 |   | 12,766                   |   | 2.95                                            |   | $                                     | 0.98   |                     | 5,979     |                                                           | $      | 1.00 |   |
| $1.12 - $1.12                 |   | 2,526,608                |   | 9.09                                            |   | 1.12                                  |   | 1,647,641                |      | 1.12                                                           |   |
| $1.20 - $1.20                 |   | 750,000                  |   | 9.54                                            |   | 1.20                                  |   | 126,642                  |      | 1.20                                                           |   |
| $2.28 - $16.52                |   | 144,455                  |   | 4.64                                            |   | 7.08                                  |   | 105,064                  |      | 8.66                                                           |   |
| $18.50 - $73.00               |   | 124,409                  |   | 5.11                                            |   | 32.13                                 |   | 107,845                  |      | 33.38                                                          |   |
|                          |   | 3,558,238                |   | 8.84                                            |   | $                                     | 2.46   |                     | 1,993,171 |                                                           | $      | 3.27 |   |

 

At June 30, 2003, the Company had three stock-based employeecompensation plans, which are described more fully above. The Company accountsfor these plans under the recognition and measurement principles of APBNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations.  The Company hasadopted the disclosure-only provisions of FAS No. 123.  Accordingly, no stock-based employeecompensation cost is reflected in net loss for options granted, as all optionsgranted under the plans had an exercise price equal to the market value of theunderlying common stock on the date of grant. Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant date for awards for three andsix months ended June 30, 2003 and 2002, consistent with the provisions of FASNo. 123, the Company’s net loss and loss per share would have beenincreased to the pro forma amounts indicated below (in thousands, except pershare data):

 
|                                                                |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |    |
|---------------------------------------------------------------------|--------|-----------------------------------|---------|---------------------------------|---------|
|                                                                |   | **2003**                          |    | **2002**                        |    | **2003** |   | **2002** |   |
| Net loss  (attributable to common stockholders) 3⁄4  as reported |   | $                                 | (9,261  | )                               | $       | (8,101 | )  | $ | (14,450 | ) | $ | (13,405 | ) |
|                                                                |   |                              |    |                            |    |   |   |   |   |
| Less fair value  of stock-based employee compensation expense       |   | (1,704                            | )  | (73                             | )  | (1,828 | )  | (146 | ) |
|                                                                |   |                              |    |                            |    |   |   |   |   |
| Net loss  (attributable to common stockholders) 3⁄4  pro forma   |   | $                                 | (10,695 | )                          | $       | (8,174 | )  | $ | (16,278 | )  | $ | (13,551 | ) |
|                                                                |   |                              |    |                            |    |   |   |   |   |
| Net loss per  share (basic and diluted) 3⁄4  as reported         |   | $                                 | (0.46   | )                          | $       | (.91 | )  | $ | (0.72 | )  | $ | (1.50 | ) |
| Net loss per  share (basic and diluted) 3⁄4  pro forma           |   | $                                 | (0.53   | )                               | $       | (.91 | )  | $ | (0.82 | )  | $ | (1.52 | ) |

 

The fair value of each option grant was estimated on the date of grantusing the Black-Scholes option-pricing model with the following weightedaverage assumptions used for grants in 2003 and 2002:  risk-free interest rates of 2.49% and 2.628%, respectively,expected option lives of 5 years and a dividend rate of zero.  The volatility factor assumptions of theexpected market price of the Company’s common stock were and 163% and 141%, for2003 and 2002, respectively.

 

Because FAS No. 123 has not been applied to options granted priorto January 1, 1995, the resulting pro forma compensation cost may not berepresentative of that to be expected in future years.  The weighted average fair value of optionsgranted for the three and six months ended June 30, 2003 and the year endedDecember 31, 2002 was $1.16, $1.08 and $2.20, respectively.

 

17

----

 

*Warrants*

 

Following is a summary of warrants outstanding as of June 30, 2003 andDecember 31, 2002:

 
| **Types of Warrants**       |   | **Amount** |       | **Warrants  Outstanding** |       | **Range of  Exercise  Prices** |            | **Warrant  Call Price** |   |
|-----------------------------|--------|------------|------------|---------------------------|------------|--------------------------------|-----------------|-------------------------|--------|
| Related party  warrants     |   | $          | 7,153,000  |                      | 9,747,757  |                           | $1.016 - $5.768 |                    | none   |   |
| Class A warrants            |   | 2,664,000  |       | 9,522,072                 |       | $                              | 1.33            |                    | $      | 2.49 |   |
| Class B warrants            |   | 2,664,000  |       | 9,522,072                 |       | $                              | 1.77            |                    | $      | 3.32 |   |
| 20% Placement  agent option |   | 1,148,000  |       | 1,452,419                 |       | $                              | 0.885           |                    | none   |   |
| Other                       |   | 55,000     |       | 12,500                    |       | $                              | 5.36            |                    | none   |   |
| December 31,  2002          |   | 13,684,000 |       | 30,256,820                |       |                           |            |                    |   |
| Other                       |   | 50,000     |       | 58,933                    |       | $ 2.00 - $3.50                 |            | none                    |   |
| June 30, 2003               |   | $          | 13,734,000 |                      | 30,315,753 |                           |            |                    |   |   |

 

At June 30, 2003, 50.9 million shares of common stock werereserved for the exercise of stock options, employee stock purchase plan,exercise of warrants, conversion of convertible notes payable, contingentwarrants and contingent shares subject to milestones per the amendments to theCompany’s License and Collaboration Agreement.

 

**13.****                               Remune®Collaboration**

 

In late June 2002, the Company amended its REMUNEâlicense and collaboration contract with Trinity Medical Group USA, Inc(“Trinity”).  The amended contractprovides for manufacturing costs and mark-up plus $50 per unit to be paid tothe Company.  The $50 per unit mark-upwould expire upon the earlier of the first one million doses of REMUNEâpurchased by Trinity or December 31, 2007.  As consideration for the increased per unit, purchase price to bepaid to the Company, Trinity was issued 1,000,000 shares of restricted commonstock valued at $2,360,000 and up to an additional 750,000 shares upon theoccurrence of certain sales milestones. All of the restricted shares issued to Trinity are subject to registrationrights.  In addition, the Company waivedthe final $5.0 million common stock purchase obligation set forth in theoriginal agreement, which would have applied in the event of the optionaltechnology transfer of REMUNEâmanufacturing rights in Trinity’s licensed territories.  Also, the Company provided an increase inthe amount of shares that Trinity will receive in exchange for a$5.0 million payment upon Thai government approval of REMUNEâto 500,000 shares from 83,333 shares.

 

**14.****                               Subsequentevents**

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire as payment for the aggregate exercise price the purchase of 1,774,888shares and an additional 887,444 incentive shares.  The Company issued an additional 3,496,118 shares equal to onehalf share of common stock for each Class A warrant exercised as an incentiveto induce holders of the Class A warrants to exercise their Class A warrantsand to allow the Company to obtain a “lock-up” on the shares of common stockissued to the holders of such exercised Class A warrants in the December 2002unit offering and the shares of the common stock issued upon the exercise ofthe Class A warrants (including the additional one half share of common stock),prohibiting the sale of such common stock for 270 days, with the “lock-up”period expiring on April 4, 2004.  Theincentive shares issued as part of the offering represent an inducement toparticipate in the voluntary exercise and will result in a charge to ourstatement of operations for beneficial inducement cost in the third quarter of2003.

 

In July 2003, the $1.0 million short-term unsecured promissory notesissued in June 2003 were repaid with interest in July 2003 with proceeds fromthe Class A warrant incentive share offering.

 

In July 2003, the Company paid Transamerica $200,000, the secondmilestone payment, as a result of the exercise of the Class A warrants.  In August 2003 the loans were paid in fullwith a final payment of $35,000.

 

On July 30, 2003 the Company exercised its option to redeem theremaining outstanding Class A warrants on September 3, 2003. If all theoutstanding Class A warrants are exercised, the Company would receive grossproceeds of approximately $3.4 million. The Company anticipates that theaggregate proceeds from the exercise of the Class A warrants, together with theexercise of the Class A warrants on July 7, 2003, will be sufficient to fundour planned operations, including necessary capital expenditures and newclinical trials, into the first quarter of 2004.

 

 

18

----

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued toit between January 1, 2003 and July 7, 2003 into shares of Series A ConvertiblePreferred Stock.  The Series AConvertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

In July 2003 Respimun Associates Ltd., our landlord, filed a complaintagainst us in Superior Court of California. The complaint alleges a breach of contract for the payment of rent atour former headquarters facility in Carlsbad, California ($79,385 per monthplus late charges and other amounts). We intend to defend the claim. However, we have accrued approximately $700,000 to cover a potentialsettlement.

 

19

----

 

**Item 2.  ****  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

The followingdiscussion contains forward-looking statements concerning our liquidity,capital resources, financial condition, results of operation and timing ofanticipated revenues and expenditures. Such statements are subject to risks anduncertainties that could cause actual results to differ materially from thoseprojected. Factors that could cause or contribute to such differences include,among others, those discussed under “Risk Factors.”  The following discussion should be read in conjunction with ourCondensed Consolidated Financial Statements and Notes thereto includedelsewhere in this Form 10-Q. These forward-looking statements speak onlyas of the date hereof. Except for our ongoing obligation to disclose materialinformation as required by federal securities laws, we undertake no obligationto publicly release the result of any revisions to these forward-lookingstatements that may be made to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events*.*

 

**Overview**

 

We are a biopharmaceutical company developing immune-based therapies toinduce specific immune responses for the treatment of HIV. Until the implementationof a restructuring program in September 2002, we also had been developingimmune-based therapies to induce specific immune responses for the treatment ofautoimmune diseases and cancer, as well as targeted, non-viral deliverytechnology for gene therapy which are designed to enable the delivery of genesdirectly to the liver via intravenous injection. As a result of ourrestructuring program, we have refocused our efforts on REMUNE® and halteddevelopment of all of our other products.

 

*Going Concern*

On May 9, 15, and June 6, 2003, we issued to Cheshire Associates, LLC,or Cheshire, an affiliate of one of our directors and principal stockholder,Mr. Kevin Kimberlin, short-term convertible promissory notes in theamounts of $80,000, $1.0 million and $819,000, respectively, bearinginterest at the rate of 8% per annum (the “Notes”). The proceeds from theissuance of the Notes were used to fund our operations.  The Notes have convertible features still tobe determined in good faith negotiation prior to their respective maturities.

 

On June 23, 2003, we issued $1.0 million of unsecured promissory notesto accredited investors, which bear interest at the rate of 12% per annum.  In conjunction with the notes, we issued166,665 shares of common stock as a discount on the loan.  The notes were paid with interest in July2003 with proceeds from the Class A warrant incentive share offering discussedbelow.

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire. We issued an additional 3,496,118 shares equal to one half share ofcommon stock for each Class A warrant exercised as an incentive to induceholders of the Class A warrants to exercise their Class A warrants and to allowus to obtain a “lock-up” on the shares of common stock issued to the holders ofsuch exercised Class A warrants in the December 2002 unit offering and theshares of the common stock issued upon the exercise of the Class A warrants(including the additional one half share of common stock), prohibiting the saleof such common stock for 270 days, with the “lock-up” period expiring on April4, 2004.

 

On July 30, 2003, we exercised our option to redeem the remainingoutstanding Class A warrants on September 3, 2003. If all the outstanding ClassA warrants are exercised, we would receive gross proceeds of approximately $3.4million. We anticipate that the aggregate proceeds from the exercise of theClass A warrants, together with the exercise of the Class A warrants on July 7,2003, will be sufficient to fund our planned operations, including necessarycapital expenditures and new clinical trials, into the first quarter of 2004.

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued tothem between January 1, 2003 and July 7, 2003 into shares of Series AConvertible Preferred Stock.  The SeriesA Convertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

Notwithstanding the exercise of the Class A warrants, we will continueto have limited cash resources. Although our management recognizes the need to secure additionalfinancing and currently is exploring its options, there can be no assurancethat we will be successful in consummating any such transaction or, if we doconsummate such a

 

20

----

 

transaction, that the terms and conditions will not be unfavorable tous.  The failure by us to obtainadditional financing before the first quarter of 2004 (assuming the exercise ofall the remaining Class A warrants), will have a material adverse effect on usand likely result in our inability to continue as a going concern.  Our independent auditors have concluded thatthere is substantial doubt as to our ability to continue as a going concern fora reasonable period of time, and have modified their report in the form of anexplanatory paragraph describing the events that have given rise to thisuncertainty regarding our 2002 annual consolidated financial statements.

 

As of June 30, 2003,we had a consolidated accumulated deficit of $272.3 million. We have notgenerated revenues from the commercialization of any product.  We expect to continue to incur substantialnet operating losses over the next several years, which would imperil ourability to continue operations. We expect to experience quarter-to-quarterfluctuations, as well, some of which could be significant, due to research,development, manufacturing scale-up and clinical trial activities. We may notbe able to generate sufficient product revenue to become profitable on a sustainedbasis, or at all, and do not expect to generate product revenue before thefirst quarter of 2007, if at all. We have operating and liquidity concerns dueto our significant net losses, negative cash flows from operations andsubstantial working capital deficit. As a result of these and other factors,our independent auditors, BDO Seidman, LLP, indicated that there is substantialdoubt about our ability to continue as a going concern.

 

Our managementcurrently is evaluating equity financing alternatives to meet our futurecapital requirements. In addition, we are seeking collaborative partners forall of our technologies. In any event, we will need to raise substantialadditional capital to fund our operations. If we were unable to raise adequate capital, it would have a materialadverse effect on us and would cause us to cease operations, at which time wewill not be able to satisfy our obligations. Our ability to find collaborative partners could be materially andadversely affected by the security interest held by Mr. Kimberlin and hisrelated parties in substantially all of our intellectual property. See “RiskFactors—We May Be Unable To Enter Into Additional Collaborations Or MaintainExisting Ones.”

 

We could raise anadditional $16.8 million if all of the Class B warrants issued as a result ofClass A warrant exercises since July 7, 2003, which are redeemable by us if theprice of our common stock is equal to or greater than $3.32, areexercised.  We believe the proceedswould provide us with sufficient funds to fund our planned operations,including capital improvements and new clinical trial costs, for an additionaltwelve months, however, there can be no assurances that all or any portion ofthe warrants will be exercised by the initial purchasers or by any subsequentholders. We also issued to Spencer Trask Ventures, Inc., the placement agentfor the December 2002 private placement, an option to purchase 1,452,419 sharesof common stock and 1,452,419 Class A warrants, which are not redeemable by us.  We have not included the exercise of thisoption and Class A warrants in the estimated proceeds discussed above. As ofJune 2002, none of the Class B warrants have been exercised.

 

*Operations*

In September 2002, weimplemented a restructuring program and management changes aimed at reducingcosts and refocusing our efforts on REMUNE®. The restructuring program reducedstaff and cut spending at our headquarters while maintaining limitedmanufacturing capacity at our production facility in King of Prussia,Pennsylvania. When fully implemented, the reductions are expected to contributean estimated $7.2 million in savings annually at approximately $600,000 in costsavings per month. Such projected cost savings assume the sublease of certainof our facilities in King of Prussia, PA and Carlsbad, CA. We have engaged theservices of a national real estate firm to sublease our vacant buildings inboth California and Pennsylvania. Not all of these subleases have beeneffected, and we cannot predict if or when these cost savings, if any, will beachieved or the actual amount of such savings until we enter into definitivesubleases covering the properties.

 

During May 2003, we disposed of excess assets, and we are negotiatingan early lease termination for our former vacated headquarters facilityresulting in exit and disposal related costs of approximately $1.3 millionrecognized as of June 30, 2003, including an estimate of approximately $700,000of additional costs accrued to cover a potential settlement.

 

On July 23, 2003 Respimun Associates Ltd., our landlord, filed acomplaint against us in Superior Court of California.  The complaint alleges a breach of contract for the payment ofrent at our former headquarters facility in Carlsbad, California ($79,385 permonth plus late charges and other amounts). We intend to defend the claim. However, we have accrued approximately $700,000 to cover a potentialsettlement.

 

**Other Significant Events**

 

On October 9, 2002,our Board of Directors formally declared a one-for-four reverse stock split ofissued and outstanding shares of common stock. On October 24, 2002, Nasdaqgranted us an additional 180-calendar day grace period to demonstratecompliance with the Nasdaq minimum $1.00 bid price per share requirement forcontinued listing. Subsequently, because the closing bid price of our commonstock was at $1.00 or greater for at least ten

 

21

----

 

consecutive tradingdays, effective on October 31, 2002, Nasdaq informed us that we were incompliance with its listing requirements. As of the quarter ended June 30, 2003, we have failed to maintain theminimum stockholders’ equity requirement of at least $2.5 million. However, theCompany has met an alternative test in that it has maintained a market value ofits listed securities of over $35.0 million. See “Risk Factors—Our Stock May Become Delisted And Subject To PennyStock Rules, Which May Make It More Difficult For You To Sell Your Securities.”

 

Since July 2001,several complaints have been filed in the United States District Court for theSouthern District of California seeking an unspecified amount of damages onbehalf of an alleged Class of persons, who purchased shares of our common stockat various times between May 17, 1999 and July 6, 2001. The various complaintsname us and certain of our officers as defendants, as well as AgouronPharmaceuticals, Inc. and one of its officers. The complaints allege that we,Agouron and/or such officers violated federal securities laws by misrepresentingand failing to disclose certain information about the results of clinicaltrials of REMUNE ®. The complaints have been consolidated into a single actionunder the name *In re  Immune ResponseSecurities Litigation*by order of the Court and a consolidatedamended complaint filed.   We have notyet formally responded to the consolidated amended complaint.  Although we intend to vigorously defend theactions, we do not believe it is feasible to predict or determine the outcomeor resolution of these proceedings or to estimate the amounts of, or potentialrange of, loss with respect to these proceedings. In addition, the timing ofthe final resolution of these proceedings is uncertain. The range of possibleresolutions of these proceedings could include judgments against us or ourofficers or settlements that could require substantial payments by us, whichcould have a material adverse impact on our financial position, results ofoperations and cash flows. These proceedings also might require substantialattention of our management team and therefore divert their time and attentionfrom our business and operations.

 

**Results of Operations**

 

***Three and Six Months Ended June 30, 2003 and 2002***

We recorded revenuesfor the three and six months ended June 30, 2003 of $14,000 and $38,000,respectively, as compared to $11,000 and $20,000 for the corresponding periodsin 2002. The increase in revenues in 2003 is due to the amortization ofadditional multi-year out-licensing contracts of various intellectual property and/orpatents that we own.  We expect noadditional revenues unless it is earned through corporate collaborations or newresearch and development agreements.  Wehave not received any revenues from the sale of products and do not expect toderive revenue from the sale of any products for the foreseeable future.

 

Our research anddevelopment expenditures for the three and six months ended June 30, 2003 were$2.5 million and $5.0 million, respectively, as compared to $3.8 million and$7.6 million for the corresponding periods in 2002. The decreases from 2002 to2003 in research and development spending of $1.2 million and $2.6 million forthe three and six month periods, respectively, are attributable to significantreductions in salaries, benefits and operating supplies, adjustments to ouroperational timelines and delaying expenditures, hiring and manufacturingscale-up activities of REMUNE®, as well as reduced spending for clinical trialsand related regulatory activities in 2003. These significant reductions are adirect result of our restructuring program announced in September 2002 andincluded completion or termination of clinical studies in our immune-basedtherapy programs and decreasing activities on our other non-HIV developmentprograms.

 

Our REMUNE® clinicalspending should continue to decrease consistent with the prior quarters, butcould increase if we entered into any new research and developmentcollaborations. However, spending associated with our scale-up of themanufacturing process for REMUNE® and the cost of producing clinical suppliesfor ongoing and future REMUNE® studies is expected to increase during fiscalyear 2003 as we focus our financial resources on REMUNE®. Clinical studyspending for our other development programs has decreased beginning in thesecond quarter of 2002 as we completed our Phase I/II clinical trial relatingto multiple sclerosis during the first quarter of 2002. We expect research anddevelopment expenditures for our other development programs to also continue todecrease due to our restructuring in September 2002 which, among other things,was intended to focus our resources on REMUNE®. Overall, we expect futureresearch and development expenditures for REMUNE® to increase but quarter toquarter fluctuations may occur due to the timing of expenditures. If we enterinto additional collaborations, research and development expenditures for ourother development programs would likely increase over their current levels.There can be no assurance that we will enter into any collaborations, thatexisting collaborations will not be terminated, or that we will be able toobtain other financing needed to continue our research and development efforts.

 

General andadministrative expenses for the three and six months ended June 30, 2003 were$2.3 million and $3.4 million, respectively, as compared to $1.2 and $2.4million for the corresponding periods in 2002. This increase was primarily attributable to a one-time adjustment of$1.2 million made in the second quarter of 2003 to salaries expense to reflectthe repricing of employee stock options. We expect quarterly general and administrative expenses

 

22

----

 

to remain consistentwith prior quarters with savings attributed to the September 2002 restructuringbeing offset by possible increased consulting fees.

 

During May 2003, we disposed of excess assets, and we are negotiatingan early lease termination for our former vacated headquarters facilityresulting in exit and disposal related costs of $1.3 million recognized as ofJune 30, 2003, including an estimate of approximately $700,000 of additionalcosts accrued to cover a potential settlement of a claim filed by the landlordfor breach of contract under the lease.

 

Investment income decreasedto $3,000 and $11,000 for the three and six months ended June 30, 2003,respectively, from $8,000 and $22,000 for the same periods in 2002. Thedecrease in investment income in 2003 from 2002 was primarily due to overalllower cash balances in interest bearing investments and lower interest ratesearned.

 

Interest expenseincreased to $3.4 million and $4.8 million for the three and six months endedJune 30, 2003, respectively, as compared to $774,000 and $1.1 million for thecorresponding periods in 2002. Accretion of convertible notes payable, as a component of interestexpense, was $3.0 million and  $4.1million for the three and six months ended June 30, 2003, respectively, ascompared to $576,000 and $828,000 for the corresponding periods in 2002.  Accretion of short-term unsecured promissorynotes, as a component of interest expense, was $71,000 for the three and sixmonths ended June 30, 2003.  Theincrease in 2003 from 2002 is partly attributable to the conversion of $5.0million of convertible debt into common stock with an additional beneficialconversion expense of $1.9 million recognized upon conversion.  The remainder of the increase is due tohigher non-cash accretion overall due to higher average convertible debtbalances in 2003 as compared to 2002. Accretion represents the amortization to interest expense, over athree-year period, of the value of the notes allocated to the value of warrantsissued in connection with the convertible notes and beneficial conversionfeature.

 

In December 2002, theFASB issued FAS No. 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure,” which amended FAS No. 123 “Accounting for Stock-BasedCompensation.” The new standard provides alternative methods of transition fora voluntary change to the fair value based method of accounting for stock-basedemployee compensation. Additionally, the statement amends the disclosurerequirements of FAS No. 123 to require prominent disclosures in the annual andinterim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reported results.This statement is effective for financial statements for fiscal years endingafter December 15, 2002. In compliance with FAS No. 148, we have elected tocontinue to follow the intrinsic value method in accounting for our stock-basedemployee compensation plan as defined by APB No. 25, “Accounting for StockIssued to Employees,” and have made the applicable disclosures in Note 12 tothe Condensed Consolidated Financial Statements.

 

**Liquidity and Capital Resources**

 

On March 28, 2003, weissued to Cheshire, a short-term convertible promissory note in the amount of$2.0 million, bearing interest at the rate of 8% per annum. The proceedswere used to fund our operations. The note is convertible into either 1,626,016 shares ofour common stock at a price of $1.23 per share (which was the closing price ofour common stock on March 27, 2003) or an equal amount of such other securitiesthat we may offer in the future by means of a private placement to “accreditedinvestors.”

 

On May 9, 15, and June 6, 2003, we issued to Cheshire short-termconvertible promissory notes in the amounts $80,000, $1.0 million and$819,000, respectively, bearing interest at the rate of 8% per annum (the“Notes”). The proceeds from the issuance of the Notes were used to fund ouroperations.  The Notes have convertiblefeatures still to be determined in good faith negotiation prior to their respectivematurities.

 

During May 2003, we held an auction to sell excess assets associatedwith our vacated former headquarters facility located in Carlsbad, California.  Transamerica was paid $187,000 of totalauction proceeds.  In July 2003, we paid$200,000, the second milestone payment owed under the June 2002 loanrestructuring agreement, as a result of the exercise of the Class Awarrants.  In August 2003, the loanswere paid in full with a final payment of $35,000.  The total amount owed to Transamerica as of June 30, 2003 andDecember 31, 2002 was approximately $280,000 and $865,000, respectively.

 

During June 2003, Cheshire exercised their option to convert $4.2million of principal on notes issued to them in November 2001, February 2002,part of the principal of the May 2002 note and all accrued and unpaid interestof $.8 million into 1,613,572 shares of our common stock.  The balance of the May 2002 note and allaccrued and unpaid interest thereon was transferred to two new notes in theapproximate amounts of $2.4 million and $1.4 million, respectively.  During July 2003, the note in the amount of$2.4 million was cancelled as payment for the aggregate

 

23

----

 

exercise price of Class A warrants to purchase 1,774,888 shares and anadditional 887,444 incentive shares of our common stock in connection with theJuly 7, 2003 incentive share offering described below.

 

On June 23, 2003, we issued $1,000,000 of unsecured promissory notes toaccredited investors, which bear interest at the rate of 12% per annum.  In conjunction with the notes, we issued166,665 shares of common stock as a discount on the loan.  The notes were paid with interest in July2003 with proceeds from the Class A warrant incentive share offering discussedbelow.

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire. We issued an additional 3,496,118 shares equal to one half share ofcommon stock for each Class A warrant exercised as an incentive to induceholders of the Class A warrants to exercise their Class A warrants and to allowus to obtain a “lock-up” on the shares of common stock issued to the holders ofsuch exercised Class A warrants in the December 2002 unit offering and theshares of the common stock issued upon the exercise of the Class A warrants(including the additional one half share of common stock), prohibiting the saleof such common stock for 270 days, with the “lock-up” period expiring on April4, 2004.  The incentive shares issued aspart of the offering represent an inducement to participate in the voluntaryexercise and will result in a charge to our statement of operations forbeneficial inducement cost in the third quarter of 2003.

 

On July 30, 2003, we exercised our option to redeem the remainingoutstanding Class A warrants on September 3, 2003. If all the outstanding ClassA warrants are exercised, we would receive gross proceeds of approximately $3.4million. We anticipate that the aggregate proceeds from the exercise of theClass A warrants, together with the exercise of the Class A warrants on July 7,2003, will be sufficient to fund our planned operations, including necessarycapital expenditures and new clinical trials, into the first quarter of 2004.

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued tothem between January 1, 2003 and July 7, 2003 into shares of Series AConvertible Preferred Stock.  The SeriesA Convertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

Notwithstanding the above transactions including the exercise of theClass A warrants, we will continue to have limited cash resources.  Although our management recognizes the needto secure additional financing and currently is exploring its options, therecan be no assurance that we will be successful in consummating any suchtransaction or, if we do consummate such a transaction, that the terms andconditions will not be unfavorable to us. The failure by us to obtain additional financing before the firstquarter of 2004 (assuming the exercise of all the remaining Class A warrants),will have a material adverse effect on us and likely result in our inability tocontinue as a going concern.  Ourindependent auditors have concluded that there is substantial doubt as to ourability to continue as a going concern for a reasonable period of time, andhave modified their report in the form of an explanatory paragraph describingthe events that have given rise to this uncertainty regarding our 2002 annualconsolidated financial statements.

 

We could raise anadditional $16.8 million if all of the Class B warrants issued as a result ofClass A warrant exercises since July 7, 2003, which are redeemable by us if theprice of our common stock is equal to or greater than $3.32, are exercised.  We believe the proceeds would provide uswith sufficient funds to fund our planned operations, including capitalimprovements and new clinical trial costs, for an additional twelve months,however, there can be no assurances that all or any portion of the warrantswill be exercised by the initial purchasers or by any subsequent holders. Wealso issued to Spencer Trask Ventures, Inc., the placement agent for theDecember 2002 private placement, an option to purchase 1,452,419 shares ofcommon stock and 1,452,419 Class A warrants, which are not redeemable byus.  We have not included the exerciseof this option and Class A warrants in the estimated proceeds discussed above.As of June 2002, none of the Class B warrants have been exercised.

 

Since our inception in1986, we have financed our activities primarily from public and private salesof equity, funding from collaborations with corporate partners, investmentincome and the issuance to entities affiliated with or related to Mr.Kimberlin, who is one of our directors and our principal stockholder, ofconvertible notes and warrants and short-term promissory notes. At June 30,2003, we had a working capital deficiency of $5.4 million, including $1.3million of cash, cash equivalents and marketable securities. This compares withworking capital of $1.0 million and $3.9 million of cash, cash equivalents andmarketable securities as of December 31, 2002. Working capital decreased duringthis period as a result of $7.1 million of cash used in operations and $766,000of equipment notes and capital lease payments. During March, May and June 2003,we issued $3.9 million of short term

 

24

----

 

convertible notespayable, and $1.0 million of short-term unsecured promissory notes, whichprovided cash but correspondingly increased current liabilities.

 

Once we have used ourcurrent cash balances, we will be forced to look for alternative sources offunding which, even if available, may be on terms substantially lessfavorable.  If we are unable to raiseadequate capital, we may be required to delay, or reduce the scope of, ourresearch or development of REMUNE®, or take other measures to cut costs, whichwould have a material adverse effect on us and likely result in our inabilityto continue as a going concern. In any event, we will need to raise substantialadditional capital to fund our operations beyond the first quarter of 2004. Wecannot provide any assurance, however, that changes in our research anddevelopment plans or other changes affecting our operating expenses will notresult in the expenditure of such resources before such time. See “RiskFactors—Our Current Cash Position, Additional Financing Requirements AndLimited Access To Financing Will Adversely Affect Our Ability To DevelopProducts And Continue As A Going Concern.”

 

We will need to raisesubstantial additional funds to conduct research and development, preclinicalstudies and clinical trials necessary to bring potential products to market andto establish manufacturing and marketing capabilities. We anticipate that forthe foreseeable future, the scale-up of the manufacturing process for REMUNE®and the cost of producing clinical supplies for ongoing and future REMUNE®studies will continue to represent a significant portion of our overallexpenditures. Overall, future REMUNE® research and development expenditures areexpected to increase from current levels in the event additional financing isobtained. Future spending for research and development may further increase ifwe enter into additional collaborations, but there can be no assurance that wewill enter into any such collaborations. We anticipate additional capitalimprovements of approximately $1.0 million to scale-up of the manufacturingprocess for REMUNE®. Other anticipated costs with respect to REMUNE ®,including investment in inventory, will depend on many factors including theneed for additional clinical trials and other factors, which will influence ourdetermination of the appropriate continued investment of our financial resourcesin this program.

 

Our future capitalrequirements will depend on many factors including whether the remainingportion of the warrants from the December 2002 Private Placement will beexercised by the initial purchasers or by any subsequent holders. Other capitalrequirement factors include continued scientific progress in our research anddevelopment programs, the scope and results of preclinical studies and clinicaltrials, the time and costs involved in obtaining regulatory approvals, thecosts involved in filing, prosecuting and enforcing patent claims, the costsinvolved in defending claims in class actions, competing technological andmarket developments, the cost of manufacturing scale-up and inventories,effective commercialization activities and arrangements and other factors notwithin our control. We intend to seek additional funding through additionalresearch and development agreements with suitable corporate collaborators andthrough public or private financing, if available. However, we cannot provideassurance that such collaboration arrangements or any public or privatefinancing will be available on acceptable terms, if at all.  If we raise funds through future equityarrangements, further dilution to stockholders will result.

 

**Critical Accounting Policies**

 

***Risks and uncertainties***

The consolidatedfinancial statements have been prepared assuming that we will continue as agoing concern. We have operating and liquidity concerns due to historicallyreporting significant net losses and negative cash flows from operations.  As of June 30, 2003, we had a workingcapital deficiency of $5.4 million and an accumulated deficit of $272.3million.  As of December 31, 2002, wehad working capital of $1.0 million and an accumulated deficit of $257.8 million.

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire. We issued an additional 3,496,118 shares equal to one half share ofcommon stock for each Class A warrant exercised as an incentive to induceholders of the Class A warrants to exercise their Class A warrants and to allowus to obtain a “lock-up” on the shares of common stock issued to the holders ofsuch exercised Class A warrants in the December 2002 unit offering and theshares of the common stock issued upon the exercise of the Class A warrants(including the additional one half share of common stock), prohibiting the saleof such common stock for 270 days, with the “lock-up” period expiring on April4, 2004.

 

On July 30, 2003, we exercised our option to redeem the remainingoutstanding Class A warrants on September 3, 2003. If all the outstanding ClassA warrants are exercised, we would receive gross proceeds of approximately $3.4million. We anticipate that the aggregate proceeds from the exercise of theClass A warrants, together with the exercise of the Class A warrants on July 7,2003, will be sufficient to fund our planned operations, including necessarycapital expenditures and new clinical trials, into the first quarter of 2004.

 

25

----

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued tothem between January 1, 2003 and July 7, 2003 into shares of Series AConvertible Preferred Stock.  The SeriesA Convertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

Notwithstanding the exercise of the Class A warrants, we will continueto have limited cash resources. Although our management recognizes the need to secure additionalfinancing and currently is exploring its options, there can be no assurancethat we will be successful in consummating any such transaction or, if we doconsummate such a transaction, that the terms and conditions will not beunfavorable to us.  The failure by us toobtain additional financing before the first quarter of 2004 (assuming theexercise of all the remaining Class A warrants), will have a material adverseeffect on us and likely result in our inability to continue as a goingconcern.  Our independent auditors haveconcluded that there is substantial doubt as to our ability to continue as agoing concern for a reasonable period of time, and have modified their reportin the form of an explanatory paragraph describing the events that have givenrise to this uncertainty regarding our 2002 annual consolidated financialstatements.

 

These factors, amongothers, raise substantial doubt about our ability to continue as a goingconcern. The condensed consolidated financial statements do not include anyadjustments relating to the recoverability and classification of asset carryingamounts or the amount and classification of liabilities that might resultshould we be unable to continue as a going concern.

 

Our products are invarious stages of development. Prior to generating product revenues, we mustcomplete the development of our products, including several years of humanclinical testing, and receive regulatory approvals prior to selling theseproducts in the human health care market. Our products may not be successfullydeveloped, regulatory approvals may not be granted, or patient and physicianacceptance of any of these products may not be achieved.

 

We face additionalrisks associated with biopharmaceutical companies whose products are in variousstages of development.  These risksinclude, among others, our need for additional financing to complete ourresearch and development programs and commercialize our technologies. Financingmay not be available to us when required or, if available, may not be availableunder favorable terms.

 

We believe thatpatents and other proprietary rights are important to our business. Our policyis to file patent applications to protect technology, inventions andimprovements to our inventions that we consider important to the development ofour business. The patent positions of pharmaceutical and biotechnology firms,including our company, are uncertain and involve complex legal and factualquestions for which important legal principles are largely unresolved. Changesin our estimates in the realizability of our intellectual property may have amaterial effect on our financial statements.

 

**Critical Accounting Estimates**

 

***Licensed technology***

Intangible assets arerecorded at cost and amortized over their estimated useful lives. In December1999, we acquired licenses to certain patent technology, which are beingamortized over seven years. Changes in our estimates of useful lives may have amaterial effect on our financial statements.

 

***Impairment of long-lived assets***

We evaluate potentialimpairment of long-lived assets in accordance with FAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets.” FAS No. 144 requires thatcertain long-lived assets, excluding investments under the equity method ofaccounting, be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not be fullyrecoverable based on expected undiscounted cash flows that result from the useand eventual disposition of the asset. The amount of any impairment is measuredas the difference between the carrying value and the fair value of the impairedasset.

 

In accordance with FASNo. 144, the Company has identified our property and equipment as long-livedassets subject to annual impairment review. Given our current financial status,our historical losses and the indeterminable outcome of the development andapproval of our products, there is substantial uncertainty as to our ability torecover our investment in these long-lived assets through the generation of netfuture cash flows. In light of this uncertainty,

 

26

----

 

we obtained anindependent third-party appraisal of these long-lived assets in the firstquarter of 2003. As a result of such appraisal, we recognized substantial impairmentcharges for the year ended December 31, 2002.

 

**Risk Factors**

**You should carefully consider the risksand uncertainties described below before making an investment decision. Therisks and uncertainties described below are not the only ones facing us.Additional risks and uncertainties not presently known to us or that wecurrently deem immaterial also may impair our business and condition. If any ofthe following risks actually occur, our business, operations and conditioncould be adversely affected. In those cases, the trading price of our commonstock could decline, and you may lose all or part of your investment.**

 

**Our Current Cash Position, AdditionalFinancing Requirements And Limited Access To Financing Will Adversely AffectOur Ability To Develop Products And Continue Operations**

In addition to thefunds we received from our private placement of units in December 2002, we willneed to raise substantial additional funds to continue our operations and toconduct research and development, preclinical studies and clinical trialsnecessary to bring our potential products to market and to establishmanufacturing and marketing capabilities.

 

On March 28, 2003, weissued to Cheshire, a short-term convertible promissory note in the amount of$2.0 million, bearing interest at the rate of 8% per annum. The proceedswere used to fund our operations. The note is convertible into either 1,626,016 shares ofour common stock at a price of $1.23 per share (which was the closing price ofour common stock on March 27, 2003) or an equal amount of such other securitiesthat we may offer in the future by means of a private placement to “accreditedinvestors.”

 

On May 9, 15, and June 6, 2003, we issued to Cheshire short-termconvertible promissory notes in the amounts of $80,000, $1.0 million and$819,000, respectively, bearing interest at the rate of 8% per annum (the“Notes”). The proceeds from the issuance of the Notes were used to fund ouroperations.  The Notes have convertiblefeatures still to be determined in good faith negotiation prior to theirrespective maturities.

 

During May 2003, we held an auction to sell excess assets associatedwith our vacated former headquarters facility located in Carlsbad, California.  Transamerica was paid $187,000 of totalauction proceeds.  In July 2003, we paid$200,000, the second milestone payment owed under the June 2002 loanrestructuring agreement, as a result of the exercise of the Class Awarrants.  In August 2003, the loanswere paid in full with a final payment of $35,000.  The total amount owed to Transamerica as of June 30, 2003 andDecember 31, 2002 was approximately $280,000 and $865,000, respectively.

 

During June 2003, Cheshire exercised their option to convert $4.2million of principal on notes issued to them in November 2001, February 2002,part of the principal of the May 2002 note and all accrued and unpaid interestof $.8 million into 1,613,572 shares of our common stock.  The balance of the May 2002 note and allaccrued and unpaid interest thereon was transferred to two new notes in theapproximate amounts of $2.4 million and $1.4 million, respectively.  During July 2003, the note in the amount of$2.4 million was cancelled as payment for the aggregate exercise price of ClassA warrants to purchase 1,774,888 shares and an additional 887,444 incentiveshares of our common stock in connection with the July 7, 2003 incentive shareoffering described below.

 

On June 23, 2003, we issued $1,000,000 of unsecured promissory notes toaccredited investors, which bear interest at the rate of 12% per annum.  In conjunction with the notes, we issued166,665 shares of common stock as a discount on the loan.  The notes were paid with interest in July 2003with proceeds from the Class A warrant incentive share offering discussed below.

 

During July 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued to Cheshire.We issued an additional 3,496,118 shares equal to one half share of commonstock for each Class A warrant exercised as an incentive to induce holders ofthe Class A warrants to exercise their Class A warrants and to allow us toobtain a “lock-up” on the shares of common stock issued to the holders of suchexercised Class A warrants in the December 2002 unit offering and the shares ofthe common stock issued upon the exercise of the Class A warrants (includingthe additional one half share of common stock), prohibiting the sale of suchcommon stock for 270 days, with the “lock-up” period expiring on April 4, 2004.

 

On July 30, 2003, we exercised our option to redeem the remainingoutstanding Class A warrants on September 3, 2003. If all the outstanding ClassA warrants are exercised, we would receive gross proceeds of approximately

 

27

----

 

$3.4 million. We anticipate that the aggregate proceeds from theexercise of the Class A warrants, together with the exercise of the Class Awarrants on July 7, 2003, will be sufficient to fund our planned operations,including necessary capital expenditures and new clinical trials, into thefirst quarter of 2004.

 

At a special meeting of our stockholders held on July 7, 2003, wereceived stockholder approval to conduct a private offering of up to $5.0million of Series A Convertible Preferred Stock.  The holders of shares of our Series A Convertible Preferred Stockwill have the right to convert each share of Series A Convertible PreferredStock into shares of our common stock. Cheshire may convert all of the convertible promissory notes issued tothem between January 1, 2003 and July 7, 2003 into shares of Series AConvertible Preferred Stock.  The SeriesA Convertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

Notwithstanding the above transactions including the exercise of theClass A warrants, we will continue to have limited cash resources.  Although our management recognizes the needto secure additional financing and currently is exploring its options, therecan be no assurance that we will be successful in consummating any suchtransaction or, if we do consummate such a transaction, that the terms andconditions will not be unfavorable to us. The failure by us to obtain additional financing before the firstquarter of 2004 (assuming the exercise of all the remaining Class A warrants),will have a material adverse effect on us and likely result in our inability tocontinue as a going concern.  Ourindependent auditors have concluded that there is substantial doubt as to ourability to continue as a going concern for a reasonable period of time, andhave modified their report in the form of an explanatory paragraph describingthe events that have given rise to this uncertainty regarding our 2002 annualconsolidated financial statements.

 

As of June 30, 2003,we had net accumulated operating losses of approximately $272.3 million, cashand cash equivalents of only $1.3 million and a working capital deficiency ofapproximately $5.4 million.  Because wedo not anticipate generating any revenue from our products until at least thefirst quarter of 2007, if at all, we will continue to have negative cash flowand will need to raise substantial additional capital to fund our operationsbeyond such time.  We could raise anadditional $16.8 million if all of the Class B warrants issued as a result ofClass A warrant exercises since July 7, 2003, which are redeemable by us if theprice of our common stock is equal to or greater than $3.32, areexercised.  We believe the proceedswould provide us with sufficient funds to fund our planned operations,including capital improvements and new clinical trial costs, for an additionaltwelve months, however, there can be no assurances that all or any portion ofthe warrants will be exercised by the initial purchasers or by any subsequentholders. We also issued to Spencer Trask Ventures, Inc., the placement agentfor the December 2002 private placement, an option to purchase 1,452,419 sharesof common stock and 1,452,419 Class A warrants, which are not redeemable byus.  We have not included the exerciseof this option and Class A warrants in the estimated proceeds discussed above.As of June 2002, none of the Class B warrants have been exercised.

 

Although we anticipatethat development of REMUNE® will continue to represent a significant portion ofour overall expenditures, costs related to the development of REMUNE® decreasedin 2002. We expect our costs related to the development of REMUNE® to increasein 2003 and 2004 in the event we are able to raise additional capital enablingus to pursue additional research and development projects. Other anticipatedcosts relating to the development of REMUNE® will depend on many factors — inparticular, a potential decrease in such costs associated with our ability toestablish a new collaborative, strategic or marketing partner to replace PfizerInc., or Pfizer. See “— Pfizer Has Terminated Its Collaboration With Us And WeHave Had To Delay Or Abandon The Continued Development And Commercialization OfREMUNE®,” “We May Be Unable To Enter Into Additional Collaborations Or MaintainExisting Ones” And “Our Failure To Develop And Commercialize ProductsSuccessfully May Cause Us To Cease Operations.”

 

On September 9, 2002,we commenced the implementation of a cost reduction strategy to focus our corecompetencies on efforts related to the research, development, commercializationand production of REMUNE®. We anticipate that the cost reductions will impact ourcash expenditures related to research, administrative and operational costs. Inthe process of implementing these cost reductions, we will incur one-timeexpenses related to severance, relocation of certain facilities and consultingpayments. Excluding these one-time payments and any expansion of our researchor manufacturing efforts, if all of our cost reductions are realized, we expectthat these cost reductions will decrease our expenses significantly. However,we intend to increase our production capabilities at our King of Prussia,Pennsylvania, facility which will necessitate additional cash and capitalrequirements for such activities. In addition, there can be no assurances thatwe will be successful in implementing all or any portion of these cost reductionmeasures or that we will recognize all or any portion of the anticipatedsavings.

 

The timing and amountof our future capital requirements will depend on many factors, including:

 

28

----

 

• our ability to raise additional funding and the amounts raised, if any;

• the cost of manufacturing scale-up;

• the time and costs involved in obtaining regulatory approvals;

• continued scientific progress in our research and development programs;

• the scope and results of preclinical studies and clinical trials;

• the costs involved in filing, prosecuting and enforcing patent claims;

• competing technological and market developments;

• effective commercialization activities and arrangements;

• the costs of defending against and settling lawsuits; and

• other factors not within our control or known to us.

 

Our access to capitalcould be limited if we do not progress in:

 

• scaling up manufacturing;

• obtaining regulatory approvals;

• our research and development programs; or

• our preclinical and clinical trials.

 

Such access also couldbe limited by (i) overall financial market conditions, (ii) applicable NationalAssociation of Securities Dealers, or NASD, rules and federal and statesecurities laws, (iii) the perfected security interest in our intellectualproperty in respect of the aggregate $13.4 million in convertible notes issuedin May 2002, November 2002, December 2002 and March 2003, May 2003, June 2003and July 2003 to affiliates and/or related parties of Mr. Kimberlin, one of ourdirectors and our principal stockholder, (iv) the effect of the exercise of certain outstanding options andwarrants exercisable into approximately 13.4 million shares of common stock,(v) the effect of the conversion of the May, November and December 2002, May2003, June 2003 and July 2003 convertible notes into approximately 10.7 millionshares of common stock, (vi) the issuance of 9,522,072 shares of common stockand 9,522,072 Class A warrants to the selling security holders in our privateplacement of units, and (vii) the issuance of the placement agent option toSpencer Trask Ventures, Inc. which is exercisable for 1,452,419 shares ofcommon stock and 1,452,419 Class A warrants, which are not redeemable by us.

 

**You Could Suffer Substantial DilutionOf Your Investment As A Result Of Proposed Subsequent Financings**

Although we havecompleted the private placement of units, we currently are actively consideringraising additional funds. On March 28, 2003, we issued to Cheshire, a short-termconvertible promissory note in the amount of $2.0 million, bearing interest atthe rate of 8% per annum. The note is convertible into either 1,626,016 sharesof our common stock at a price of $1.23 per share (which was the closing priceof our common stock on March 27, 2003) or an equal amount of such othersecurities that we may offer in the future by means of a private placement to“accredited investors” as discussed below.

 

On May 9, 15, and June 6, 2003, we issued to Cheshire short-termconvertible promissory notes in the amounts of $80,000, $1.0 million and$819,000, respectively, bearing interest at the rate of 8% per annum (the“Notes”). The Notes have convertible features still to be determined in goodfaith negotiation prior to their respective maturities.

 

Alternatively, Cheshire may convert all of the convertible promissorynotes issued between January 1, 2003 and July 7, 2003 into shares ofSeries A Convertible Preferred Stock in connection with a proposedoffering.   We received stockholderapproval to conduct a private offering of up to $5.0 million of Series AConvertible Preferred Stock at a special meeting of our stockholders held onJuly 7, 2003.  The holders of shares ofour Series A Convertible Preferred Stock will have the right to convert eachshare of Series A Convertible Preferred Stock into shares of our commonstock.  The Series A ConvertiblePreferred Stock will receive dividends in preference to any dividend issued toholders of shares of our common stock. Additionally, the holders of shares of our Series A ConvertiblePreferred Stock are entitled to liquidation preference.  As of July 31, 2003, we have not commencedthe offering.

 

Notwithstanding the above transactions, we will continue to havelimited cash resources.  Although ourmanagement recognizes the need to secure additional financing, there can be noassurance that we will be successful in consummating any such transaction or,if we do consummate such a transaction, that the terms and conditions of suchfinancing will not be unfavorable to us. The failure by us to obtain additional financing before the firstquarter of 2004 (assuming the conversion of all of the remaining Class Awarrants), will have a material adverse effect on us and likely result in ourinability to continue as a going concern. Our independent auditors have concluded that there is substantial doubtas to our ability to continue as a going concern for a reasonable period oftime, and have, therefore, modified their report in the form of an explanatoryparagraph describing the events that have given rise to this uncertaintyregarding our annual consolidated financial statements.

 

29

----

 

Any subsequentofferings may require the creation or issuance of a class or series of stockthat by its terms ranks senior to the common stock with respect to rightsrelating to dividends and/or liquidation. If we are unable to raise funds onterms favorable to our then existing shareholders, your ownership interest and thevalue of your investment may be significantly diluted.

 

We do not expect toreceive proceeds from product revenues sooner than the first quarter of 2007,if at all. Notwithstanding our current financing efforts, we will continue tohave negative cash flow and will need to raise substantial additional capitalto fund our operations beyond such time. We may be able to secure financingonly on terms substantially less favorable to our current investors and to us,if at all. If we raise funds through equity arrangements, further dilution tostockholders will result. If we are unable to obtain financing before wegenerate enough revenue from our products to become cash flow break-even, wewill be unable to pay our debts and will be forced to cease operations andpotentially enter into bankruptcy.

 

**You Could Suffer Substantial DilutionOf Your Investment As The Result Of Adjustments To The Convertible Notes,Warrants And Other Securities Issued In May 2002, July 2002, November 2002,December 2002, March 2003, May 2003, June 2003 and July 2003**

In November 2001, weissued to Kevin Kimberlin Partners LLP, or KKP, a $2.0 million convertible noteand a warrant, each of which were initially convertible and exercisable,respectively, for 433,426 shares of common stock. In February 2002, we issuedto Oshkim Limited Partnership, or Oshkim, a $2.0 million convertible note and awarrant, each of which were initially convertible and exercisable,respectively, for 429,000 shares of common stock, pursuant to the note purchaseagreement. In May 2002, we issued to Oshkim Limited Partnership, or Oshkim, a$4.0 million convertible note and a warrant, each of which were initiallyconvertible and exercisable, respectively, for 2,319,109 shares of commonstock. Such notes were issued pursuant to a note purchase agreement, datedNovember 11, 2001. The number of shares, as well as the applicable conversionor exercise price, as the case may be, are subject to weighted averageantidilution adjustment in the event that we issue certain securities below theapplicable conversion or exercise price and in certain other events which woulddilute your interest in us. All the principal and all accrued and unpaidinterest on notes issued in November 2001 and February 2002 and part of theprincipal on the May 2002 note was converted on June 3, 2003 by CheshireAssociates into 1,613,572 shares of our common stock.  The balance of the May 2002 note and all accrued and unpaidinterest thereon was transferred to two new notes in the approximate amounts of$2.4 and $1.4, respectively.  The July7, 2003 note in the amount of $2.4 was cancelled as payment for the aggregateexercise price of Class A warrants to purchase 2,622,332 shares of our commonstock in connection with the July 7, 2003 incentive share offering.

 

In June 2002, weissued to Oshkim a $1.0 million convertible note and a warrant, each of whichwas initially convertible and exercisable, respectively, for 523,451 shares ofcommon stock or $1.0 million in units offered in the private placement.  Additionally, on July 11, 2002, we issued toThe Kimberlin Family 1998 Irrevocable Trust, or the Kimberlin Family Trust, a$566,638 convertible note and a warrant, each of which was initiallyconvertible and exercisable, respectively, for 354,858 shares of common stock.On July 30, 2002, we issued to the Kimberlin Trust a $637,189 convertible noteand a warrant, each of which was initially convertible and exercisable,respectively, for 430,068 shares of common stock. Up to $1.0 million of thenotes issued in July was convertible into units offered in the privateplacement. Each of the notes and warrants issued in November 2001 and February,May, June and July 2002 was subsequently contributed by the initial holder toCheshire Associates.

 

On November 12, 2002,we issued to Cheshire Associates a $4,847,608 convertible note and a warrant,each of which is initially convertible and exercisable, respectively, for4,243,354 shares of common stock. On November 15, 2002, we issued to CheshireAssociates a $200,000 convertible note and a warrant, each of which isinitially convertible and exercisable, respectively, for 174,581 shares ofcommon stock. On November 20, 2002, we issued to Cheshire Associates a $200,000convertible note and a warrant, each of which is initially convertible andexercisable, respectively, for 184,638 shares of common stock. On November 27,2002, we issued to Cheshire Associates a $215,000 convertible note and awarrant, each of which is initially convertible and exercisable, respectively,for 264,518 shares of common stock.

 

In conjunction withour private placement of units, $2.0 million of principal and interest on theJune and July notes and related warrants were converted by Cheshire Associatesinto 20 units. The convertible note and warrant issued to the Kimberlin FamilyTrust on July 30, 2002 and contributed to Cheshire Associates has been reducedto $278,320 as a result of the $2.0 million conversion and has been transferredto a new promissory note and warrant dated December 10, 2002 which wasinitially convertible and exercisable, respectively, for 187,851 shares ofcommon stock. Following the close of the unit offering, the number of sharesand applicable conversion and exercise price of the convertible notes andwarrants issued to Oshkim, KKP, the Kimberlin Family Trust and CheshireAssociates, respectively, were adjusted pursuant to their weighted averageanti-dilution provisions for the unit offering as well as for the conversion ofthe equity underlying the converted notes and warrants. Consequently, thenumber of shares of common stock issuable upon conversion of the outstandingconvertible notes has decreased

 

30

----

 

to 9,449,843 and thenumber of shares of common stock issuable upon the exercise of the relatedwarrants has decreased to 9,747,757 shares. Such number of shares, as well asthe applicable conversion or exercise price, as the case may be, are subject toadjustment in the event that we issue certain securities below the applicableconversion or exercise price and in certain other events. This also may diluteyour interest in us.

 

On March 28, 2003, weissued to Cheshire Associates a short-term convertible promissory note in theamount of $2.0 million, bearing interest at the rate of 8% per annum.  The note issued in March 2003 is convertibleinto either 1,626,016 shares of our common stock at a price of $1.23 per share(which was the closing price of our common stock on March 27, 2003) or an equalamount of such other securities that we may offer in the future by means of aprivate placement to “accredited investors” as discussed below.

 

On May 9, 15 and June 6, 2003, we issued to Cheshire Associatesshort-term convertible promissory notes in the amount of $80,000,$1.0 million and $819,000, respectively, bearing interest at the rate of8% per annum (the “ Notes”).  The Noteshave a convertible feature still to be determined in good faith negotiationprior to their respective maturities.

 

Alternatively, Cheshire may convert all of the convertible promissorynotes issued to them between January 1, 2003 and July 7, 2003 into shares ofSeries A Convertible Preferred Stock in connection with a proposedoffering.  We received stockholderapproval to conduct a private offering of up to $5.0 million of Series AConvertible Preferred Stock at a special meeting of our stockholders held onJuly 7, 2003.  The holders of shares ofour Series A Convertible Preferred Stock will have the right to convert eachshare of Series A Convertible Preferred Stock into shares of our commonstock.  The Series A ConvertiblePreferred Stock will receive dividends in preference to any dividend issued toholders of shares of our common stock. Additionally, the holders of shares of our Series A Convertible PreferredStock are entitled to liquidation preference. As of July 31, 2003, we have not commenced the offering.

 

We also issued anoption to our placement agent to purchase 1,452,419 shares of common stock and1,452,419 Class A warrants (which are not redeemable by us) which, ifexercised, may dilute your interest in us.

 

On June 26, 2002, weentered into an agreement with Trinity Medical Group USA, Inc. and itsaffiliate, Trinity Medical Group, Co. Ltd., a Thailand company, collectivelyTrinity, to amend certain of our existing agreements with Trinity. Inconsideration for entering into these amendments, Trinity has received 1.0million shares of our common stock valued at approximately $2.4 million at thedate of the amendments and also will receive as additional consideration,250,000 shares of our common stock (up to 750,000 shares in the aggregate) asof the date of the satisfaction by Trinity of each of the followingobligations: (i) the purchase by Trinity from us of an aggregate of 300,000doses of REMUNE®, (ii) the purchase by Trinity from us of an aggregate of600,000 doses of REMUNE® and (iii) the purchase by Trinity from us of anaggregate of 1.0 million doses of REMUNE®. Under the current agreement, Trinityalso is obligated to purchase 500,000 shares of common stock at a purchaseprice of $10 per share on the date that is 30 days after the date on whichTrinity receives the required marketing approval from the Food and DrugAdministration of the Ministry of the Public Health of Thailand, or the Thai FDA.The issuance by us to Trinity of these 2,250,000 shares of common stock, andthe granting by us to Trinity of certain registration rights relating to suchshares, will dilute your interest in us. On June 23, 2002, the registrationstatement covering the sale of 500,000 shares of common stock, held in the nameof Trinity, was declared effective by the SEC.

 

We may in the futureissue additional convertible notes, warrants or other securities. We areanticipating a subsequent offering which we plan to commence in the near futureif the Class B warrants are not exercised. The number of underlying shares ofcommon stock and the terms of the securities are not determinable at this time,but would dilute your interest in us.

 

**You Could Suffer Substantial DilutionOf Your Investment If Certain Warrants And Options To Purchase Common Stock AreExercised Or Our Convertible Notes Are Converted Into Common Stock**

As of June 30, 2003,we had reserved approximately 5.6 million shares of our common stock forpotential issuance upon the exercise of stock options or purchases under theemployee stock purchase plan. Issuance of any of these additional shares couldsubstantially dilute your interest in us. Furthermore, we have warrantsoutstanding which, if exercised, will purchase approximately 19.3 millionshares of our common stock and approximately 10.7 million shares which areissuable upon conversion of our outstanding convertible notes.  Additionally, we issued an option to ourplacement agent to purchase 1,452,419 shares of common stock and 1,452,419Class A warrants, which are not redeemable by us. The Class A warrants areexercisable for additional shares of common stock and Class B warrants.  In addition, we may issue up to 750,000shares of our common stock to Trinity pursuant to our License and CollaborationAgreement. See also “— You Could Suffer Substantial Dilution of Your InvestmentAs The Result Of Adjustments To The Convertible Notes, Warrants And OtherSecurities Issued In May 2002, July 2002, November 2002, December 2002, March2003, May 2003, June 2003 and July 2003.”

 

31

----

 

**Our Independent Auditors Have Expressed Substantial Doubt AsTo Our Ability To Continue As A Going Concern**

As of June 30, 2003,we had a consolidated accumulated deficit of $272.3 million. We have notgenerated revenues from the commercialization of any product.  We expect to continue to incur substantialnet operating losses over the next several years, which would imperil ourability to continue operations.  We maynot be able to generate sufficient product revenue to become profitable on asustained basis, or at all, and do not expect to generate product revenuebefore the first quarter of 2007, if at all. We have operating and liquidity concerns due to our significant netlosses, negative cash flows from operations and substantial working capitaldeficit.  Additionally, it may take asignificant length of time before we can raise capital from any subsequentfinancing.  As a result of these andother factors, our independent auditors, BDO Seidman, LLP, indicated that thereis substantial doubt about our ability to continue as a going concern.

 

**Our Stock May Become Delisted AndSubject To Penny Stock Rules, Which May Make It More Difficult For You To SellYour Securities**

On March 12, 2002, ourcommon stock commenced trading below $1.00 per share on The Nasdaq NationalMarket. The National Association of Securities Dealers Automated QuotationSystem, or Nasdaq, listing rules provide that if the closing bid price of acompany’s stock is below $1.00 for more than 30 consecutive trading days, thecompany faces possible delisting from Nasdaq. Additionally, Nasdaq listingrules require that a company’s stockholder equity be at least $4.0 million, andafter October 2002, be at least $10.0 million. Due to our common stock tradingbelow $1.00 per share for more than 30 consecutive days, as of April 23, 2002,we received notification from Nasdaq that our common stock would be delistedfrom the Nasdaq National Market if we could not demonstrate compliance withNASD rules by July 24, 2002.

 

On September 4, 2002,the NASD approved our application to transfer our common stock to The NasdaqSmallCap Market and consequently extended, until October 22, 2002, the periodfor us to comply with the minimum $1.00 bid per share requirement. Our commonstock was moved to The Nasdaq SmallCap Market, effective September 9, 2002. OnSeptember 29, 2002, we submitted to Nasdaq a request to grant us an additional180 calendar-day grace period to demonstrate compliance with Nasdaq continuedlisting requirements. On October 24, 2002, Nasdaq granted us the 180 dayextension or until April 21, 2003. Subsequently, Nasdaq informed us that we metthe listing requirements.  However as ofJune 30, 2003, we have fallen below the minimum stockholders’ equityrequirement of $2.5 million for the Nasdaq SmallCap Market’s continued listingrequirement. However, we meet an alternative test of having the market value ofour securities exceed $35 million. See “— We Implemented A 1-For-4 ReverseStock Split. The Effect Of A Reverse Split On The Trading Price Of Our CommonStock Is Unpredictable.”

 

The transfer of ourcommon stock to The Nasdaq SmallCap Market may adversely affect the liquidityand trading volume of our common stock and reduce the number of market makerswilling to trade in our common stock, making it more likely that widerfluctuations in the quoted price of our common stock will occur. As a result,there is a risk that holders of our common stock will not be able to obtainaccurate price quotes or be able to correctly assess the market price of ourcommon stock. Increases in volatility also could make it more difficult topledge shares of our common stock as collateral, if holders sought to do so,because a lender also might be unable to accurately value our common stock.

 

If we are delistedfrom the Nasdaq for any reason, our common stock will be considered a pennystock under regulations of the Securities and Exchange Commission, or the SEC,and therefore would be subject to rules that impose additional sales practicerequirements on broker-dealers who buy and sell our securities. The additionalburdens imposed upon broker-dealers by these requirements could discouragebroker-dealers from effecting transactions in our common stock, which couldseverely limit the market liquidity of the common stock and warrants and yourability to sell our securities in the secondary market. We cannot assure youthat we will be able to maintain our listing on the Nasdaq. Being delistedwould limit our ability to raise additional financing.

 

**If An Active Trading Market Does NotContinue For The Warrants, Holders Of Warrants May Not Be Able To Resell TheirClass A Or Class B Warrants**

We are unable to predictwhether an active trading market will be sustained for the Class A and Class Bwarrants.  If no active trading marketis sustained, holders of the warrants may not be able to resell their warrantsat their fair market value or at all.

 

Any securities firmthat acts as a market maker could cease its market making at any time. Inaddition, the liquidity of the trading market in the warrants, and the marketprices quoted for the warrants, may be adversely affected by changes in theoverall market conditions and by changes in our financial performance orprospects in the prospects for companies in our industry generally. See “—ThereAre Limits On Your Ability To Exercise The Warrants And Adverse Effects MayResult From The Possible Redemption Of The Warrants.”

 

32

----

 

**We Implemented A 1-For-4 Reverse StockSplit. The Effect Of A Reverse Split On The Trading Price Of Our Common StockIs Unpredictable**

At our Annual Meetingof Stockholders held on June 17, 2002, our stockholders granted to our Board ofDirectors the discretion to effect a 1-for-4 reverse stock split. On October 9,2002, we announced that our Board of Directors had formally declared a 1-for-4reverse stock split of issued and outstanding shares of our common stockeffective as of the open of trading on October 9, 2002. Although thetheoretical effect of a reverse stock split is to increase the per share priceof common stock, the actual price effect of a reverse stock split is difficultto predict. There is historical evidence and academic research relating toreverse stock splits which indicates that shares of listed companies do notperform well subsequent to a reverse stock split. It is possible that thepost-split trading price of our stock could fall below the level one wouldexpect based on the proportional effect of the split alone.

 

**An Existing Stockholder Directly OwnsApproximately 20.3% Of Our Common Stock And Has The Rights To Acquire AnAdditional 26,772,329 Shares, Of Our Common Stock Which Could Result InOwnership Of Up To Approximately 64.4% Of Our Outstanding Shares And CouldAllow Him To Influence Stockholder Votes**

Kevin B. Kimberlin, amember of our Board of Directors, together his affiliates and/or relatedparties currently own of record approximately 20.3% of our outstanding sharesof common stock and have the right to acquire through the conversion of notesand exercise of options and warrants beneficially owned by them 26,772,329additional shares. If the notes, options and warrants were to be converted andexercised in full, Mr. Kimberlin and his affiliates and/or related partieswould own approximately 64.4% of our outstanding shares of common stock on apost-conversion/exercised basis. As a result of his ownership of our commonstock and the ability to acquire additional shares, Mr. Kimberlin and hisaffiliates and/or related persons could have the ability to control orinfluence substantially all matters requiring approval by our stockholders,including the election of directors and the approval of mergers or otherbusiness combination transactions. If your interests as a stockholder aredifferent from his interests, you may not agree with his decisions and youmight be adversely affected thereby.

 

Mr. Kimberlin, inaddition to being one of our directors and our principal stockholder, is thecontrolling stockholder of Spencer Trask & Co., which is the parent companyof Spencer Trask Ventures, Inc., which acted as exclusive placement agent for,and was paid fees by us in connection with, the private placement of unitscompleted in December 2002.

 

**The Warrant Terms Were ArbitrarilyDetermined**

The exercise andredemption prices and other terms of the Class A and Class B warrants sold aspart of our private offering completed on December 10, 2002, were determinedthrough negotiations between us and our placement agent and do not necessarilybear any relationship to our assets, book value, revenues or financialcondition, or to any other recognized criterion of value. Such prices and otherterms of the warrants should not be construed to indicate or predict futuretrading prices of our warrants or common stock in the public markets.

 

**Limits On Ability To Exercise TheWarrants; Adverse Effects May Result From The Possible Redemption Of TheWarrants**

Purchasers of ourClass A and Class B warrants will be able to exercise the warrants only if acurrent prospectus relating to the securities underlying the warrants is thenin effect under the Securities Act of 1933, or the Securities Act, and thewarrants are qualified for sale or exempt from qualification under theapplicable securities or “blue sky” laws of the states in which the variousholders of the warrants then reside. Although we have agreed to make certainefforts to maintain the effectiveness of a current prospectus covering thesecurities underlying the warrants, there can be no assurance that we will beable to do so. The value of the warrants may be greatly reduced if a currentprospectus covering the securities to be issued upon the exercise of thewarrants is not kept effective under the Securities Act or if such securitiesare not qualified or exempt from qualification in the states in which theholders of the warrants then reside.

 

On July 7, 2003, we raised $9.3 million in gross proceeds through thevoluntary exercise of 6,992,236 of our Class A warrants.  The proceeds included $6.9 million in cashand the cancellation of $2.4 million of convertible notes previously issued toCheshire. We issued an additional 3,496,118 shares equal to one half share ofcommon stock for each Class A warrant exercised as an incentive to induceholders of the Class A warrants to exercise their Class A warrants and to allowus to obtain a “lock-up” on the shares of common stock issued to the holders ofsuch exercised Class A warrants in the December 2002 unit offering and theshares of the common stock issued upon the exercise of the Class A warrants(including the additional one half share of common stock), prohibiting the saleof such common stock for 270 days, with the “lock-up” period expiring on April4, 2004.

 

On July 30, 2003, we exercised our option to redeem the remainingoutstanding Class A warrants on September 3, 2003. If all the outstanding ClassA warrants are exercised, we would receive gross proceeds of approximately

 

33

----

 

$3.4 million. We anticipate that the aggregate proceeds from theexercise of the Class A warrants, together with the exercise of the Class Awarrants on July 7, 2003, will be sufficient to fund our planned operations,including necessary capital expenditures and new clinical trials, into thefirst quarter of 2004.

 

In addition, the ClassB warrants are subject to redemption by us, at a price of $0.01 per warrant,following the effectiveness of the Form S-1 and upon at least 30 days priorwritten notice to the holders of the warrants if the average of the closing bidprices of common stock for any 10 consecutive trading days ending within 30days prior to the date of the notice of redemption is greater than or equal to$3.32. If the warrants are redeemed, holders of warrants will lose their rightto exercise the warrants, except during such 30-day notice of redemptionperiod. Upon the receipt of a notice of redemption of the warrants, the holderswill be required to: exercise the warrants and pay the exercise price at a timewhen it may be disadvantageous or difficult for them to do so; sell thewarrants at the then market price when they might otherwise wish to hold thewarrants; or accept the redemption price, which is equal to $0.01 per warrant.

 

**Legal Proceedings Could Require Us ToSpend Substantial Amounts Of Money And Impair Our Operations**

Since July 2001,several complaints have been filed in the United States District Court for theSouthern District of California seeking an unspecified amount of damages onbehalf of an alleged class of persons, who purchased shares of our common stockat various times between May 17, 1999 and July 6, 2001. The various complaintsname us, one of our directors, one of our officers, Agouron Pharmaceuticals,Inc., or Agouron, and one of its officers, as defendants. The complaints allegethat we, Agouron and/or such officers violated federal securities laws bymisrepresenting and failing to disclose certain information about the resultsof clinical trials of REMUNE®. The complaints have been consolidated into asingle action under the name *In re Immune Response Securities Litigation*byorder of the Court and a consolidated amended complaint has been filed. We havenot yet formally responded to the consolidated amended complaint. Although weintend to vigorously defend the actions, we can not now predict or determinethe outcome or resolution of these proceedings, or to estimate the amounts of,or potential range of, loss with respect to these proceedings. In addition, thetiming of the final resolution of these proceedings is uncertain. The range ofpossible resolutions of these proceedings could include judgments against us orour officers or settlements that could require substantial payments by us,which could have a material adverse impact on our financial position, resultsof operations and cash flows. These proceedings also might require substantialattention of our management team and therefore divert their time and attentionfrom our business and operations.

 

On July 23, 2003 Respimun Associates Ltd., our landlord, filed acomplaint against us in Superior Court of California.  The complaint alleges a breach of contract for the payment of rentat our former headquarters facility in Carlsbad, California ($79,385 per monthplus late charges and other amounts). We intend to defend the claim. However, we have accrued approximately $700,000 to cover a potentialsettlement.

 

**The Annual Use Of Our Net OperatingLosses Has Likely Been Limited As A Result Of Changes In Our Ownership**

We have had numerousequity transactions that have more likely than not resulted in several changesin ownership of us as defined by Section 382 of the Internal Revenue Code of1986, as amended, or the Code. Pursuant to Sections 382 and 383 of the Code,the annual use of our net operating losses, or NOLs would be limited if thereis a cumulative change of ownership (as that term is defined in Section 382(g)of the Code) of greater than 50% in the past three years. If such Section 382ownership change occurs, there would be a substantial limitation on our abilityto utilize our NOLs to offset future taxable income. As reported in Note 15 toour 2002 Annual Consolidated Financial Statements, we had approximately $218.0million of NOL carryforwards at such time. We have not completed our analysisif and when change(s) of ownership have occurred, thus, there is uncertainty asto the realizability of our NOL’s. Furthermore, we cannot assure you, however,that we will generate taxable income in the future against which the NOLs couldbe applied.

 

On September 11, 2002,the State of California enacted one of the budget trailer bills implementingthe State’s 2002-2003 Budget Bill (A425). The new law suspends the NOLcarryover deduction for tax years 2002 and 2003. To compensate for thededuction suspension, the period of availability for these NOL deductions hasbeen extended for two years.

 

**Pfizer Has Terminated Its CollaborationWith Us And We Have Had To Delay Or Abandon The Continued Development AndCommercialization Of REMUNE®**

We received in July2001, a letter from Pfizer which indicated that Pfizer had elected toimmediately terminate, in their entirety, all of its rights and obligationsunder our agreement with them. Our agreement with Pfizer permitted thistermination and the letter we received from Pfizer provided no explanation asto why Pfizer had elected to exercise its termination right.  In addition, no explanation has beenprovided to us by Pfizer at any time after the July 2001 termination letter.Although we retained all rights relating to REMUNE® upon Pfizer’s termination,we lost a significant source of funding. Following the termination of ouragreement with Pfizer, we decided not to proceed

 

34

----

 

with one of ourclinical trials of REMUNE® developed by Agouron (subsequently acquired byPfizer). The termination of this agreement has had, and may continue to have, amaterial adverse effect on our stock price and, consequently, our ability tosuccessfully raise additional capital.

 

**We May Be Unable To Enter IntoAdditional Collaborations Or Maintain Existing Ones**

We are seekingadditional collaborative arrangements to develop and commercialize ourproducts. We may not be able to negotiate collaborative arrangements onfavorable terms in the future, or at all, and our current or futurecollaborative arrangements may not be successful or continue. We also arecontemplating a renegotiation of our License and Collaboration Agreement withTrinity. However, we have not yet entered into any significant discussions withTrinity regarding such renegotiation.

 

Cheshire Associates(an affiliate and/or related person of Mr. Kimberlin) has a perfected securityinterest in our intellectual property as collateral for the May 2002, November2002, December 2002, March 2003, May 2003, June 2003 and July 2003 convertiblenotes. Pursuant to an agreement with Cheshire Associates, we must comply withcertain covenants with respect to our intellectual property. The securityinterests and covenants could impair our ability to enter into collaborativeand licensing arrangements.

 

**Our Failure To Develop AndCommercialize Products Successfully May Cause Us To Cease Operations**

We have not completedthe development of any product and, as part of our restructuring programannounced in September 2002, have ceased development of all products other thanREMUNE®. Our failure to develop and commercialize products successfully maycause us to cease operations. Our potential therapies which were underdevelopment prior to September 2002 will require significant additionalresearch and development efforts and regulatory approvals prior to potentialcommercialization should these development efforts be continued in the future.

 

The discontinuation inMay 1999 of a previous Phase III trial of REMUNE® due to the inability to meetcertain primary clinical endpoints has had a material adverse effect on us. Themost recent pivotal trial of REMUNE® conducted by our former collaborativepartner, Pfizer, was discontinued by us. See “—Pfizer Has Terminated ItsCollaboration With Us And We Have Had To Delay The Continued Development AndCommercialization Of REMUNE®.”  Wecannot assure you that any future trials of REMUNE® will be conducted.Furthermore, we cannot guarantee that we, or our corporate collaborators, ifany, will ever obtain any regulatory approvals of REMUNE®. We currently arefocusing our core competencies on REMUNE® although there can be no assurancethat we will be successful in so doing.

 

Prior to the cessationof the development efforts in September 2002, our other therapies andtechnologies are at earlier stages of development than REMUNE® and may not beshown to be safe or effective and may never receive regulatory approval.  Some of our technologies have not yet beentested in humans. Regulatory authorities may not permit human testing ofpotential products based on these technologies. Even if human testing is permitted,the products based on these technologies may not be successfully developed orshown to be safe or effective.

 

The results of ourpreclinical studies and clinical trials may not be indicative of futureclinical trial results. A commitment of substantial resources to conducttime-consuming research, preclinical studies and clinical trials will berequired if we are to develop any products. Delays in planned patientenrollment in our clinical trials may result in increased costs, program delaysor both. None of our potential products may prove to be safe or effective inclinical trials. Approval of the Food and Drug Administration, the FDA, orother regulatory approvals, including export license permissions, may not beobtained and even if successfully developed and approved, our products may notachieve market acceptance. Any products resulting from our programs may not besuccessfully developed or commercially available for a number of years, if atall.

 

Moreover, unacceptabletoxicity or side effects could occur at any time in the course of humanclinical trials or, if any products are successfully developed and approved formarketing, during commercial use of our products. Although preliminary researchand clinical evidence has shown REMUNE® to be safe, the appearance of anyunacceptable toxicity or side effects could interrupt, limit, delay or abortthe development of any of our products or, if previously approved, necessitatetheir withdrawal from the market.

 

**Our Patents And Proprietary TechnologyMay Not Be Enforceable And The Patents And Proprietary Technology Of Others MayPrevent Us From Commercializing Products**

We have a portfolio of173 patents worldwide. Although we believe these patents to be protected andenforceable, the failure to obtain meaningful patent protection for ourpotential products and processes would greatly diminish the value of ourpotential products and processes.

 

35

----

 

Cheshire Associates,an entity related to Mr. Kimberlin, has a perfected security interest in ourintellectual property as collateral for the May 2002, November 2002, December2002, March 2003, May 2003, June 2003 and July 2003 convertible notes.

 

In addition, whetheror not our patents are issued, or issued with limited coverage, others mayreceive patents, which contain claims applicable to our products. Patents weare not aware of may adversely affect our ability to develop and commercializeproducts. Also, our patents related to HIV therapy have expiration dates thatrange from 2010 to 2015 and our patents related to autoimmune diseases haveexpiration dates that range from 2010 to 2018. The limited duration of ourpatents could diminish the value of our potential products and processes.

 

The patent positions ofbiotechnology and pharmaceutical companies are often highly uncertain andinvolve complex legal and factual questions. Therefore, the breadth of claimsallowed in biotechnology and pharmaceutical patents cannot be predicted. Wealso rely upon non-patented trade secrets and know how, and others mayindependently develop substantially equivalent trade secrets or know how. Wealso rely on protecting our proprietary technology in part throughconfidentiality agreements with our current and former corporate collaborators,employees, consultants and certain contractors. These agreements may bebreached, and we may not have adequate remedies for any such breaches. Inaddition, our trade secrets may otherwise become known or independentlydiscovered by our competitors. Litigation may be necessary to defend againstclaims of infringement, to enforce our patents or to protect trade secrets.Litigation could result in substantial costs and diversion of managementefforts regardless of the results of the litigation. An adverse result inlitigation could subject us to significant liabilities to third parties,require disputed rights to be licensed or require us to cease using certaintechnologies.

 

Our products andprocesses may infringe, or be found to infringe, on patents not owned orcontrolled by us. If relevant claims of third-party patents are upheld as validand enforceable, we could be prevented from practicing the subject matterclaimed in the patents, or would be required to obtain licenses or redesign ourproducts or processes to avoid infringement.

 

**The Lengthy Product Approval ProcessAnd Uncertainty Of Government Regulatory Requirements May Delay Or Prevent UsFrom Commercializing Products**

Clinical testing,manufacture, promotion, export and sale of our products are subject toextensive regulation by numerous governmental authorities in the United States,principally the FDA, and corresponding state and foreign regulatoryagencies.  This regulation may delay orprevent us from commercializing products. Noncompliance with applicablerequirements can result in, among other things, fines, injunctions, seizure orrecall of products, total or partial suspension of product manufacturing andmarketing, failure of the government to grant premarket approval, withdrawal ofmarketing approvals and criminal prosecution.

 

The regulatory processfor new therapeutic drug products, including the required preclinical studiesand clinical testing, is lengthy and expensive. We may not receive necessaryFDA clearances for any of our potential products in a timely manner, or at all.The length of the clinical trial process and the number of patients the FDAwill require to be enrolled in the clinical trials in order to establish thesafety and efficacy of our products is uncertain.

 

Even if additionalclinical trials of REMUNE® are initiated and successfully completed, the FDAmay not approve REMUNE® for commercial sale. We may encounter significantdelays or excessive costs in our efforts to secure necessary approvals.Regulatory requirements are evolving and uncertain. Future United States orforeign legislative or administrative acts could also prevent or delayregulatory approval of our products. We may not be able to obtain the necessaryapprovals for clinical trials, manufacturing or marketing of any of ourproducts under development. Even if commercial regulatory approvals areobtained, they may include significant limitations on the indicated uses forwhich a product may be marketed.

 

In addition, amarketed product is subject to continual FDA review. Later discovery ofpreviously unknown problems or failure to comply with the applicable regulatoryrequirements may result in restrictions on the marketing of a product orwithdrawal of the product from the market, as well as possible civil orcriminal sanctions.

 

Among the otherrequirements for regulatory approval is the requirement that prospectivemanufacturers conform to the FDA’s Good Manufacturing Practices, or GMP,requirements. In complying with the FDA’s GMP requirements, manufacturers mustcontinue to expend time, money and effort in production, record keeping andquality control to assure that products meet applicable specifications andother requirements. Failure to comply and maintain compliance with the FDA’sGMP requirements subjects manufacturers to possible FDA regulatory action andas a result, may have a material adverse effect on us. We, or our contractmanufacturers, if any, may not be able to maintain compliance with the FDA’sGMP requirements on a continuing basis. Failure to maintain compliance couldhave a material adverse effect on us.

 

36

----

 

The FDA has notdesignated expanded access protocols for REMUNE® as “treatment” protocols. TheFDA may not determine that REMUNE® meets all of the FDA’s criteria for use ofan investigational drug for treatment use. Even if REMUNE® is allowed fortreatment use, third party payers may not provide reimbursement for the costsof treatment with REMUNE®. The FDA also may not consider REMUNE® or any otherof our products under development to be appropriate candidates for acceleratedapproval, expedited review or fast track designation.

 

Marketing any drugproducts outside of the United States will subject us to numerous and varying foreignregulatory requirements governing the design and conduct of human clinicaltrials and marketing approval. Additionally, our ability to export drugcandidates outside the United States on a commercial basis is subject to thereceipt from the FDA of export permission, which may not be available on atimely basis, if at all. Approval procedures vary among countries and caninvolve additional testing, and the time required to obtain approval may differfrom that required to obtain FDA approval. Foreign regulatory approvalprocesses include all of the risks associated with obtaining FDA approval setforth above, and approval by the FDA does not ensure approval by the healthauthorities of any other country, including those in Thailand.

 

Specifically, in orderfor us to export REMUNE® to Thailand for clinical use in that country, we needto meet a number of regulatory requirements. One of those requirements is thatwe must ensure that we can manufacture REMUNE® at our United Statesmanufacturing facility in a manner that is in “substantial compliance” withcurrent United States GMP requirements. We must provide the FDA with “crediblescientific evidence” that REMUNE® would be safe and effective under theconditions of proposed use in Thailand. Furthermore, the Thai FDA must (i)formally request the FDA to approve export of REMUNE® to Thailand, (ii) certifyto the FDA that it is aware that REMUNE® is not approved in the United Statesor in any of several other countries with comprehensive drug review and approvalsystems and (iii) concur that the scientific evidence presented to the FDA is“credible scientific evidence that REMUNE® will be reasonably safe andeffective” for use in Thailand. There can be no assurance, however, that wewill successfully meet any or all of these requirements for the export ofREMUNE®, and if we are unable to successfully meet all regulatory requirements,we will not be permitted by the FDA to export REMUNE® to Thailand for clinicaluse, even if the Thai government were to approve REMUNE® for such use. Therecan be no assurance that Trinity, our collaborative partner, will be successfulin its capacity or efforts to obtain regulatory approval from the Thai FDA.

 

**Technological Change And CompetitionMay Render Our Potential Products Obsolete**

The pharmaceutical andbiotechnology industries continue to undergo rapid change, and competition isintense and is expected to increase. Competitors may succeed in developingtechnologies and products that are more effective or affordable than any thatwe are developing or that would render our technology and products obsolete ornoncompetitive. Many of our competitors have substantially greater experience,financial and technical resources and production, marketing and developmentcapabilities than us. Accordingly, some of our competitors may succeed inobtaining regulatory approval for products more rapidly or effectively than us,or technologies and products that are more effective and affordable than anythat we are developing.

 

**Our Lack Of Commercial ManufacturingAnd Marketing Experience May Prevent Us From Successfully CommercializingProducts**

We have notmanufactured any of our products in commercial quantities. We may notsuccessfully make the transition from manufacturing clinical trial quantitiesto commercial production quantities or be able to arrange for contractmanufacturing and this could prevent us from commercializing products or limitour profitability from our products. Even if REMUNE® is successfully developedand receives FDA approval, we have not demonstrated the capability tomanufacture REMUNE® in commercial quantities. Except for REMUNE®, we have notdemonstrated the ability to manufacture in large-scale clinical quantities anyof our treatments. We rely on a third party for the final inactivation step ofthe REMUNE® manufacturing process. If the existing manufacturing operationsprove inadequate, there can be no assurance that any arrangement with a thirdparty can be established on a timely basis or that we can establish othermanufacturing capacity on a timely basis.

 

We have no experiencein the sales, marketing and distribution of pharmaceutical or biotechnologyproducts. Thus, our products may not be successfully commercialized even ifthey are developed and approved for commercialization.

 

The manufacturingprocess of our products involves a number of steps and requires compliance withstringent quality control specifications imposed by us and by the FDA.Moreover, our products can be manufactured only in a facility that hasundergone a satisfactory inspection and certification by the FDA. For thesereasons, we would not be able to quickly replace our manufacturing capacity ifwe were unable to use our manufacturing facilities as a result of a fire,natural disaster (including an earthquake), equipment failure or otherdifficulty, or if such facilities are deemed not in compliance with the GMPrequirements, and the noncompliance could not be rapidly rectified.

 

37

----

 

Our inability orreduced capacity to manufacture our products would prevent us from successfullycommercializing our products.

 

We may enter intoarrangements with contract manufacturing companies to expand our own productioncapacity in order to meet requirements for our products, or to attempt toimprove manufacturing efficiency. If we choose to contract for manufacturingservices, we may encounter costs, delays and/or other difficulties inproducing, packaging and distributing our clinical trials and finished product.Further, contract manufacturers must also operate in compliance with the GMPrequirements; failure to do so could result in, among other things, thedisruption of our product supplies. Our potential dependence upon third partiesfor the manufacture of our products may adversely affect our profit margins andour ability to develop and deliver products on a timely and competitive basis.

 

**Our Other Therapies And TechnologiesHave Been Halted At Early Stages Of Development, Thus We Are Dependent Upon TheSuccess Of REMUNE®**

In September 2002, weannounced a restructuring program which includes focusing our core competenciesand financial resources on REMUNE®. As part of the restructuring, thedevelopment of our other therapies and technologies, which were at earlierstages of development than REMUNE® and have not yet been shown to be safe oreffective, has been halted. Our other therapies and technologies might never befully developed and if they are they might never receive regulatory approval.  Thus, we are completely dependent upon thesuccess of REMUNE® and there can be no assurance that we will be successful indeveloping or commercializing this product.

 

**Adverse Determinations ConcerningProduct Pricing, Reimbursement and Related Matters Could Prevent Us FromSuccessfully Commercializing REMUNE® Or Any Of Our Other Products**

Our ability to earnsufficient revenue on REMUNE® or any other of our products will depend in parton the extent to which reimbursement for the costs of the products and relatedtreatments will be available from government health administration authorities,private health coverage insurers, managed care organizations and otherorganizations. Failure to obtain appropriate reimbursement may prevent us fromsuccessfully commercializing REMUNE® or any of our other products. Third-partypayers are increasingly challenging the prices of medical products andservices. If purchasers or users of REMUNE® or any of our other products arenot able to obtain adequate reimbursement for the cost of using the products,they may forego or reduce their use. Significant uncertainty exists as to thereimbursement status of newly approved health care products and whetheradequate third party coverage will be available.

 

**Our Success May Depend Upon The AcceptanceOf REMUNE® By The Medical And HIV-Activist Communities**

Our ability to marketand commercialize REMUNE® depends on the acceptance and utilization of REMUNE®by the medical and HIV-activist communities. We will need to developcommercialization initiatives designed to increase awareness about us andREMUNE® among targeted audiences, including public health and AIDS activistsand community-based outreach groups in addition to the investment community.Currently, we have not developed any such initiatives. Without such acceptanceof REMUNE®, the product upon which we are completely dependent, we may not beable to successfully commercialize REMUNE® or generate revenue.

 

**Product Liability Exposure May ExposeUs To Significant Liability**

We face an inherent businessrisk of exposure to product liability and other claims and lawsuits in theevent that the development or use of our technology or prospective products isalleged to have resulted in adverse effects. We may not be able to avoidsignificant liability exposure. We may not have sufficient insurance coverage,and we may not be able to obtain sufficient coverage at a reasonable cost. Aninability to obtain product liability insurance at acceptable cost or tootherwise protect against potential product liability claims could prevent orinhibit the commercialization of our products. A product liability claim couldhurt our financial performance. Even if we avoid liability exposure,significant costs could be incurred that could hurt our financial performance.

 

**If We Lose Our Key Personnel Or AreUnable To Attract And Retain Additional Personnel, We May Be Unable ToSuccessfully Develop Our Technology**

On May 21, 2002, weannounced that Howard Sampson resigned as our Vice President of Finance, ChiefFinancial Officer, Secretary and Treasurer. Subsequently, on June 21, 2002, we announced the appointment of MichaelL. Jeub as Vice President of Finance, Chief Financial Officer, Secretary andTreasurer. In September 2002, Dr. Carlo resigned as our Chief Executive Officerand President.  On January 7, 2003,after a four-month search, we appointedJohn N. Bonfiglio, Ph.D., as our Chief Executive Officer.  On January 13, 2003, we announced thatRonald B. Moss resigned as our President. There can be no assurances that we will not lose additional members ofour executive management team or, if so, whether we would be able to hireadequate replacements for any such individuals.

 

Additionally, ourability to conduct business, raise additional financing and commercialize REMUNE®or our other products may be hindered if we lose additional executive officersor experienced personnel with historical

 

38

----

 

knowledge of ourbusiness, transactions, science and technology.  Currently, our most experienced executive officer has been withus for less than one year.

 

In addition,recruiting and retaining qualified scientific personnel to assist in scaling upour manufacturing facilities and performing future research and developmentwork will be critical to our success. It has been particularly difficult for usto retain personnel in light of the performance of our common stock and theincurrence of substantial net operating losses. We do not have sufficientpersonnel to fully execute our business plan, and there is currently a shortageof skilled executives and scientists, which is likely to continue. As a result,competition for experienced executives and scientists from numerous companiesand academic and other research institutions may limit our ability to hire orretain new executives and other qualified personnel on acceptable terms. If wefail to attract and retain sufficient qualified personnel, we may not be ableto develop or implement our technology.

 

**Hazardous Materials And EnvironmentalMatters Could Expose Us To Significant Costs**

We may be required toincur significant costs to comply with current or future environmental laws andregulations. Although we do not currently manufacture commercial quantities ofour product candidates, we produce limited quantities of these products for ourclinical trials. Our research and development and manufacturing processesinvolve the controlled storage, use and disposal of hazardous materials,biological hazardous materials and radioactive compounds. We are subject tofederal, state and local laws and regulations governing the use, manufacture,storage, handling and disposal of these materials and some waste products.Although we believe that our safety procedures for handling and disposing of thesematerials comply with the standards prescribed by these laws and regulations,the risk of contamination or injury from these materials cannot be completelyeliminated. In the event of an incident, we could be held liable for anydamages that result, and any liability could exceed our resources. Current orfuture environmental laws or regulations may have a material adverse effect onour operations, business and assets.

 

**Volatility Of Our Stock Price AndAbsence Of Dividends May Hurt Our Security Holders**

The market price ofour common stock has been and is likely to continue to be highly volatile.Factors such as the following could have a significant adverse impact on themarket price of our common stock and Class A and Class B warrants:

 

• our ability to obtain additional financing and, if available, the termsand conditions of the financing;

• our financial position and results of operations;

• the results of preclinical studies and clinical trials by us, ourcollaborators or our competitors;

• concern as to, or other evidence of, the safety or efficacy of ourproducts or our competitors’ products;

• announcements of technological innovations or new products by us or ourcompetitors;

• U.S. and foreign governmental regulatory actions;

• actual or anticipated changes in drug reimbursement policies;

• developments with our collaborators;

• developments concerning patent or other proprietary rights of ours orour competitors (including litigation);

• status of litigation;

A • period-to-period fluctuation in our operatingresults;

• changes in estimates of our performance by any securities analysts;

• new regulatory requirements and changes in the existing regulatoryenvironment;

• market conditions for biopharmaceutical stocks in general; and

• other factors not within our control.

 

We have never paidcash dividends on our common stock and do not anticipate paying any cashdividends in the foreseeable future.

 

**Changes To Financial AccountingStandards May Affect Our Reported Results Of Operations**

We prepare ourfinancial statements in conformity with accounting principles generallyaccepted in the United States, or GAAP. GAAP are subject to interpretation bythe American Institute of Certified Public Accountants, the SEC and variousbodies formed to interpret and create appropriate accounting policies. A changein those policies can have a significant effect on our reported results and mayeven affect our reporting of transactions completed before a change isannounced. Accounting policies affecting many other aspects of our business,including rules relating to the carrying value of long-lived assets, employeestock option grants and revenue recognition have recently been revised or areunder review. Changes to those rules or the questioning of current practicesmay adversely affect our reported financial results or the way we conduct ourbusiness. In addition, our preparation of financial statements in accordancewith GAAP requires that we make estimates and assumptions that affect therecorded amounts of assets and liabilities, disclosure of those assets andliabilities at the date of the financial statements and the recorded amounts ofexpenses during the reporting period. A change in the facts and circumstancessurrounding those estimates could result in a change to our estimates and couldimpact our future operating results. Additionally, certain provisions of theSarbanes-Oxley Act of 2002 will impact our business. In

 

39

----

 

particular, thecreation by the SEC of an independent accounting oversight board to oversee andregulate audits will affect us and all public companies.

 

**Our Certificate of Incorporation AndBylaws Include Provisions That Could Make Attempts By Stockholders To ChangeManagement More Difficult**

The approval of 662/3 percent of our voting stock is required toapprove certain transactions and to take certain stockholder actions, includingthe calling of special meetings of stockholders and the amendment of any of theanti-takeover provisions, such as those providing for a classified board ofdirectors, contained in our certificate of incorporation. Further, pursuant tothe terms of our stockholder rights plan, we have distributed a dividend of oneright for each outstanding share of common stock. These rights will causesubstantial dilution to the ownership of a person or group that attempts toacquire us on terms not approved by our Board of Directors and may have theeffect of deterring hostile takeover attempts. The substantial aggregate equitypositions of Mr. Kimberlin and his affiliates and/or related parties would makesuch hostile takeover attempts very unlikely. The practical effect of theseprovisions is to require a party seeking control of us to negotiate with ourBoard of Directors, which could delay or prevent a change in control. Theseprovisions could limit the price that investors might be willing to pay in thefuture for our securities and make attempts by stockholders to changemanagement more difficult.

 

We are subject to theanti-takeover provisions of Section 203 of the Delaware General CorporationLaw, which prohibits us from engaging in a “business combination” with an“interested stockholder” for a period of three years after the date of thetransaction in which the person first becomes an “interested stockholder,”unless the business combination is approved in a prescribed manner. Theapplication of Section 203 also could have the effect of delaying or preventinga change of control.

 

**There May Be Risks Related To OurPrevious Use Of Arthur Andersen LLP As Our Independent Auditors**

On March 14, 2002,Arthur Andersen LLP, our independent public auditor, was indicted on federalobstruction of justice charges arising from the federal government’sinvestigation of Enron Corporation. On June 15, 2002, Arthur Andersen wasconvicted of these charges. Although we have engaged BDO Seidman, LLP,effective as of August 5, 2002, to replace Arthur Andersen as our independentpublic auditors, there are certain risks related to our consolidated financialstatements for the fiscal year ended December 31, 2000, which was auditedby Arthur Andersen. The SEC has said that it will continue accepting financialstatements audited by Arthur Andersen as long as a reasonable effort is made tohave Arthur Andersen reissue its reports and to obtain a manually signedaccountant’s report from Arthur Andersen. Former representatives of ArthurAndersen have notified us that Arthur Andersen is no longer able to reissue itsreports because the firm is no longer in existence.

 

Our currentindependent auditor, BDO Seidman, LLP, informed us that it discovered certainmisclassifications of certain convertible notes issued by us to a related partyin the financial statements included in our Annual Report on Form 10-K, asamended by Amendment No. 1 to Form 10-K, for the fiscal year ended December 31,2001. As a result of this misclassification, BDO Seidman, LLP re-audited ourfinancial statements and we have restated certain financial informationcontained in our Form 10-K/A for the fiscal year ended 2001. We also haverestated certain financial information contained in our Quarterly Report onForm 10-Q for the quarterly period ended March 31, 2002 by filing Amendment No.1 to the Quarterly Report. Certain amounts were incorrectly classified as debtrather than equity.

 

Certain investors,including significant funds and institutional investors, may choose not to holdor invest in securities of a company that does not have current financialreports available. Our access to the capital markets and our ability to maketimely filings with the SEC could be impaired if the SEC ceases acceptingfinancial statements from a prior period audited by Arthur Andersen for whichArthur Andersen will not reissue an audit report. In that case, we would not beable to access the public capital markets unless another independent accountingfirm is able to audit the financial statements originally audited by ArthurAndersen. Any delay or inability to access the public capital markets caused bythese circumstances would be disruptive and adversely affect the price andliquidity of our securities and would have a material adverse effect on ourbusiness and financial condition.

 

## **Item** **3.****          ****Quantitativeand Qualitative Disclosures about Market Risk**

 

We invest our excess cash primarily in U.S. government securities andmoney market accounts.  Theseinstruments have maturities of two years or less when acquired.  We do not utilize derivative financialinstruments, derivative commodity instruments or other market risk sensitiveinstruments, positions or transactions. Accordingly, we believe that, while the instruments we hold are subjectto changes in the financial standing of the issuer of such securities, we arenot subject to any material risks arising from changes in interest rates,foreign currency exchange rates, commodity prices, equity prices or othermarket changes that affect market risk sensitive instruments.

 

40

----

 

**Item 4.****           Controls and Procedures**

 

*Evaluation of disclosure controls and procedures****.*** We maintain “disclosure controls and procedures,” as such term isdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934 (the “Exchange Act”), that are designed to ensure that informationrequired to be disclosed by us in reports that we file or submit under theExchange Act is recorded, processed, summarized, and reported within the timeperiods specified in Securities and Exchange Commission rules and forms, andthat such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating our disclosurecontrols and procedures, management recognized that disclosure controls andprocedures, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the disclosurecontrols and procedures are met. Additionally, in designing disclosure controls and procedures, ourmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible disclosure controls and procedures.  The design of any disclosure controls andprocedures also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

 

Based on their evaluation as of the endof the period covered by this Quarterly Report on Form 10-Q, our ChiefExecutive Officer and Chief Financial Officer have concluded that, subject tothe limitations noted above, our disclosure controls and procedures wereeffective to ensure that material information relating to us, including ourconsolidated subsidiaries, is made known to them by others within thoseentities, particularly during the period in which this Quarterly Report on Form10-Q was being prepared.

 

*Changesin internal control over financial reporting*. There were no significant changes in ourinternal control over financial reporting or, to our knowledge, in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

41

----

 

###### **PART II.****  OTHERINFORMATION**

 

**Item 1.****           Legal Proceedings**

 

From time to time, the Company is subject to various claims andlitigation incidental to our business activities. Since July 2001, several complaints have been filed in the United StatesDistrict Court for the Southern District of California seeking an unspecifiedamount of damages on behalf of an alleged class of persons, who purchasedshares of our common stock at various times between May 17, 1999 and July 6,2001.  The various complaints name usand certain of our officers as defendants, as well as Agouron Pharmaceuticals,Inc. and one of its officers.  Thecomplaints allege that we, Agouron and/or such officers violated federalsecurities laws by misrepresenting and failing to disclose certain informationabout the results of clinical trials of REMUNE®.  The complaints have been consolidated byorder of the Court and a consolidated amended complaint has been filed. We havenot yet formally responded to the consolidated amended complaint.  Although we intend to vigorously defend theactions, we do not believe it is feasible to predict or determine the outcomeor resolution of these proceedings, or to estimate the amounts of, or potentialrange of, loss with respect to these proceedings.  In addition, the timing of the final resolution of theseproceedings is uncertain.  The range ofpossible resolutions of these proceedings could include judgments against us orour officers or settlements that could require substantial payments by us,which could have a material adverse impact on our financial position, resultsof operations and cash flows.  Theseproceedings also might require substantial attention of our management team andtherefore divert their time and attention from our business and operations.

 

On July 23, 2003 Respimun Associates Ltd., our landlord, filed acomplaint against us in Superior Court of California.  The complaint alleges a breach of contract for the payment ofrent at our former headquarters facility in Carlsbad, California ($79,385 permonth plus late charges and other amounts). We intend to defend the claim. However, we have accrued approximately $700,000 to cover a potentialsettlement.

 

**Item 2.****           Changes in Securities and Use of Proceeds**

 

On March 17, 2003, we issued to a consultant for services renderedwarrants to purchase up to an aggregate of 50,000 shares of our commonstock.  The warrants have an exerciseprice of $2.50 per share as to 25,000 shares and an exercise price of $3.50 pershare as to the remaining 25,000 shares.

 

On May 9, May 15 and June 6, 2003, we issued to Cheshire AssociatesLLC, an affiliate of one of our directors and principal stockholder, Mr. KevinKimberlin, short-term convertible promissory notes in the aggregate amount of$1.9 million, bearing interest at the rate of 8% per annum.   The notes are convertible into such othersecurities that we may offer in the future by means of a private placement toaccredited investors.  At a specialmeeting of our stockholders held on July 7, 2003, we received stockholderapproval to conduct a private offering of up to $5.0 million of Series AConvertible Preferred Stock.  Theholders of shares of our Series A Convertible Preferred Stock will have theright to convert each share of Series A Convertible Preferred Stock into sharesof our common stock.  CheshireAssociates may convert all of the convertible promissory notes issued to thembetween January 1, 2003 and July 7, 2003 into shares of Series A ConvertiblePreferred Stock.  The Series AConvertible Preferred Stock will receive dividends in preference to anydividend issued to holders of shares of our common stock.  Additionally, the holders of shares of ourSeries A Convertible Preferred Stock are entitled to liquidationpreference.  As of July 31, 2003, wehave not commenced the offering.

 

On June 3, 2003, we issued to Cheshire AssociatesLLC, 1,613,572 shares of our common stock on conversion of an aggregate of $4.2million of convertible promissory notes plus interest which were issued to themon November 9, 2001, February 14, 2002 and May 3, 2002, respectively.  Two convertible promissory notes dated as ofJuly 7, 2003 in the amounts of approximately $2.4 million and $1.4 million wereissued to Cheshire AssociatesLLC for the remaining debt and interest owed under the partially converted May3, 2002 note.  The $2.4 million note wassubsequently surrendered for cancellation as payment for the exercise ofcertain Class A Warrants.   The $1.4million note bears interest at the rate of 8% per annum and is convertible into1,006,986 shares of our common stock at a price of $1.457 per share (which wasthe closing price of our common stock on May 2, 2003).

 

On June 23, 2003, we issued 166,665 shares of our common stock as adiscount on the loan in connection with a private placement with accreditedinvestors of $1.0 million of short-term unsecured promissory notes. Inconnection with the private placement, we issued to our placement agentswarrants to purchase up to 8,933 shares of our common stock with an exerciseprice of $2.00 per share.

 

## Theissuances of these securities shares were completed in reliance upon the safeharbors provided by Section 4(2) of the Securities Act of 1933.

##  

42

----

 

## **Item 4.****          ****Submission of Matters to a Vote of Security Holders**

 

On May 20, 2003, the Company held its Annual Meeting ofStockholders.  There were issued andoutstanding on April 21, 2003, the record date, 19,670,729 shares ofcommon stock.  There were present at themeeting in person or by proxy, stockholders of the Company who were the holdersof 12,603,146 shares of common stock entitled to vote, constituting aquorum.  The following actions weretaken at the meeting:

 

1.                                       Thefollowing Class II director was elected:Alan S. Rosenthal, M.D. 12,488,905 shares were voted in favor of the nominee,113,742 shares withheld their vote.

 

2.                                       Theadoption of the Company’s 2003 Stock Plan was approved and ratified.  Shares voted for the proposal were12,282,758, with 281,054 shares voted against, 39,334 shares abstained.

 

3.                                       Theproposal to issue Convertible Notes and Warrants in connection with theCompany’s proposed private placement was approved.  Shares voted for the proposal were 6,333,681, with 212,391 sharesvoted against, 23,780 shares abstained and 6,033,294 were broker non-votes.

 

4.                                       Theselection of BDO Seidman, LLP as the Company’s independent auditors wasratified. Shares voted for the proposal were 12,557,160, with 31,336 sharesvoted against, 14,650 shares abstained.

 

On July 7, 2003, the Company held a special meeting ofStockholders.  There were issued andoutstanding on June 12, 2003, the record date, 21,284,301 shares of commonstock.  There were present at themeeting in person or by proxy, stockholders of the Company who were the holdersof 10,858,467 shares of common stock entitled to vote, constituting a quorum.  The following actions were taken at themeeting:

 

1.                                       Anamendment to the Company’s restated Certificate of Incorporation to increasethe number of authorized shares of preferred stock was approved. Shares votedfor the amendment were 10,674,663, with 164,787 shares voted against, 18,917shares abstained and 282,586 were broker non-votes.

 

2.                                       Theproposal to revise terms and conditions for certain holders of shares of commonstock and Class A warrants of the Company in connection with the Company’sprivate placement completed in December 2002 was approved. Shares voted for theproposal were 10,701,168, with 132,509 shares against, 24,490 shares abstainedand 300 were broker non-votes.

 

3.                                       Theproposal to issue up to $5.0 million shares of Series A Convertible PreferredStock in connection with the Company’s proposed private placement was approved.The holders will have the right to convert each share into shares of commonstock. Shares voted for the proposal were 10,699,904, with 142,273 shares votedagainst, 16,190 shares abstained and 100 were broker non-votes.

 

## **Item 5.****          ****Other Information**

 

The Chief Executive Officer and Chief Financial Officer of the Companyhave certified that the Quarterly Report of the Company and Form 10-Q for thequarterly period ended June 30, 2003 fully complies with the requirements of section 13(a) or 15(d)of the Securities Exchange Act of 1934 (15 U.S.C. (ss) 78m or (ss) 78o(d)) andthat information contained in such report fairly presents, in all materialrespects, the financial condition and results of operations of the Company.

 

43

----

 

## **Item 6.****          ****Exhibits and Reports on Form 8-K**

 

a)                   Exhibits

 
| **Exhibit  Number** |   | **Description of Document**                                                                                                                         |
|---------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                |
| 10.137              |   |                                                                                                                                                | Consulting Agreement  dated May 30, 2003 by and between the Company,Randall Letcavage and Rosemary  Nguyen (1) |
|                |   |                                                                                                                                                |   |
| 10.138              |   |                                                                                                                                                | Consultant Agreement  dated June 4, 2003 by and between the Company and CEO Cast, Inc. (2) |
|                |   |                                                                                                                                                |   |
| 10.139              |   |                                                                                                                                                | 8% Convertible  Promissory Note dated as of May 9, 2003 |
|                |   |                                                                                                                                                |   |
| 10.140              |   |                                                                                                                                                | 8% Convertible  Promissory Note dated as of May 15, 2003 |
|                |   |                                                                                                                                                |   |
| 10.141              |   |                                                                                                                                                | 8% Convertible  Promissory Note dated as of June 6, 2003 |
|                |   |                                                                                                                                                |   |
| 10.142              |   |                                                                                                                                                | Purchase Agreement  dated June 23, 2003 by and among the Company and the Investors listed on  Exhibit A thereto. |
|                |   |                                                                                                                                                |   |
| 10.143              |   |                                                                                                                                                | Registration Rights  Agreement dated June 23, 2003 by and among the Company and the Investors  listed on Exhibit A to the Purchase Agreement dated June 23, 2003. |
|                |   |                                                                                                                                                |   |
| 10.144              |   |                                                                                                                                                | Form of 12%  Promissory Note dated June 23, 2003 issued to Investors listed on Exhibit A  to the Purchase Agreement dated June 23, 2003. |
|                |   |                                                                                                                                                |
| 31.1                |   | Certification of the  Chief Executive Officer of the Company pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934.                 |
| 31.2                |   | Certification of the  Chief Financial Officer of the Company pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934.                 |
| 32.1                |   | Certification  furnished pursuant to Section 1350 of Chapter 63 of 18 U.S.C. as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2                |   | Certification  furnished pursuant to Section 1350 of Chapter 63 of 18 U.S.C. as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

----

(1)  Incorporated by reference to exhibit 10.1 to theCompany’s Registration Statement on Form S-8 filed July 7, 2003

 

(2)  Incorporated by reference to exhibit 10.2 to theCompany’s Registration Statement on Form S-8 filed July 7, 2003

 

b)                                     Reportson Form 8-K

 

None

 

44

----

 

**SIGNATURE**

 

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

 

 
|                         |   | THE IMMUNE RESPONSE CORPORATION                       |
|------------------------------|--------|-------------------------------------------------------|
|                         |   |                                                  |
|                         |   |                                                  |
| Date:  August  19, 2003 |   | /s/ Michael L. Jeub                                   |
|                         |   | Michael L. Jeub                                       |
|                         |   | Vice President of Finance and Chief Financial Officer |

 

45

----