UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





x
            QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the quarterly period ended September 30, 2009





Or





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the transition period from ___________________to____________________





Commission
file number 001-33874





XCORPOREAL,
INC.


(Exact
name of small business issuer as specified in its charter)





Delaware
            75-2242792(State
      or other jurisdiction of
              incorporation
      or organization)
            (I.R.S.
      Employer Identification No.)





12121
Wilshire Blvd., Suite 350, Los Angeles, California 90025


(Address
of principal executive offices) (Zip Code)





(310)
923-9990


(Registrant’s
telephone number, including area code)





Not
applicable


(Former
name, former address and former fiscal year, if changed since last
report)





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to
submit and post such files).    Yes ̈   No ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.




 ̈
      Large accelerated filer
               ̈ Accelerated filer ̈ Non-accelerated filer  (Do not check if a smaller reporting company)
              þ Smaller reporting company





Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).Yes ̈ NoR





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.





Class
                
                Outstanding
      as of November 12, 2009Common
      Stock, $0.0001 par value
                
                15,154,687
      shares





INDEX





PART
      I — FINANCIAL INFORMATION
                
                2Item
      1. Financial Statements
                
                2Balance
      Sheets at September 30, 2009 (unaudited) and December 31,
    2008
                
                2Statements
      of Operations (unaudited) for the three and nine months ended September
      30, 2009 and September 30, 2008 and the period from inception (May 4,
      2001) to September 30, 2009
                
                3Statements
      of Cash Flows (unaudited) for the nine months ended September 30, 2009 and
      September 30, 2008 and the period from inception (May 4, 2001) to
      September 30, 2009
                
                4Statement
      of Stockholders Equity (Deficit) for the nine months ended September 30,
      2009 and the period from inception (May 4, 2001) to September 30, 2009
      (unaudited)
                
                5Notes
      to the Interim Financial Statements
                
                6Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
                
                18Item
      3. Quantitative and Qualitative Disclosures about Market
    Risk
                
                26Item
      4. Controls and Procedures
                
                27PART
      II — OTHER INFORMATION
                
                28Item
      1. Legal Proceedings
                
                28Item
      1A. Risk Factors
                
                30Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
                
                32Item
      6. Exhibits
                
                33Signatures
                
                34


1





PART
I — FINANCIAL INFORMATION





ITEM
1. Financial Statements





XCORPOREAL,
INC.


(a
Development Stage Company)


BALANCE
SHEETS


(Unaudited)





September 30,
                      
                      
                      December 31,2009
                      
                      
                      2008ASSETSCurrentCash
      and cash equivalents
                      
                      $
                      35,734
                      
                      
                      $
                      407,585Marketable
      securities, at fair value
                      
                      
                      288,703
                      
                      
                      
                      2,955,714Restricted
      cash
                      
                      
                      305,871
                      
                      
                      
                      301,675Prepaid
      expenses and other current assets
                      
                      
                      123,351
                      
                      
                      
                      260,024Expense
      receivable
                      
                      
                      54,641
                      
                      
                      
                      -Tenant
      improvement allowance receivable
                      
                      
                      43,260
                      
                      
                      
                      87,658Total
      Current Assets
                      
                      
                      851,560
                      
                      
                      
                      4,012,656Property
      and equipment, net
                      
                      
                      246,804
                      
                      
                      
                      337,554Other
      assets
                      
                      
                      819
                      
                      
                      
                      863Total
      Assets
                      
                      $
                      1,099,183
                      
                      
                      $
                      4,351,073LIABILITIESCurrentAccounts
      payable
                      
                      $
                      945,385
                      
                      
                      $
                      789,827Accrued
      legal fees and licensing expense
                      
                      
                      1,871,430
                      
                      
                      
                      2,873,396Accrued
      royalties
                      
                      
                      -
                      
                      
                      
                      583,333Accrued
      professional fees
                      
                      
                      442,444
                      
                      
                      
                      211,820Accrued
      compensation
                      
                      
                      143,040
                      
                      
                      
                      149,664Accrued
      other liabilities
                      
                      
                      72,137
                      
                      
                      
                      54,429Payroll
      liabilities
                      
                      
                      1,054
                      
                      
                      
                      7,448Deferred
      compensation
                      
                      
                      171,513
                      
                      
                      
                      -Deferred
      gain
                      
                      
                      200,000
                      
                      
                      
                      -Deferred
      rent
                      
                      
                      280,390
                      
                      
                      
                      148,651Total
      Current Liabilities
                      
                      
                      4,127,393
                      
                      
                      
                      4,818,568Shares
      issuable
                      
                      
                      -
                      
                      
                      
                      1,569,100COMMITMENTS
      & CONTINGENCIESSTOCKHOLDERS'
      DEFICITPreferred
      stock, $0.0001 par value, 10,000,000 shares authorized, none
      outstanding
                      
                      
                      -
                      
                      
                      
                      -Common
      stock, $0.0001 par value, 40,000,000 shares authorized, 15,154,687 and
      14,754,687 issued and outstanding on September 30, 2009 and December 31,
      2008, respectively
                      
                      
                      1,515
                      
                      
                      
                      1,475Additional
      paid-in capital
                      
                      
                      44,328,779
                      
                      
                      
                      42,547,023Deficit
      accumulated during the development stage
                      
                      
                      (47,358,504
                      )
                      
                      
                      (44,585,093
                      )Total
      Stockholders' Deficit
                      
                      
                      (3,028,210
                      )
                      
                      
                      (2,036,595
                      )Total
      Liabilities & Stockholders' Deficit
                      
                      $
                      1,099,183
                      
                      
                      $
                      4,351,073





See
accompanying notes to interim financial statements.


2





XCORPOREAL,
INC.


(a
Development Stage Company)


STATEMENTS
OF OPERATIONS


(Unaudited)





May 4, 2001 (DateThree Months Ended
                    
                    
                    Nine Months Ended
                    
                    
                    of Inception) toSeptember 30,
                    
                    
                    September 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008
                    
                    
                    2009Operating
      Expenses:Selling,
      general and administrative
                    
                    $
                    924,454
                    
                    
                    $
                    2,111,578
                    
                    
                    $
                    3,493,481
                    
                    
                    $
                    7,756,230
                    
                    
                    $
                    26,897,992Research
      and development
                    
                    
                    586,741
                    
                    
                    
                    12,694,055
                    
                    
                    
                    2,415,055
                    
                    
                    
                    18,900,027
                    
                    
                    
                    31,758,372Other
      expenses
                    
                    
                    -
                    
                    
                    
                    1,871,430
                    
                    
                    
                    -
                    
                    
                    
                    1,871,430
                    
                    
                    
                    1,871,430Depreciation
      and amortization
                    
                    
                    30,672
                    
                    
                    
                    27,253
                    
                    
                    
                    92,274
                    
                    
                    
                    75,837
                    
                    
                    
                    229,259Loss
      before other income, income taxes and other expenses
                    
                    
                    (1,541,867
                    )
                    
                    
                    (16,704,316
                    )
                    
                    
                    (6,000,810
                    )
                    
                    
                    (28,603,524
                    )
                    
                    
                    (60,757,053
                    )Reduction
      of liabilities due to arbitrator's ruling & settlement
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,647,799
                    
                    
                    
                    -
                    
                    
                    
                    1,647,799Loss
      on disposal
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (382
                    )
                    
                    
                    -
                    
                    
                    
                    (382
                    )Interest
      and other income
                    
                    
                    915
                    
                    
                    
                    44,871
                    
                    
                    
                    11,657
                    
                    
                    
                    278,941
                    
                    
                    
                    1,602,136Change
      in and reduction of shares issuable
                    
                    
                    -
                    
                    
                    
                    5,538,000
                    
                    
                    
                    1,569,100
                    
                    
                    
                    5,538,000
                    
                    
                    
                    10,153,000Loss
      before income taxes and other expenses
                    
                    
                    (1,540,952
                    )
                    
                    
                    (11,121,445
                    )
                    
                    
                    (2,772,636
                    )
                    
                    
                    (22,786,583
                    )
                    
                    
                    (47,354,500
                    )Income
      taxes
                    
                    
                    -
                    
                    
                    
                    300
                    
                    
                    
                    775
                    
                    
                    
                    1,900
                    
                    
                    
                    4,004Net
      loss
                    
                    $
                    (1,540,952
                    )
                    
                    $
                    (11,121,745
                    )
                    
                    $
                    (2,773,411
                    )
                    
                    $
                    (22,788,483
                    )
                    
                    $
                    (47,358,504
                    )Basic
      and diluted loss per share
                    
                    $
                    (0.10
                    )
                    
                    $
                    (0.76
                    )
                    
                    $
                    (0.19
                    )
                    
                    $
                    (1.57
                    )Weighted
      average number of shares outstanding
                    
                    
                    14,759,035
                    
                    
                    
                    14,704,687
                    
                    
                    
                    14,756,152
                    
                    
                    
                    14,561,070





See
accompanying notes to interim financial statements.


3





XCORPOREAL,
INC.


(a
Development Stage Company)


STATEMENTS
OF CASH FLOWS


(Unaudited)





May 4, 2001 (DateNine Months Ended
                        
                        
                        of Inception) toSeptember 30,
                        
                        
                        September 30,2009
                        
                        
                        2008
                        
                        
                        2009Cash
      flows used in operating activitiesNet
      loss for the period
                        
                        $
                        (2,773,411
                        )
                        
                        $
                        (22,788,483
                        )
                        
                        $
                        (47,358,504
                        )Adjustments
      to reconcile net loss to net cash (used in) operating
      activities:Directors,
      officers, employees stock based compensation
                        
                        
                        1,718,109
                        
                        
                        
                        3,813,158
                        
                        
                        
                        10,407,884Consultants
      stock based compensation
                        
                        
                        3,687
                        
                        
                        
                        92,842
                        
                        
                        
                        5,174,913Common
      stock issuance for consulting services rendered
                        
                        
                        60,000
                        
                        
                        
                        798,000
                        
                        
                        
                        972,000Increase
      in shares issuable
                        
                        
                        -
                        
                        
                        
                        10,153,000
                        
                        
                        
                        10,153,000Mark
      to market of shares issuable
                        
                        
                        (1,569,100
                        )
                        
                        
                        (5,538,000
                        )
                        
                        
                        (10,153,000
                        )Depreciation
                        
                        
                        92,230
                        
                        
                        
                        75,792
                        
                        
                        
                        229,078Net
      change in assets and liabilities:Increase
      in receivables
                        
                        
                        (10,243
                        )
                        
                        
                        -
                        
                        
                        
                        (97,901
                        )Decrease
      (increase) in prepaid expenses and other current assets
                        
                        
                        136,673
                        
                        
                        
                        107,830
                        
                        
                        
                        (123,351
                        )Decrease
      (increase) in other assets
                        
                        
                        44
                        
                        
                        
                        45
                        
                        
                        
                        (819
                        )(Decrease)
      increase in accounts payable and accrued liabilities
                        
                        
                        (1,194,427
                        )
                        
                        
                        2,859,622
                        
                        
                        
                        3,438,119Increase
      in deferred compensation
                        
                        
                        171,513
                        
                        
                        
                        -
                        
                        
                        
                        171,513Increase
      in deferred gain
                        
                        
                        200,000
                        
                        
                        
                        -
                        
                        
                        
                        200,000Increase
      in deferred rent
                        
                        
                        131,739
                        
                        
                        
                        40,929
                        
                        
                        
                        280,390Net
      cash used in operating activities
                        
                        
                        (3,033,186
                        )
                        
                        
                        (10,385,265
                        )
                        
                        
                        (26,706,678
                        )Cash
      flows from investing activitiesCapital
      expenditures
                        
                        
                        (1,480
                        )
                        
                        
                        (113,629
                        )
                        
                        
                        (475,882
                        )Restricted
      cash
                        
                        
                        (4,196
                        )
                        
                        
                        228
                        
                        
                        
                        (305,871
                        )Purchase
      of marketable securities
                        
                        
                        (22,044,286
                        )
                        
                        
                        (8,598,102
                        )
                        
                        
                        (55,642,388
                        )Sale
      of marketable securities
                        
                        
                        24,711,297
                        
                        
                        
                        19,243,315
                        
                        
                        
                        55,353,685Net
      cash provided by (used in) investing activities
                        
                        
                        2,661,335
                        
                        
                        
                        10,531,812
                        
                        
                        
                        (1,070,456
                        )Cash
      flows from financing activitiesCapital
      stock issued
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        27,549,748Advances
      from related party
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        64,620Additional
      proceeds from the sale of common stock in 2006
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        198,500Net
      cash provided by financing activities
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        27,812,868(Decrease)
      increase in cash during the period
                        
                        
                        (371,851
                        )
                        
                        
                        146,547
                        
                        
                        
                        35,734Cash
      at beginning of the period
                        
                        
                        407,585
                        
                        
                        
                        106,495
                        
                        
                        
                        -Cash
      at end of the period
                        
                        $
                        35,734
                        
                        
                        $
                        253,042
                        
                        
                        $
                        35,734Supplemental
      disclosure of cash flow information; cash paid for:Interest
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -Income
      taxes
                        
                        $
                        775
                        
                        
                        $
                        1,900
                        
                        
                        $
                        4,004





See
accompanying notes to interim financial statements.


4





XCORPOREAL,
INC.


(a
Development Stage Company)


STATEMENTS
OF STOCKHOLDERS’ EQUITY (DEFICIT)


For
the Period May 4, 2001 (Inception) to September 30, 2009


(Unaudited)





DeficitAccumulatedAdditional
                                        
                                        
                                        DuringCommon Stock
                                        
                                        
                                        Paid-in
                                        
                                        
                                        DevelopmentShares
                                        
                                        
                                        Amount
                                        
                                        
                                        Capital
                                        
                                        
                                        Stage
                                        
                                        
                                        TotalCommon
      stock issued for cash at $0.01 per share
                                        
                                        
                                        2,500,000
                                        
                                        
                                        $
                                        250
                                        
                                        
                                        $
                                        24,750
                                        
                                        
                                        
                                        
                                        
                                        $
                                        25,000Net
      Loss for the year ended December 31, 2001
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        (40,255
                                        )
                                        
                                        
                                        (40,255
                                        )Balance
      as of December 31, 2001
                                        
                                        
                                        2,500,000
                                        
                                        
                                        
                                        250
                                        
                                        
                                        
                                        24,750
                                        
                                        
                                        
                                        (40,255
                                        )
                                        
                                        
                                        (15,255
                                        )Common
      stock issued for cash at $0.05 per share
                                        
                                        
                                        1,320,000
                                        
                                        
                                        
                                        132
                                        
                                        
                                        
                                        65,868
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        66,000Net
      Loss for the year ended December 31, 2002
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (31,249
                                        )
                                        
                                        
                                        (31,249
                                        )Balance
      as of December 31, 2002
                                        
                                        
                                        3,820,000
                                        
                                        
                                        
                                        382
                                        
                                        
                                        
                                        90,618
                                        
                                        
                                        
                                        (71,504
                                        )
                                        
                                        
                                        19,496Net
      Loss for the year ended December 31, 2003
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (12,962
                                        )
                                        
                                        
                                        (12,962
                                        )Balance
      as of December 31, 2003
                                        
                                        
                                        3,820,000
                                        
                                        
                                        
                                        382
                                        
                                        
                                        
                                        90,618
                                        
                                        
                                        
                                        (84,466
                                        )
                                        
                                        
                                        6,534Net
      Loss for the year ended December 31, 2004
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (23,338
                                        )
                                        
                                        
                                        (23,338
                                        )Balance
      as of December 31, 2004
                                        
                                        
                                        3,820,000
                                        
                                        
                                        
                                        382
                                        
                                        
                                        
                                        90,618
                                        
                                        
                                        
                                        (107,804
                                        )
                                        
                                        
                                        (16,804
                                        )Net
      Loss for the year ended December 31, 2005
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (35,753
                                        )
                                        
                                        
                                        (35,753
                                        )Balance
      as of December 31, 2005
                                        
                                        
                                        3,820,000
                                        
                                        
                                        
                                        382
                                        
                                        
                                        
                                        90,618
                                        
                                        
                                        
                                        (143,557
                                        )
                                        
                                        
                                        (52,557
                                        )Common
      stock issued for license rights at $0.0001 per share
                                        
                                        
                                        9,600,000
                                        
                                        
                                        
                                        960
                                        
                                        
                                        
                                        40
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,000Capital
      stock cancelled
                                        
                                        
                                        (3,420,000
                                        )
                                        
                                        
                                        (342
                                        )
                                        
                                        
                                        342
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Warrants
      granted for consulting fees
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,162,611
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,162,611Forgiveness
      of related party debt
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        64,620
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        64,620Common
      stock issued for cash at $7.00, net of placement fees of
      $2,058,024
                                        
                                        
                                        4,200,050
                                        
                                        
                                        
                                        420
                                        
                                        
                                        
                                        27,341,928
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        27,342,348Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        88,122
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        88,122Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        176,129
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        176,129Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (4,380,212
                                        )
                                        
                                        
                                        (4,380,212
                                        )Balance
      as of December 31, 2006
                                        
                                        
                                        14,200,050
                                        
                                        
                                        
                                        1,420
                                        
                                        
                                        
                                        29,924,410
                                        
                                        
                                        
                                        (4,523,769
                                        )
                                        
                                        
                                        25,402,061Capital
      stock cancelled
                                        
                                        
                                        (200,000
                                        )
                                        
                                        
                                        (20
                                        )
                                        
                                        
                                        20
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Common
      stock issued pursuant to consulting agreement at $4.90 per
      share
                                        
                                        
                                        20,000
                                        
                                        
                                        
                                        2
                                        
                                        
                                        
                                        97,998
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        98,000Recapitalization
      pursuant to merger
                                        
                                        
                                        352,422
                                        
                                        
                                        
                                        35
                                        
                                        
                                        
                                        (37,406
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        (37,371
                                        )Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,917,309
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,917,309Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        3,721,485
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        3,721,485Additional
      proceeds from the sale of common stock in 2006
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        198,500
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        198,500Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (17,074,051
                                        )
                                        
                                        
                                        (17,074,051
                                        )Balance
      as of December 31, 2007
                                        
                                        
                                        14,372,472
                                        
                                        
                                        
                                        1,437
                                        
                                        
                                        
                                        36,822,316
                                        
                                        
                                        
                                        (21,597,820
                                        )
                                        
                                        
                                        15,225,933Common
      stock issued as compensation for consulting services at $3.61 per
      share
                                        
                                        
                                        200,000
                                        
                                        
                                        
                                        20
                                        
                                        
                                        
                                        721,980
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        722,000Common
      stock issued as compensation for consulting services at $3.80 per
      share
                                        
                                        
                                        20,000
                                        
                                        
                                        
                                        2
                                        
                                        
                                        
                                        75,998
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        76,000Cashless
      exercise of warrants
                                        
                                        
                                        112,215
                                        
                                        
                                        
                                        11
                                        
                                        
                                        
                                        (11
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Common
      stock issued as compensation for consulting services at $0.32 per
      share
                                        
                                        
                                        50,000
                                        
                                        
                                        
                                        5
                                        
                                        
                                        
                                        15,995
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        16,000Reversal
      of liability from the sale of common stock in 2006
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        115,400
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        115,400Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        91,306
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        91,306Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        4,704,039
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        4,704,039Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (22,987,273
                                        )
                                        
                                        
                                        (22,987,273
                                        )Balance
      as of December 31, 2008
                                        
                                        
                                        14,754,687
                                        
                                        
                                        
                                        1,475
                                        
                                        
                                        
                                        42,547,023
                                        
                                        
                                        
                                        (44,585,093
                                        )
                                        
                                        
                                        (2,036,595
                                        )Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,771
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,771Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        385,848
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        385,848Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (176,830
                                        )
                                        
                                        
                                        (176,830
                                        )Balance
      as of March 31, 2009
                                        
                                        
                                        14,754,687
                                        
                                        
                                        $
                                        1,475
                                        
                                        
                                        $
                                        42,934,642
                                        
                                        
                                        $
                                        (44,761,923
                                        )
                                        
                                        $
                                        (1,825,806
                                        )Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,895
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,895Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        661,780
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        661,780Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (1,055,629
                                        )
                                        
                                        
                                        (1,055,629
                                        )Balance
      as of June 30, 2009
                                        
                                        
                                        14,754,687
                                        
                                        
                                        $
                                        1,475
                                        
                                        
                                        $
                                        43,598,317
                                        
                                        
                                        $
                                        (45,817,552
                                        )
                                        
                                        $
                                        (2,217,760
                                        )Common
      stock issued as compensation for consulting services at $0.15 per
      share
                                        
                                        
                                        400,000
                                        
                                        
                                        
                                        40
                                        
                                        
                                        
                                        59,960
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        60,000Consultants
      stock-based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        21
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        21Directors,
      officers, employees stock based compensation expense
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        670,481
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        670,481Net
      loss for the period
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (1,540,952
                                        )
                                        
                                        
                                        (1,540,952
                                        )Balance
      as of September 30, 2009
                                        
                                        
                                        15,154,687
                                        
                                        
                                        $
                                        1,515
                                        
                                        
                                        $
                                        44,328,779
                                        
                                        
                                        $
                                        (47,358,504
                                        )
                                        
                                        $
                                        (3,028,210
                                        )





See
accompanying notes to interim financial statements


5


XCORPOREAL,
INC.


(a
Development Stage Company)


NOTES
TO INTERIM FINANCIAL STATEMENTS


September
30, 2009


(Unaudited)




Note 1 - Interim Reporting





While information presented in the
accompanying interim financial statements is unaudited, it includes normal and
recurring adjustments, which are, in the opinion of management, necessary to
present fairly the financial position, results of operations, and cash flows for
the interim period presented.





The
results of operations for the period ended September 30, 2009 are not
necessarily indicative of the results that can be expected for the year ending
December 31, 2009.





Note
2 – Nature of Operations and Going Concern Uncertainty





On
October 12, 2007, pursuant to a merger agreement with Xcorporeal, Inc.
(hereinafter referred to as “Operations”), our wholly-owned subsidiary, merged
with and into Operations, which became our wholly-owned subsidiary and changed
its name to “Xcorporeal Operations, Inc.” In connection with the merger, we
changed our name from CT Holdings Enterprises, Inc. (“CTHE”), to “Xcorporeal,
Inc.” In this merger, CTHE was considered to be the legal acquirer and
Xcorporeal to be the accounting acquirer. As the former stockholders of
Operations owned over 97% of the outstanding voting common stock of CTHE
immediately after the merger and CTHE was a public shell company, for accounting
purposes Operations was considered the accounting acquirer and the transaction
was considered to be a recapitalization of Operations. As a result of the
merger, we transitioned to a development stage company focused on researching,
developing, and commercializing technology and products related to the treatment
of kidney failure.





As of
November 12, 2009, we had available cash of approximately $120,000, excluding
restricted cash. We currently have a monthly burn rate of approximately
$116,000. Under these current conditions, we will have sufficient cash
approximately through the next 30 days from November 12, 2009, assuming no
further cash injections are received. In addition to previously taken
restructuring efforts, including reduction of personnel, we also reduced our
cash outflows by means of deferring 50% of the monthly compensation for 5 of our
6 active employees effective July 1, 2009 and currently continue to defer 50% of
the monthly compensation for 3 of our 6 active employees. Two of our engineers
are providing consulting services to a certain third party with which we have
agreed to an exclusivity period to negotiate a potential cooperative transaction
and such third party is fully reimbursing us for our employment expenses of our
two engineers including salaries and overhead. As of September 30, 2009, we
deferred approximately a total of $172,000 in employee compensation, recognized
under “Deferred compensation” on our balance sheet. We will consider, if
feasible, further reduction of our costs and expenses. Therefore, we must raise
additional funds to be able to continue our operations. If we are unable to
secure additional capital within the approximately the next 30 days from
November 12, 2009, we will be forced to file for bankruptcy and/or cease our
operations. The accompanying financial statements have been prepared on the
basis of a going concern and do not reflect any adjustments due to these
conditions.





We are
currently actively considering all potential transactions, which may include the
Proposed Transaction (as described below under Note 4, “Legal Proceedings”),
strategic partnership(s), disposition of substantially all or all of our assets
or a business combination with another entity in a transaction where we would
not be the surviving entity. As part of a potential strategic transaction
we have been considering, we have entered into an arrangement with a certain
third party, with which we have agreed to an exclusivity period to negotiate a
potential cooperative transaction, in exchange for a non-refundable payment of
$200,000 made to us by such third party, recognized under “Deferred gain” as of
September 30, 2009 on our balance sheet. The exclusivity period expires upon the
later of 100 calendar days from September 21, 2009 and the termination date of a
definitive agreement entered into with such third party, if any, at which time
the non-refundable exclusivity payment will be earned and recognized as other
income; however, if a definitive agreement for a transaction is entered into
with such third party prior thereto, the exclusivity payment will be credited
against the purchase price in such transaction. During the exclusivity period,
we will provide to the third party access to our employees, properties,
contracts, records and other related materials. In addition, in the mutual
interests of us and such third party and at the direction of the third party, in
connection with the potential strategic transaction, we actively resumed
research and development of our Portable Artificial Kidney product with direct
reimbursement of related expenditures by such third party. As of September 30,
2009, we incurred and expect reimbursement of approximately $43,000, recognized
under “Expense receivable” on our balance sheet and offset as a credit to our
statement of operations for the three months ended September 30, 2009, for these
expenses. Currently, the exclusivity period remains in effect and negotiations
continue. Among other reasons, due to the current economic conditions and those
particularly affecting healthcare related companies and because of our lack of
liquidity, there is no assurance that any such transaction will occur or that it
would be accretive to our stockholders or result in any payment being made to
our stockholders. If we are unsuccessful in obtaining immediate debt or equity
financing on terms acceptable to us or otherwise unsuccessful in addressing our
liquidity concerns or if we are unable to enter into any such transaction, this
could have a material adverse effect on our plan of operation, may result in the
curtailment of our operations and/or require us to file for
bankruptcy.





The approximate total of $55,000 under
“Expense receivable” recognized and offset as a credit to our statement of
operations as of September 30, 2009, consists of an anticipated payroll tax
refund in the amount of approximately $12,000 pursuant to COBRA premium
assistance payments and the reimbursable research and development expenses in
the amount of approximately $43,000 described above.


6





Effective as of September 4, 2009, our
common stock commenced trading on the Pink Sheets Electronic OTC Market, an
inter-dealer electronic quotation service of securities traded over-the-counter
also known as the Pink Sheets (“Pink Sheets”), under the symbol “XCRP.PK”. In
addition, effective as of the same date, our common stock was suspended from
trading on NYSE Amex LLC (formerly American Stock Exchange) (“Amex”). As part of
our analysis of ways to reduce costs and in light of the high cost of continuing
to be a public reporting company under the Exchange Act and complying with the
Sarbanes-Oxley Act of 2002, we are contemplating exploring and may be required
to explore other alternatives, such as deregistering under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), or “going dark” and
having our common stock continue to be quoted on the Pink Sheets without being a
reporting company under Section 12(g) of the Exchange Act. We are
continuing to evaluate our options. Our recent move to the Pink
Sheets has provided meaningful savings to us as a result of the elimination
of fees associated with being listed on a national stock exchange and
deregistering under the Exchange Act would provide substantial savings as a
result of the elimination of the costs of being registered under the Exchange
Act. Analysis of deregistering under the Exchange Act involves not only
reducing costs, but also our expected sources of future capital as well as the
number of record holders of our outstanding common stock. Subject to our
satisfaction of certain conditions, a move to deregister under the Exchange Act
may result in a less liquid market for our shares, but would result in continued
public trading of our common stock by holders wishing to trade.





We expect to incur negative cash flows
and net losses for the foreseeable future. Based upon our current plans, we
believe that our existing cash reserves will not be sufficient to meet our
current liabilities and other obligations as they become due and payable.
Accordingly, within approximately the next 30 days we will need to seek to
obtain additional debt or equity financing through a public or private placement
of shares of our preferred or common stock or through a public or private
financing or we will need to effect a transaction for the sale or license of
substantially all or all of our assets. Our ability to meet such obligations
will depend on our ability to sell securities, borrow funds, reduce operating
costs, effect a transaction for the sale or license of substantially all or all
of our assets or enter into a business combination with another entity in a
transaction where we would not be the surviving entity or some combination
thereof. We may not be successful in obtaining necessary financing on acceptable
terms, if at all. As of September 30, 2009, we had negative working capital of
$3,275,833, accumulated deficit of $47,358,504, and total stockholders’ deficit
of $3,028,210. Cash used in operations for the nine months ended September 30,
2009 was $3,033,186. As a result of these and other conditions described herein,
there is substantial doubt about our ability to continue as a going concern. The
financial statements filed as part of this Quarterly Report on Form 10-Q do not
include any adjustments that might result from the outcome of this
uncertainty.




Our
operating activities and research and development efforts resulted in a net loss
of $23.0 million in 2008 and $2.8 million during the nine months ended September
30, 2009, including a reduction in arbitration liabilities of approximately $1.6
million and change in fair value of shares issuable of approximately $1.6
million as a result of the issuance of the Partial Final Award and the execution
of the Agreement and Stipulation Regarding Partial Final Award entered into
among us, Operations and National Quality Care, Inc. (“NQCI”) on August 7, 2009
in connection with the arbitration proceeding between us and NQCI, as more
fully discussed in Note 4, “Legal Proceedings” below. Both the reduction of
$1.6 million in arbitration liabilities and the change in fair value of $1.6
million were non-cash items. In addition, we invested $25.0 million in high
grade money market funds and marketable securities during the first quarter of
2007 and since then, we sold $24.7 million of these investments, leaving a
balance of $0.3 million as of September 30, 2009.




Pursuant
to the terms of the Partial Final Award issued on April 13, 2009, NQCI was
awarded an amount equal to approximately $1.87 million in attorneys’ fees and
costs consistent with the Arbitrator’s order issued on August 13, 2008 related
to the same and NQCI’s application for interim royalties and expenses was
denied. For a further discussion of the Partial Final Award, see Note 4, “Legal
Proceedings” below. We intend to pay the $1.87 million in attorneys’ fees and
costs due to NQCI from the proceeds received in connection with the consummation
of the Proposed Transaction, or another Transaction (each term as defined below
in Note 4, “Legal Proceedings”), if such transaction is consummated, or upon
raising of additional capital to sufficiently satisfy the award and or other
immediate liquidity requirements, which funds we will need to obtain within
approximately the next 30 days from November 12, 2009. Pursuant to the terms of
the Agreement and Stipulation Regarding Partial Final Award entered into in
connection with the Memorandum, as more fully explained below in Note 4, “Legal
Proceedings”, NQCI agreed not to attempt before December 1, 2009 to execute on
or file any motion, petition or application or commence any proceeding seeking
the collection of such award of attorneys’ fees and costs, which is intended to
allow us, Operations and NQCI a sufficient period within which to execute a
definitive agreement in connection for the Proposed Transaction or a
Transaction. Such period shall automatically be extended for a period of 120
days from December 1, 2009 if the acquisition agreement is executed in full on
or before December 1, 2009. In addition, if the execution of the acquisition
agreement occurs on or before December 1, 2009, the December 1, 2009 deadline
shall automatically be further extended for a period of 60 days for each
amendment to a proxy or information statement related to the transactions
contemplated by such definitive agreement, filed by us in response to comments
made by the Securities and Exchange Commission (the “SEC”). However, there can
be no assurances that the Proposed Transaction or any other Transaction will
occur.





We are a
medical device company that has been engaged in developing an innovative extra-corporeal platform
technology to be used in devices to replace the function of various human
organs. We hope that the platform will lead to the following three initial
products: (i) a Portable Artificial Kidney (“PAK”) for attended care Renal
Replacement Therapy, (ii) a PAK for home hemodialysis and (iii) a Wearable
Artificial Kidney (“WAK”) for continuous ambulatory hemodialysis. Our rights to
the WAK derive in part from the License Agreement between Operations and NQCI,
dated as of September 1, 2006 (“License Agreement”), pursuant to which we
obtained a perpetual exclusive license in the Technology. See Note 4, “Legal
Proceedings” below.


7




We have
focused much of our efforts on development of the PAK, which we do not believe
has been derived from the technology covered by the License Agreement. Through
the productive research and development efforts of the PAK, we have completed
functional prototypes of our attended care and home PAKs that we hope to
commercialize after 510(k) notification clearance from the Food and Drug
Administration (“FDA”) which we hope to submit sometime in the future. Prior to
the 510(k) submission to the FDA for clinical use under direct medical
supervision, the units will undergo final verification and validation. It
generally takes 4 to 12 months from the date of a 510(k) submission to obtain
clearance from the FDA, although it may take longer. We hope to begin to shift
out of the development and build phase of the prototype equipment and into
product phase, which should help us to reduce the related spending on research
and development costs as well as consulting and material costs. See Note 15,
“Product Development Agreement” below. With this transition, we hope to shift
available resources towards verification and validation of our devices along
with developing a marketing plan for the PAK. This plan will be dependant on our
ability to raise funds to satisfy our current liabilities and other obligations
as they become due and obtaining additional debt or equity financing and
otherwise continuing our business operations. If we are unsuccessful in doing
so, we will not be able to submit a 510(k) notification with the FDA for this
product.




In addition, we have used some of our
resources for the development of the WAK of which we have demonstrated a
feasibility prototype. Commercialization of the WAK will require development of
a functional prototype and likely a full pre-market approval by the FDA, which
could take several years. Subject to us continuing our business operations
and/or entering into a transaction for the sale of substantially all or all of
our assets or a business combination with another entity in a transaction where
we would not be the surviving entity, we will determine whether to devote
available resources to the development of the WAK.




Because
neither the PAK nor the WAK is yet at a stage where it can be marketed
commercially, we are not able to predict the portion of our future business
which will be derived from each.





Note 3 – Development Stage
Company





We are a
development stage company, devoting substantially all of our efforts to the
research, development, and commercialization of kidney failure treatment
technologies.





Risks and Uncertainties — We
operate in an industry that is subject to intense competition, government
regulation, and rapid technological change. Our operations are subject to
significant risk and uncertainties including financial, operational,
technological, legal, regulatory, and other risks associated with a development
stage company, including the potential risk of business failure.




Note
4 – Legal Proceedings





Partial
Final Award





On
December 1, 2006, Operations initiated the arbitration proceeding (the
“Proceeding”) against NQCI for its breach of the License Agreement. On April 13,
2009, the arbitrator (the “Arbitrator”) issued a Partial Final Award (“Partial
Final Award”) which resolved the remaining issues that were pending for
decision in the Proceeding. The Partial Final Award provided that we and
Operations shall have a perpetual exclusive license (“Perpetual License”) in the
Technology (as defined in the Merger Agreement, dated as of September 1, 2006
(the “Merger Agreement”), among us, Operations and NQCI and the License
Agreement) primarily related to the WAK and any other Technology contemplated to
be transferred under the Technology Transaction (as defined in the Merger
Agreement). Under the terms of the Partial Final Award, in consideration of the
Perpetual License to us, NQCI was awarded a royalty of 39% of all net income,
ordinary or extraordinary, received by us (“Royalty”) and NQCI is to receive 39%
of any shares received in any merger transaction to which we or Operations may
become a party. NQCI’s interest as licensor under the Perpetual License shall be
freely assignable. In addition, the Partial Final Award provided that we shall
pay NQCI an amount equal to approximately $1,871,000 in attorneys’ fees and
costs previously awarded by the Arbitrator in an order issued on August 13,
2008, that NQCI’s application for interim royalties and expenses was denied and
that NQCI was not entitled to recover any additional attorneys’ fees. Finally,
the Partial Final Award also provides that the Arbitrator retained jurisdiction
to supervise specific performance of the terms and obligations of the Award
including, but not limited to, any dispute between the parties over the manner
of calculation of the Royalty. The Partial Final Award was issued as a result of
each party’s request for the Arbitrator to order alternative relief due the
parties’ inability to proceed with the Technology Transaction. For a full
description of the Proceeding and the Arbitrator’s interim awards issued in
connection therewith, please see Item 3 - Legal Proceedings of our Annual Report
on Form 10-K for the year ended December 31, 2008 and our subsequent reports
filed with the SEC.





As a result of the award to NQCI under
the terms of the Partial Final Award of approximately $1.87 million in
attorneys’ fees and costs but denial of NQCI’s application of interim expenses,
we reversed the accruals for the related expenses resulting in an approximately
$1.0 million non-operating reduction in arbitration liabilities to the statement
of operations for the nine months ended September 30, 2009.  The $1.87
million award of NQCI’s attorneys’ fees and costs was recognized as “Other
expenses” during the year ended December 31, 2008, and remains accrued under
“Accrued legal fees & licensing expense” on our balance sheet as of
September 30, 2009.


8





Binding
Memorandum of Understanding





On August
7, 2009, to clarify, resolve and settle certain issues and any disputes that
have arisen between us and NQCI with respect to the Final Partial Award and the
Proceeding, we and Operations (collectively, the “Xcorp Parties”) entered into a
Binding Memorandum of Understanding (the “Memorandum”) with NQCI (NQCI, together
with the Xcorp Parties is collectively referred to as the “Parties”). Under the
terms of the Memorandum, among other things, the Parties agreed to: (i) assign
and transfer all of their rights, title and interest in and to
certain technology comprised of a certain U.S. Patent Application and
related intellectual property (as described in the Memorandum) (the “Polymer
Technology”) to a limited liability company to be formed under the laws of the
State of Delaware (the “Joint Venture”), which will be jointly owned by the
Parties and through which the Parties will jointly pursue the development and
exploitation of the Polymer Technology, and (ii) negotiate, execute and deliver
within 60 days following the Stockholder Vote Date (as defined below) an
operating agreement governing the operation of the Joint Venture based on the
terms set forth in the Memorandum (the “Operating Agreement”).





The Xcorp
Parties and NQCI will be the initial two members of the Joint Venture (Xcorp
Parties’ interest shall be held of record by either us or Operations, as
determined by the Xcorp Parties) with NQCI and the Xcorp Parties having a 60%
and 40% membership interest (the “Membership Interests”) in the Joint Venture,
respectively. Subject to such other terms and provisions as the Parties may
agree upon, the Operating Agreement shall include the following
terms:





·
            the
      Joint Venture shall be managed by a three-member board of managers (the
      “JV Board”);


·
            until
      such time as NQCI fails to hold a greater percentage of the Membership
      Interests than the Xcorp Parties, two members of the JV Board (each, a “JV
      Manager”) shall be designated by NQCI and until such time as the Xcorp
      Parties fail to hold at least 10% of the Membership Interests and one JV
      Manager shall be designated by the Xcorp
  Parties;


·
            NQCI
      shall have the right to appoint a Chairman and/or a Chief Executive
      Officer of the Joint Venture, who will have day-to-day management
      authority with respect to the Joint Venture, subject to oversight by the
      JV Board and the terms and conditions of the Memorandum and the Operating
      Agreement, and a Chief Scientific Officer, who may be employed by the
      Joint Venture upon customary and reasonable terms and
      conditions;


·
            if
      a JV Manager provides additional services to the Joint Venture as an
      employee or a consultant, he or she may be compensated by the Joint
      Venture as is mutually reasonably approved in writing by the Parties;
      provided that with the exception of reimbursement of reasonable expenses
      incurred in connection with their services performed for the Joint Venture
      in their official officer capacity, neither Robert Snukal, the Chief
      Executive Officer of NQCI, nor Kelly McCrann, our Chairman and Chief
      Executive Officer (or such other persons as may be appointed or elected in
      their place), shall in any event receive a salary or other compensation
      from the Joint Venture;


·
            except
      as otherwise required by law, all decisions related to the operations of
      the Joint Venture shall be made by a majority of the JV Board, except that
      certain actions (as described in the Memorandum) by the Joint Venture or
      any of its subsidiaries shall require the affirmative vote or written
      consent of the holders of at least 90.1% of the Membership Interests then
      outstanding; and


·
            from
      and after August 1, 2009, the Xcorp Parties shall pay 61% and NQCI shall
      pay 39% of the reasonable costs and expenses related to protecting,
      preserving and exploiting the Licensed Technology (as defined
      below).





In
addition, the Xcorp Parties agreed to contribute $500,000 in cash to the bank
account established by the Joint Venture, on the later of (x) three business
days of the consummation of the first to occur of the Proposed Transaction or
another Transaction (as such terms are defined below) and (y) the date on which
the Joint Venture establishes such bank account, for which the Parties (or their
representatives) shall be joint signatories. Furthermore, provided that the
Proposed Transaction or a Transaction has been consummated, NQCI agreed to
contribute on the Xcorp Parties’ behalf an additional $500,000 in cash to the
Joint Venture at such time as the JV Board reasonably determines that such funds
are required to facilitate the Joint Venture’s development of the Polymer
Technology. This additional contribution amount will be reimbursed to NQCI by
the Xcorp Parties from the first funds distributed to the Xcorp Parties by the
Joint Venture (other than pursuant to certain quarterly tax related
distributions). Additionally, with respect to the Joint Venture, the Parties
agreed to certain liquidity rights consisting of customary rights of first
refusal and co-sale rights, unlimited piggyback registration rights and the
right to up to two demand registrations (subject to lock-ups and other
underwriter requirements), customary preemptive rights (available to a member of
the Joint Venture for so long as such member holds at least 10% of the
Membership Interests then outstanding), customary anti-dilution protections and
other standard distribution and information rights.





The
Parties also agreed to cooperate as reasonably required by the Xcorp Parties in
order for us to consummate a transaction involving an exclusive license
and/or sale to a third party (the “Proposed Transaction”) of a part,
substantially all or all of our technology and other intellectual property
rights licensed to us under the License Agreement, other than the Polymer
Technology (the “Licensed Technology”), or any other transaction (a
“Transaction”) involving the sale, license or other disposition by us of a part,
substantially all or all of the Licensed Technology. The Parties further agreed
that upon the consummation of a Proposed Transaction, they will allocate any
license fees and any other additional consideration received in such transaction
between the Parties (collectively, the “Transaction Proceeds”), in accordance
with the terms set forth in the Memorandum and summarized below, subject to the
actual terms of the Proposed Transaction, when and if such transaction is
consummated. However, there can be no assurances that the Proposed Transaction
or any other Transaction will occur or that the terms thereof will be similar to
those provided for in the Memorandum and summarized below, and the actual terms
of the Proposed Transaction or another Transaction will be provided for in the
definitive agreement entered into in connection with such
transaction.





·
            NQCI
      shall receive 36.96% of the Transaction Proceeds (which amount is intended
      to represent an amount equal to 39% of the net royalty payments provided
      for by the terms of the Partial Final Award following the deduction
      therefrom of the Xcorp Parties expenses incurred in connection with
      the Proposed Transaction), plus $1,871,430 in attorneys’ fees and costs
      payable to NQCI pursuant to the terms of the Partial Final Award
      (collectively, the “NQCI Amount”);


·
            The
      third party will pay the Xcorp Parties $250,000 upon the earlier of the
      signing of a letter of intent and an acquisition agreement providing for
      the Proposed Transaction, approximately 50% (less the foregoing $250,000)
      of the Transaction Proceeds payable in cash to the Xcorp Parties upon the
      closing of the Proposed Transaction (the “First Installment”),
      approximately 25% of such proceeds such number of months after the
      consummation of the Proposed Transaction as provided in the documents
      governing the Proposed Transaction (the “Second Installment”)and 25% of such
      proceeds after the payment of the Second Installment (the “Third
      Installment”, and collectively with the First Installment and the Second
      Installment, the
“Installments”).


9





·
            The
      Transaction Proceeds shall be allocated between the Parties as
      follows: (i) $250,000 to the Xcorp Parties, payable to the Xcorp
      Parties on the earlier of the signing of a letter of intent and an
      acquisition agreement providing for the Proposed Transaction, (ii) to
      NQCI, an amount equal to the NQCI Amount less the sum of the Second
      Installment and the Third Installment, payable to NQCI within seven
      business days of receipt of the First Installment, (iii) to the Xcorp
      Parties, the remainder of the First Installment, (iv) to NQCI, the amount
      of the Second Installment, payable to NQCI within three business days of
      receipt of the Second Installment, (v) to NQCI, the amount of the Third
      Installment, payable to NQCI within three business days of receipt of the
      Third Installment (the “Third NQCI Payment”) and (vi) the remainder
      of the Transaction Proceeds shall be retained by the Xcorp Parties;
      provided that under no circumstances shall NQCI be entitled to or receive
      from the Transaction Proceeds an amount greater than the NQCI
      Amount;


·
            In
      the event any of the Installments are paid by the third party in other
      than cash, NQCI shall receive its proportionate share of such
      consideration in accordance with the terms of the Memorandum;
      and


·
            The
      Xcorp Parties shall also pay to NQCI 39% of any royalty or other payments
      received by the Xcorp Parties in excess of the Transaction Proceeds in
      connection with the Proposed
Transaction.





In the event that the timing or the
amount of the payments from the third party under the terms of the Proposed
Transaction (or another Transaction) is other than as contemplated in the
Memorandum, the Parties shall make such equitable adjustments as are required to
preserve, to the maximum extent possible, the intent of the distribution of
Transaction Proceeds provisions of the Memorandum. In the event that the Xcorp
Parties do not consummate the Proposed Transaction or if the terms of the
Proposed Transaction are other than what is contemplated under the Memorandum
and the Xcorp Parties instead consummate an alternative Transaction, the Parties
shall apply the methodology specified in the Memorandum to the maximum extent
possible in order to allocate between them the proceeds of such
Transaction.





Additionally, NQCI agreed to use its
best efforts to enter into an agreement with a certain third party pursuant to
which such third party and NQCI will each (a) confirm and acknowledge (i) their
joint ownership of the Polymer Technology, (ii) the existence and validity of
the exclusive license to NQCI of the medical applications of the Polymer
Technology and (iii) the existence and validity of the exclusive license to such
third party of the non-medical applications of the Polymer Technology; and
(b) agree to prepare, execute and deliver as promptly as practicable upon
request by either of such parties a definitive license agreement reflecting the
terms and conditions of the foregoing exclusive licenses. The Parties also
agreed to certain customary representation and warranty, indemnity and other
miscellaneous terms.





The
foregoing summary of the Memorandum and the transactions contemplated thereby
does not purport to be complete and is subject to, and qualified in its entirety
by, the full text of the Memorandum, annexed as Exhibit 10.1 to our Quarterly
Report on Form 10-Q for the six-month period ended June 30, 2009, filed with the
SEC on August 13, 2009.





Agreement
and Stipulation Regarding Partial Final Award





In
connection with the issuance of the Partial Final Award and the execution of the
Memorandum between the Parties, on August 7, 2009 Operations entered into an
Agreement and Stipulation Regarding Partial Final Award (the “Stipulation”) with
NQCI. Pursuant to the terms of the Stipulation, Operations and NQCI agreed (i)
not to challenge the terms of the Partial Final Award or any portion of such
award, (ii) that any of the Parties may, at any time, seek to confirm all but
not part of the Partial Final Award through the filing of an appropriate
petition or motion with the appropriate court and in response to such action to
confirm the Partial Final Award, no Party will oppose, object to or in any way
seek to hinder or delay the court’s confirmation of the Partial Final Award, but
will in fact support and stipulate to such confirmation, (iii) to waive any and
all right to appeal from, seek appellate review of, file or prosecute any
lawsuit, action, motion or proceeding, in law, equity, or otherwise,
challenging, opposing, seeking to modify or otherwise attacking the confirmed
Partial Final Award or the judgment thereon and (iv) subject to certain
conditions, NQCI will not attempt before December 1, 2009 (the “Non-Execution
Period”) to execute on or file any motion, petition or application or
commence any proceeding seeking the collection of any attorneys’ fees that have
been awarded in NQCI’s favor under the terms of the Partial Final Award, which
is intended to allow the Parties a sufficient period within which to execute a
definitive acquisition agreement (the “Acquisition Agreement”) in connection
with the Proposed Transaction or a Transaction; provided that such period shall
automatically be extended for a period of 120 days from December 1, 2009 (the
“Extension Date”) if the Acquisition Agreement is executed in full on or before
December 1, 2009. If the execution of the Acquisition Agreement occurs on or
before December 1, 2009, the Extension Date shall automatically be further
extended for a period of 60 days for each amendment to a proxy or information
statement related to the transactions contemplated by the Acquisition Agreement,
filed by us in response to comments made by the SEC.





In the
event we enter into an Acquisition Agreement for the Proposed Transaction or a
Transaction, we anticipate that we will call a special or annual meeting of our
stockholders at which our stockholders will be asked to vote on the terms of the
Proposed Transaction or a Transaction, pursuant to a proxy or information
statement that we would file with the SEC in connection therewith (the
“Stockholder Vote Date”). If and when we do file such proxy or information
statement with the SEC, our stockholders and other investors are urged to
carefully read such statement and any other relevant documents filed with the
SEC when they become available, because they will contain important information
about us and the transaction. Copies of such proxy or information statement and
other documents filed by us with the SEC will be available at the Web site
maintained by the SEC at www.sec.gov.


10





The
foregoing summary of the Stipulation and the transactions contemplated thereby
does not purport to be complete and is subject to, and qualified in its entirety
by, the full text of the Stipulation, annexed as Exhibit 99.2 to our Quarterly
Report on Form 10-Q for the six-month period ended June 30, 2009, filed with the
SEC on August 13, 2009.





As a result of the issuance of the
Partial Final Award and the execution of the Stipulation the Technology
Transaction will not occur, we are no longer obligated to issue the 9,230,000
shares of our common stock (the “Shares”) to NQCI, formerly required pursuant to
the terms of the Second Interim Award issued by the Arbitrator on August 4,
2008, and we are no longer required to file a resale registration statement
under the Securities Act of 1933, as amended, for the Shares. Accordingly, the
net fair value of $1,569,100 for the Shares accrued under “Shares issuable” as
of December 31, 2008 was reversed resulting in an adjustment of $1,569,100 to
non-operating income in the statement of operations, recognized as “Change in
and reduction of shares issuable”, for the nine months ended September 30,
2009.





In addition, pursuant to the terms of
the Stipulation, we reversed the accruals for the minimum royalty under the
terms of the License Agreement, resulting in a $645,833 non-operating reduction
in arbitration liabilities to the statement of operations for the nine months
ended September 30, 2009. See Note 12, “License Agreement” below.





In the event we are unable to comply
with the terms of the Stipulation, this could have a material adverse effect on
our capital structure, business and financial condition.





Note
5 – Cash Equivalents and Marketable Securities





We invest
available cash in short-term commercial paper, certificates of deposit, money
market funds, and high grade marketable securities. We consider any liquid
investment with an original maturity of three months or less when purchased to
be cash equivalents. Investments, including certificates of deposit with
maturity dates greater than three months when purchased, and which have readily
determined fair values, are classified as available-for-sale investments and
reflected in current assets as marketable securities at fair market value.
Historically, we have complied with our investment policy which requires that
all investments be investment grade quality and no more than ten percent of our
portfolio may be invested in any one security or with one institution. However,
recently, our ability to continue to follow this policy has not been practicable
due to the small aggregate amount of investment funds that has been remaining
for investment. As a result, as of September 30, 2009, all of our cash was held
in a high grade money market fund.





Restricted
cash represents deposits secured as collateral for a letter of credit pursuant
to our operating facility lease agreement at September 30, 2009.





Note
6 – Fair Value Measurements





Effective
January 1, 2008, we adopted Accounting Standards Codification (“ASC”) 820 Fair Value Measurements and
Disclosures(“ASC 820”) (formerly Statement of Financial Standards No.
(“FAS”) 157 Fair Value
Measurements). ASC 820 defines fair value, establishes a framework for
measuring fair value, and expands disclosures about fair value measurements.
This statement does not require any new fair value measurements; rather, it
applies to other accounting standards that require or permit fair value
measurements. In February 2008, ASC 820-10-65 Fair Value Measurements and
Disclosures,subtopic Overall,section Transition and Open Effective Date
Information(“ASC 820-10-65”) (formerly Financial Accounting Standards
Board (“FASB”) Staff Positions (“FSP”) FAS 157-2 Effective Date of FASB Statement
No. 157), was issued, which delays the effective date of ASC 820 to
fiscal years and interim periods within those fiscal years beginning after
November 15, 2008 for non-financial assets and non-financial liabilities,
except for items that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually). We elected to defer the
adoption of the standard for these non-financial assets and
liabilities.





Fair
value is defined under ASC 820 as the price that would be received to sell an
asset or paid to transfer a liability in the principal or most advantageous
market in an orderly transaction between market participants on the measurement
date. ASC 820 also establishes a three-level hierarchy, which requires an entity
to maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value.





Beginning
January 1, 2008, assets and liabilities recorded at fair value in the balance
sheets are categorized based upon the level of judgment associated with the
inputs used to measure their fair value. Level inputs, as defined by ASC 820,
are as follows:





·
            Level
      I - inputs are unadjusted, quoted prices for identical assets or
      liabilities in active markets at the measurement
  date.





·
            Level
      II - inputs, other than quoted prices included in Level I, that are
      observable for the asset or liability through corroboration with market
      data at the measurement date.





·
            Level
      III - unobservable inputs that reflect management’s best estimate of what
      market participants would use in pricing the asset or liability at the
      measurement date.





The
following table summarizes fair value measurements by level at September 30,
2009 for assets and liabilities measured at fair value on a recurring
basis:


11




Level I
                    
                    
                    Level II
                    
                    
                    Level III
                    
                    
                    TotalCash
      and cash equivalents
                    
                    $
                    35,734
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    35,734Marketable
      securities:Commercial
      paper
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Corporate
      securities fixed rate
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Money
      market fund
                    
                    
                    288,703
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    288,703Restricted
      cash
                    
                    
                    305,871
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    305,871Total
      assets (1)
                    
                    $
                    630,308
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    630,308





(1) The
carrying amount for cash and cash equivalents, marketable securities, and
restricted cash approximates the fair value of such instruments due to the
variable rate of interest and/or the short maturities of these financial
instruments.





ASC
825-10-50 Financial
Instruments,subtopic Overall,section Disclosure(“ASC 825-10-50”)
(formerly FAS 107 Disclosures
about Fair Value of Financial Instruments), requires disclosure of fair
value information about certain financial instruments for which it is practical
to estimate that value. The carrying amounts reported on our balance sheet for
cash and cash equivalents, marketable securities and restricted cash
approximates the fair value because of the variable rate of interest and/or
short-term maturity of these financial instruments. The total aggregate carrying
value of our cash and cash equivalents, marketable securities and restricted
cash was $630,308 and $3,664,974 as of September 30, 2009 and December 31, 2008,
respectively, which approximates the total aggregate fair value at the end of
the same periods. As considerable judgment is required to develop estimates of
fair value, the estimates are not necessarily indicative of the amounts we could
realize in a current market exchange. The use of different market assumptions
and/or estimation methodologies may have a material effect on the estimated fair
value amounts.





Short-term
investments classified as available-for-sale were as follows:





September 30, 2009Aggregate Fair
                      Value
                    
                    
                    Gross Unrealized
                      Gains / (Losses)
                    
                    
                    Estimated Fair
                      ValueCommercial
      paper
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -Corporate
      securities fixed rate
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -





We review
impairments associated with the above in accordance with ASC 320-10-35 Investments-Debt and Securities,subtopic Overall,section Subsequent
Measurement(“ASC 320-10-35”) (formerly FAS 115 Accounting for Certain Investments
in Debt and Equity Securities and FSP FAS 115-1 and FAS 124-1 The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments) to determine the
classification of the impairment as temporary or other-than-temporary. However,
due to the small aggregate amount of available investment funds, we did not hold
investments in commercial paper and/or high grade marketable securities, but
rather held our cash in a high grade money market fund as of September 30, 2009.
There were no short-term investments classified as available-for-sale as of
September 30, 2009 and as a result, the related impairments review was not
necessary.





There
were no gross unrealized gains or losses as of September 30, 2009.





Note
7 – Property and Equipment





Property
and equipment consist of the following at September 30, 2009:





Property
      and equipment
                    
                    $
                    474,244Accumulated
      depreciation
                    
                    
                    (227,440
                    )Property
      and equipment, net
                    
                    $
                    246,804




Depreciation
expense for the three and nine months ended September 30, 2009 was $30,658 and
$92,230, respectively, compared to $27,238 and $75,792, respectively, for the
same periods in 2008.





During
the three months ended September 30, 2009, we did not dispose of any fixed
assets. During the nine months ended September 30, 2009, we disposed of two
fixed assets decreasing our property and equipment by an aggregate of $2,514 and
as a result, we recognized a total net loss on disposal in the amount of
$382.





In
accordance with ASC 360-10-35 Property, Plant, and Equipment,subtopic Overall,section Subsequent
Measurement(“ASC 360-10-35”) (formerly FAS 144 Accounting for the Impairment or
Disposal of Long-Lived Assets), we performed a test of recoverability on
our property and equipment as of September 30, 2009. As a result of this test,
we determined our property and equipment not to be impaired and the carrying
value to be recoverable.


12





Note
8 – Shares Issuable





Formerly,
pursuant to the terms of the Second Interim Award issued on August 4, 2008,
which stated that the Technology Transaction was required to be submitted for
approval by our stockholders and subject to such approval, the Shares were
required to be issued to NQCI to effectuate the transaction, we accrued for the
issuance of the Shares to NQCI. As the Second Interim Award stated that we had
to issue the Shares upon the closing of the Technology Transaction and we were
unable to consummate the transaction, such contingency not being within our
control, we therefore, recorded the issuance as a liability, rather than as an
equity issuance. As of December 31, 2008, we accrued for the Shares to be issued
to NQCI in accordance with ASC 450 Contingencies(“ASC 450”)
(formerly FAS 5 Accounting for
Contingencies), with the initial fair value of the Shares measured on
August 4, 2008, the date of the Second Interim Award.Until issued, the
Shares were marked to market in accordance with ASC 815-40 Derivatives and Hedging,subtopic Contracts in
Entity’s Own Equity(“ASC 815-40”) (formerly Emerging Issues Task Force
No. (“EITF”) 00-19 Accounting
for Derivative Financial Instruments Indexed to and Potentially Settled in, a
Company’s Own Stock ), with subsequent changes in fair value recorded as
non-operating change in fair value of shares issuable to our statement of
operations. The fair value of the Shares was measured using the closing price of
our common stock on the reporting date. The measured fair value of $10,153,000
for the accrued Shares on August 4, 2008, the date of the Second Interim Award,
was accrued under “Shares issuable” and expensed to “Research and development.”
From marking to market, the fair value of the Shares was revalued at $1,569,100
as of December 31, 2008. The resulting non-operating adjustment in fair value of
$8,583,900 to the statement of operations for the year ended December 31, 2008
was recognized as “Change in fair value of shares issuable.”





As a
result of the issuance of the Partial Final Award and the execution of the
Stipulation and the Memorandum, see Note 4, “Legal Proceedings” above, the
Technology Transaction will not occur, we are no longer obligated to issue the
Shares to NQCI, we are no longer required to file a resale registration
statement under the Securities Act covering the Shares and the Technology
Transaction will not be submitted to our stockholders for approval. Accordingly,
the net fair value of $1,569,100 for the Shares accrued under “Shares issuable”
as of December 31, 2008, was reversed due to the arbitrator’s Partial Final
Award, resulting in an adjustment of $1,569,100 to non-operating income in the
statement of operations, recognized as “Change in and reduction of shares
issuable”, for the nine months ended September 30, 2009.





Note
9 - Leases





As of
February 22, 2008, we entered into a 5-year lease agreement and relocated our
corporate office to a location in Los Angeles, CA. The total lease payments will
be $1,096,878 over the lease term. As of September 30, 2009, our remaining total
lease payments for our corporate office were $796,068.





The
following is a schedule by years of future minimum lease payments required under
the 5-year corporate office lease as of September 30, 2009:





Year
      ending December 31:2009
                                          
                                          $
                                          54,313
                                          
                                          
                                          ( 1)2010
                                          
                                          
                                          224,6502011
                                          
                                          
                                          233,5282012
                                          
                                          
                                          242,8422013
                                          
                                          
                                          40,735
                                          
                                          
                                          ( 2)Total
      minimum payments required
                                          
                                          $
                                          796,068





( 1 )
excludes lease payments made through September 30, 2009


( 2 )
initial term of the lease agreement ends February 2013





In
October 2008, we entered into a 5-year lease agreement through November 26,
2013, for our operating facility in Lake Forest, CA. The lease agreement
includes a tenant improvement allowance of $363,800, 50% of which can be applied
to rent payments with the remaining 50% applied to tenant improvement and
related expenditures. As of September 30, 2009, we expended $88,865 in
improvement and related expenses. After the drawdown of the 50% of the tenant
improvement allowance applicable to rent payments, in lieu of reimbursement to
us of cash by the landlord for the incurred improvements, the $88,865 will be
applied to rent payments with $45,605 applied as of September 30, 2009. The
remaining $43,260 was recognized under “Tenant improvement allowance receivable”
on our balance sheet as of September 30, 2009. The total lease payments,
including the 50% of the tenant improvement allowance applied to rent payments,
will amount to $1,367,507 over the lease term. As of September 30, 2009, our
remaining total lease payments for our operating facility are
$1,276,581.





The
following is a schedule, by years, of future minimum lease payments required
under the 5-year operating facility lease as of September 30,
2009:


13





Year
      ending December 31:2009
                            
                            
                            71,590
                            
                            
                            ( 1
      )2010
                            
                            
                            293,7222011
                            
                            
                            303,9942012
                            
                            
                            314,2662013
                            
                            
                            293,009
                            
                            
                            ( 2
      )Total
      minimum payments required
                            
                            $
                            1,276,581





( 1 )
excludes lease payments made and applied through September 30, 2009


( 2 )
initial term of the lease agreement ends November 2013





All of
the space is in good condition and we expect it to remain suitable to meet our
needs for the foreseeable future. We intend to consolidate our offices and
sublease our current corporate office located in Los Angeles, California. As of
September 30, 2009, we continued to utilize both locations.





Note
10 – Interest Income





Interest
income of $915 and $11,657 and $44,871 and $278,941 was reported for the three
and nine months ended September 30, 2009 and 2008, respectively.





Note
11 – Related Party Transactions





In
connection with the contribution of certain assets to us by Consolidated
National, LLC (“CNL”), on August
31, 2006we issued
to CNL of which Terren Peizer, formerly our Executive Chairman and currently a
member of our Board of Directors, who beneficially owned 41.1% of our
outstanding common stock as of September 30, 2009, is the sole managing member
and beneficial owner, an aggregate of 9,600,000 shares of our common stock of
which 6,232,596 shares are still held by CNL.





We
previously entered into an Executive Chairman Agreement with Mr. Peizer for an
initial term of three years, with automatic one-year renewals. Mr. Peizer served
as our Executive Chairman until October 2008. For his services as our Executive
Chairman, Mr. Peizer was (i) scheduled to receive compensation in the amount of
$450,000 per annum as of July 1, 2007, with a signing bonus of $225,000,
(ii) scheduled to receive an annual bonus at the discretion of our Board of
Directors based on our performance goals and targeted at 100% of his base
compensation and (iii) eligible to participate in any of our equity incentive
plans. In the event Mr. Peizer’s position was terminated without good cause
or he resigned for good reason, we were obligated to pay Mr. Peizer a lump
sum in an amount equal to three years’ base compensation plus 100% of the
targeted bonus. Pursuant to the Executive Chairman Agreement, Mr. Peizer was
paid as an independent consultant. On August 19, 2008, Mr. Peizer and we agreed
that Mr. Peizer would cease serving as our Executive Chairman and would defer
cash payments of his compensation until further notice. Pursuant to Mr. Peizer's
non-involvement in operational aspects of the Company, we did not accrue for
related services for the three months ended September 30, 2009; however, Mr.
Peizer continues to be a member of our Board of Directors. As of September 30,
2009, we accrued, under “Accrued professional fees”, $393,750 for his deferred
compensation. We are currently in discussions with Mr. Peizer for the
forgiveness of the entire deferred compensation amount.





Dr.
Victor Gura, our Chief Medical and Scientific Officer, owns 15,497,250 shares of
common stock of NQCI (or approximately 20.9% of NQCI’s common stock outstanding
as of January 31, 2009), the company with which we entered into the License
Agreement. Such shares include 800,000 shares owned by Medipace Medical Group,
Inc., an affiliate of Dr. Gura (or approximately 1.1% of NQCI’s common stock
outstanding as of January 31, 2009), and 250,000 shares subject to warrants held
by Dr. Gura which are currently exercisable (or approximately less than 1.0% of
NQCI’s common stock outstanding as of January 31, 2009).





Dr. Gura
maintains an office located in Beverly Hills, California. Pursuant to a
reimbursement agreement effective January 29, 2008, we reimburse 50% of the
rental and 50% of his monthly parking. The term of the agreement commenced on
April 23, 2007, the date of the office lease agreement, and will continue until
the date on which Dr. Gura ceases to use the remote office to perform his duties
as our Chief Medical and Scientific Officer. From commencement through September
30, 2009, we incurred $2,317 and $59,542, reimbursed Dr. Gura $2,216 and
$55,873, and deferred $101 and $3,669 for the 50% reimbursement of the monthly
parking and rental, respectively.





Note
12 – License Agreement





On August
31, 2006, we entered into a Contribution Agreement with CNL. We issued CNL
9,600,000 shares of common stock in exchange for (a) the right, title, and
interest to the name “Xcorporeal” and related trademarks and domain names, and
(b) the right to enter into a License Agreement with NQCI, pursuant to which we
obtained the exclusive rights to the technology relating to our kidney failure
treatment and other medical devices which, as listed under “Technology” on the
License Agreement, are “all existing and hereafter developed Intellectual
Property, Know-How, Licensor Patents, Licensor Patent Applications, Derivative
Works and any other technology, invented, improved or developed by Licensor, or
as to which Licensor owns or holds any rights, arising out of or relating to the
research, development, design, manufacture or use of (a) any medical device,
treatment or method as of the date of this Agreement, (b) any portable or
continuous dialysis methods or devices, specifically including any Wearable
Artificial Kidney and related devices, (c) any device, methods or treatments for
congestive heart failure, and (d) any artificial heart or coronary device.”
Operations was a shell corporation prior to the transaction. We valued the
License Agreement at the carry-over basis of $1,000. As consideration for being
granted the License, we agreed to pay to NQCI a minimum annual royalty of
$250,000, or 7% of net sales, although we have asserted in the Proceeding that
NQCI’s breaches of the License Agreement excused our obligation to make the
minimum royalty payments. However, as a result of the execution of the
Memorandum and the Stipulation, in the event we enter into the Proposed
Transaction or another Transaction, we will no longer be obligated to pay NQCI
any royalty payments under the License Agreement. For a more detailed discussion
of the Memorandum and the Stipulation, see Note 4, “Legal Proceedings”
above.


14





Although
under the terms of the Partial Final Award the Arbitrator denied NQCI’s
application for interim royalties, we recorded $645,833 in royalty expenses
covering the minimum royalties from commencement of the License Agreement
through March 31, 2009. Pursuant to the Memorandum and the Stipulation the
parties thereto agreed to forego the interim royalties provided for under the
terms of the Partial Final Award. As a result, we reversed the accruals for the
minimum royalty payments, resulting in a $645,833 non-operating reduction in
arbitration liabilities to the statement of operations for the nine months ended
September 30, 2009. See Note 4, “Legal Proceedings” above.





Note
13 – Stock Options and Warrants





Incentive
Compensation Plan





On
October 12, 2007, we adopted the Xcorporeal, Inc. 2007 Incentive Compensation
Plan and the related form of option agreement that is substantially identical to
the 2006 Incentive Compensation Plan that was in effect at Operations
immediately prior to the merger.




The plan
authorizes the grant of stock options, restricted stock, restricted stock units,
and stock appreciation rights. There are 3,900,000 shares of common stock
authorized for issuance under to the 2007 Incentive Compensation Plan (subject
to adjustment in accordance with the provisions of the plan). The plan will
continue in effect for a term of up to ten years. As of September 30, 2009,
there were outstanding options to purchase 720,000 shares of our common stock
and 3,180,000 shares were available for issuance under the 2007 Incentive
Compensation Plan.





On
October 12, 2007, we also assumed options to purchase up to 3,880,000 shares of
common stock that were granted by Operations under its 2006 Incentive
Compensation Plan, of which 1,635,000 have since been forfeited, canceled, or
expired, and therefore, options to purchase 2,245,000 shares of our common stock
remain outstanding.





Stock
Options to Employees, Officers and Directors





The
Compensation Committee of our board of directors determines the terms of the
options granted, including the exercise price, the number of shares subject to
option, and the vesting period. Options generally vest over five years and have
a maximum life of ten years.





During
the three months ended September 30, 2009, no options were granted, forfeited,
canceled, or exercised.





We
reported $670,481 and $1,718,109 in stock-based compensation expense for
employees, officers, and directors for the three and nine months ended September
30, 2009, respectively. For the three and nine months ended September 30, 2008,
we reported $1,731,200 and $3,813,158, respectively, in stock-based compensation
expense for employees, officers, and directors.





All
compensation expense for stock options granted has been determined under the
fair value method using the Black-Scholes option-pricing model with the
following assumptions:





For the nine months endedSeptember 30, 2009Expected
      dividend yields
                    
                    zeroExpected
      volatility
                    
                    
                    130%Risk-free
      interest rate
                    
                    
                    3.53-3.81%Expected
      terms in years
                    
                    2.12-9.01
      years





Warrants
and Stock Options to Non-Employees





During
the three months ended September 30, 2009, we did not issue any warrants. As of
September 30, 2009, there were 551,721 warrants outstanding, which were fully
vested and exercisable.





We reported $21 and $3,687 in
stock-based compensation expenses for consultants for the three and nine months
ended September 30, 2009, respectively. We reported $8,097 and $92,842 in
stock-based compensation expense for consultants for the three and nine months
ended September 30, 2008, respectively. The reduction in stock-based
compensation expense was a result of options forfeited as a result of the
termination of consulting services of certain of our consultants and vesting
options and warrants.


15





Compensation
for options granted to non-employees has been determined in accordance with ASC
718 Compensation-Stock
Compensation(“ASC 718”) (formerly FAS 123R Share-Based Payment) and ASC
505-50 Equity,subtopic
Equity-Based Payments to
Non-Employees(“ASC 505-50”) (formerly EITF 96-18 Accounting For Equity Instruments
That Are Issued To Other Than Employees For Acquiring or In Conjunction With
Selling Goods Or Servicesand EITF 00-18 Accounting Recognition for Certain
Transaction Involving Equity Instruments Granted to Other Than
Employees). Accordingly, compensation is determined using the fair value
of the consideration received or the fair value of the equity instruments
issued, whichever is more reliably measured.





For
options and warrants issued as compensation to non-employees for services that
are fully vested and non-forfeitable at the time of issuance, the estimated
value is recorded in equity and expensed when the services are performed and
benefit is received as provided by ASC 505-50.





All
charges for warrants granted have been determined under the fair value method
using the Black-Scholes option-pricing model with the following
assumptions:




For the nine months endedSeptember 30, 2009Expected
      dividend yields
                  
                  zeroExpected
      volatility
                  
                  
                  130%Risk-free
      interest rate
                  
                  
                  1.05-3.19%Expected
      terms in years
                  
                  0.14-7.62
      years





The
following table shows the change in unamortized compensation expense for stock
options and warrants issued to employees, officers, directors and non-employees
during the nine months ended September 30, 2009:





Stock Options and
                        Warrants
                        Outstanding
                      
                      
                      Unamortized Compensation
                        ExpenseJanuary
      1, 2009
                      
                      
                      4,429,221
                      
                      
                      
                      10,092,109Granted
      in the period
                      
                      
                      -
                      
                      
                      
                      -Forfeited
      & Cancelled in the period
                      
                      
                      (912,500
                      )
      (1)
                      
                      
                      (2,932,478
                      )Expensed
      in the period
                      
                      
                      -
                      
                      
                      
                      (2,167,551
                      )Exercised
      in the period
                      
                      
                      -
                      
                      
                      
                      -September
      30, 2009
                      
                      
                      3,516,721
                      
                      
                      $
                      4,992,080





(1) As
part of streamlining our operations, we terminated 19 employees on March 13,
2009 and one employee on April 30, 2009. As a result, the terminated employees’
unvested and unexercised vested options were forfeited. The terminated employees
did not exercise their vested options and therefore, the vested options expired
60 days from their termination date.




Number of
                        Options and
                        Warrants
                      
                      
                      Weighted
                        Average
                        Exercise
                        PriceStock Options and WarrantsBalance
      at January 1, 2009
                      
                      
                      4,429,221
                      
                      
                      $
                      5.62Granted
                      
                      
                      -
                      
                      
                      
                      -Exercised
                      
                      
                      -
                      
                      
                      
                      -Forfeited
      & Cancelled
                      
                      
                      (
      912,500
                      )
                      
                      
                      7.00Balance
      at September 30, 2009
                      
                      
                      3,516,721
                      
                      
                      $
                      5.26




Note
14 – Stockholders’ Deficit





Effective
as of September 4, 2009, our common stock commenced trading on the Pink Sheets
Electronic OTC Market, an inter-dealer electronic quotation service of
securities traded over-the-counter also known as the Pink Sheets (“Pink
Sheets”), under the symbol “XCRP.PK”. In addition, effective as of the same
date, our common stock was suspended from trading on NYSE Amex LLC (formerly
American Stock Exchange) (“Amex”).





On
September 30, 2009, 400,000 shares of common stock were granted as compensation
for consulting services rendered to us.


16





Our
“Total Stockholders’ Deficit” as of September 30, 2009, is a result of our
continued operating losses with our deficit accumulated during the development
stage being greater than our additional paid in capital.





Note
15 – Product Development Agreement





In July
2007, we entered into the Aubrey Agreement for assistance with the development
of the PAK. As of March 31, 2009, the work was completed and we terminated the
agreement with Aubrey.





Note
16 – Subsequent Events





On
October 15, 2009, we paid approximately $76,000, which was non-reimbursable by a
certain third party described above under Note 2, “Nature of Operations and
Going Concern Uncertainty”, of the approximately $172,000 in deferred employee
compensation as of September 30, 2009. As of November 12, 2009, we had
approximately $162,000 in deferred employee compensation recognized under
“Deferred compensation” on our balance sheet.





As of
November 12, 2009, the “Expense receivable” balance of approximately $43,000
formerly existing as of September 30, 2009, described above under Note 2,
“Nature of Operations and Going Concern Uncertainty”, was paid in full. As of
the same date, we had approximately $112,000 in “Expense receivable” which
included approximately $12,000 of an anticipated payroll tax refund pursuant to
COBRA premium assistance payments as of September 30, 2009.





As of
November 12, 2009, the exclusivity negotiation period remains in effect and we
are continuing negotiations with a certain third party, as more fully described
above under Note 2, “Nature of Operations and Going Concern
Uncertainty”.





Our
management has evaluated subsequent events and their impact on the reported
results and disclosures through November 16, 2009, which is the date these
financial statements were issued and filed with the SEC.


17





ITEM
2.         Management’s Discussion and Analysis of
Financial Condition andResults of Operations.





The
following discussion of our financial condition and results of operations should
be read in conjunction with our interim financial statements and the related
notes, and the other financial information included in this report.





Forward-Looking
Statements





Unless
the context otherwise indicates or requires, as used in this Quarterly Report on
Form 10-Q, or the “Quarterly Report”, references to “Xcorporeal, ”“we,” “us,”
“our” or the “Company” refer to Xcorporeal, Inc., a Delaware corporation, and
prior to October 12, 2007, the company which is now our subsidiary and known as
Xcorporeal Operations, Inc., or “Operations”.





This
Quarterly Report contains “forward-looking statements” within the meaning of the
Private Securities Litigation Reform Act of 1995 with respect to the financial
condition, results of operations, business strategies, operating efficiencies or
synergies, competitive positions, growth opportunities for existing products,
plans and objectives of management, markets for our stock and other
matters. Statements in this Quarterly Report that are not historical facts are
“forward-looking statements” for the purpose of the safe harbor provided by
Section 21E of the Securities Exchange Act of 1934, as amended, or the “Exchange
Act”, and Section 27A of the Securities Act of 1933, or the “Securities Act”.
Forward-looking statements reflect our current expectations or forecasts of
future events. Forward-looking statements generally can be identified by the use
of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,”
“intend,” “estimate,” “believe,” “project,” “continue,” “plan,” “forecast,” or
other similar words. Such forward-looking statements, including, without
limitation, those relating to our future business prospects, revenues and
income, wherever they occur, are necessarily estimates reflecting the best
judgment of our senior management on the date on which they were made, or if no
date is stated, as of the date of this Quarterly Report. These
forward-looking statements are subject to risks, uncertainties and assumptions,
including those described below in Item 1A - Risk Factors, in the section
captioned “Risk Factors” of our Annual Report on Form 10-K (the “Annual
Report”) filed with the United States Securities and Exchange Commission (the
“SEC”) on March 31, 2009, and in the section captioned “Risk Factors” in
each of our Quarterly Reports on Form 10-Q, filed with the SEC on May 15, 2009
and August 13, 2009 (collectively, the “Quarterly Reports”), that may affect the
operations, performance, development and results of our business. Because these
factors could cause our actual results or outcomes to differ materially from
those expressed in any forward-looking statements made by us or on our behalf,
you should not place undue reliance on any such forward-looking statements.
New factors emerge from time to time, and it is not possible for us to predict
which factors will arise. In addition, we cannot assess the impact of each
factor on our business or the extent to which any factor, or combination of
factors, may cause actual results to differ materially from those contained in
any forward-looking statements.





You
should understand that, in addition to those factors discussed below in Item 1A
- Risk Factors and in the section captioned “Risk Factors” of our Annual
Report and events discussed below in the section captioned “Recent
Developments,” factors that could affect our future results and could cause our
actual results to differ materially from those expressed in such
forward-looking statements, include, but are not limited to:





·
            the
      effect of receiving a “going concern” statement in our independent
      registered public accounting firm’s report on our 2008 financial
      statements included in the Annual
Report;


·
            our
      substantial capital needs and ability to obtain financing both on
      immediate, short-term and a long-term
basis;


·
            the
      results of the arbitration proceeding with National Quality Care, Inc., or
      “NQCI”, and its impact on our ability to exercise our business plan going
      forward;


·
            our
      ability to successfully research and develop marketable
      products;


·
            our
      ability to obtain regulatory approval to market and distribute our
      products;


·
            anticipated
      trends and conditions in the industry in which we operate, including
      regulatory changes;


·
            general
      economic conditions; and


·
            other
      risks and uncertainties as may be detailed from time to time in our public
      announcements and filings with the
SEC.





Although
we believe that our expectations are reasonable, we cannot assure you that our
expectations will prove to be correct. Should any one or more of these risks or
uncertainties materialize, or should any underlying assumptions prove incorrect,
actual results may vary materially from those described in this Quarterly Report
as anticipated, believed, estimated, expected or intended.





These
factors are not exhaustive, and new factors may emerge or changes to the
foregoing factors may occur that could impact our business. Except to the extent
required by law, we undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or any other reason. All subsequent forward-looking statements
attributable to us or any person acting on our behalf are expressly qualified in
their entirety by the cautionary statements contained or referred to herein. In
light of these risks, uncertainties and assumptions, the forward-looking events
discussed in this Quarterly Report may not occur. You should review carefully
Item 1A - Risk Factors, this Item 2 and the section captioned “Risk Factors”
included in our Annual Report and Quarterly Reports for a more complete
discussion of these and other factors that may affect our business.





Overview




We
are a medical device company that has been engaged in developing an
innovativeextra-corporeal platform technology to be used in devices to replace the
function of various human organs. These devices will seek to provide patients
with improved, efficient and cost effective therapy. We hope that the platform
will lead to the following three products:


18





·
            A
      Portable Artificial Kidney, or “PAK”, for attended care Renal Replacement
      Therapy, or “RRT”, for patients suffering from Acute Renal Failure, or
      “ARF”


·
            A
      PAK for home hemodialysis for patients suffering from End Stage Renal
      Disease, or “ESRD”


·
            A
      Wearable Artificial Kidney, or “WAK”, for continuous ambulatory
      hemodialysis for treatment of ESRD





Because
of our lack of resources and difficulty in obtaining financing, we have been
unable to continuously engage in our development activities, and therefore, are
evaluating our immediate and substantial liquidity needs as described herein. If
we are unable to obtain the necessary capital for any reason, including through
the sale of all or substantially all of our assets, a business combination with
another entity in a transaction where we would not be the surviving entity or a
combination thereof, we may need to or will be forced to discontinue our
operations and liquidate our assets and/or may be forced to seek protection
under bankruptcy laws. Subject to us first entering into a transaction for the
sale of substantially all or all of our assets or a business combination
with another entity in a transaction where we would not be the surviving entity,
if we are able to obtain necessary capital and otherwise continue our business
operations, (i) we plan to continue testing and developing the technology for
ourextra-corporeal
platform and (ii) while we hope to eventually exploit our technology’s potential
Congestive Heart Failure, or “CHF”, applications through licensing or strategic
arrangements, we intend to focus initially on the renal replacement applications
described below.





We have
completed functional prototypes of our attended care and home PAKs that we hope
to commercialize after obtaining notification clearance from the Food and Drug
Administration, or “FDA”, under Section 510(k) of the Federal Food, Drug and
Cosmetic, or “FDC”, Act based on the existence of predicate devices, which,
subject to our capital limitations described below, we plan to seek in the
future. We have demonstrated a feasibility prototype of the WAK and we will
determine whether to devote any available resources to the development of
the WAK; commercialization of the WAK will require development of a functional
prototype and likely a full pre-market approval, or “PMA”, by the FDA, which
could take several years or longer. Subject to us first entering into a
transaction for the sale of substantially all or all of our assets or a
business combination with another entity in a transaction where we would not be
the surviving entity, unless we are able to raise funds to satisfy our
current liabilities and other obligations as they become due, obtain additional
debt or equity financing and otherwise continue our business operations, we will
not be able to submit a 510(k) notification with the FDA for the PAK or
the WAK.





Our PAK
for the attended care market is a portable, multifunctional renal replacement
device that will offer cost-effective therapy for those patients suffering from
ARF, causing a rapid decline in kidney function. We have completed our
functional prototype of this product, which is currently undergoing bench
testing, and, subject to our capital limitations described below, plan to submit
a 510(k) filing with the FDA in the future. We plan to commercialize this
product after receiving clearance from the FDA. Timing of FDA clearance is
uncertain at this time. Subject to us first entering into a transaction for the
sale of substantially all or all of our assets or a business combination
with another entity in a transaction where we would not be the surviving entity,
unless we are able to raise funds to satisfy our current liabilities and other
obligations as they become due, obtain additional debt or equity financing and
otherwise continue our business operations, we will not be able to submit a
510(k) notification with the FDA for this product.





Our PAK
for the home hemodialysis market is a device for patients suffering from ESRD,
in whom the kidneys have ceased to function. We have also completed our
functional prototype of this product, which is currently undergoing bench
testing, and, subject to our capital limitations described below, we intend
to submit a 510(k) with the FDA in the future. Subject to us first entering into
a transaction for the sale of substantially all or all of our assets or a
business combination with another entity in a transaction where we would not be
the surviving entity, unless we are able to raise funds to satisfy our current
liabilities and other obligations as they become due, obtain additional debt or
equity financing and otherwise continue our business operations, we will not be
able to submit a 510(k) notification with the FDA for this product. Clinical
trials would be anticipated to commence after the FDA clearance is
received.





Our WAK
is a device for the chronic treatment of ESRD. We have successfully demonstrated
a prototype system that weighs less than 6 kg., is battery operated, and can be
worn by an ambulatory patient. Subject to us first entering into a transaction
for the sale of substantially all or all of our assets or a business
combination with another entity in a transaction where we would not be the
surviving entity, assuming we are able to raise funds to satisfy our current
liabilities and other obligations as they become due and obtain additional debt
or equity financing and assuming we continue our business operations, we will
continue to evaluate the feasibility of furthering our development of this
product.





We also
hope to implement our validation and verification strategy including bench
testing, clinical testing and regulatory strategy in the U.S. and
abroad.





We have
focused much of our efforts on development of the PAK, which we do not believe
has been derived from the Technology (as defined below) covered by the License
Agreement (as defined below). As described below under “Recent
Developments,” subject to us first entering into a transaction for the sale
of substantially all or all of our assets or a business combination with
another entity in a transaction where we would not be the surviving entity, we
will determine whether to devote any available resources to development of the
WAK. Because none of our products is yet at a stage where it can be marketed
commercially and because of the capital limitations that we are experiencing, we
are not able to predict what portion of our future business, if any, will be
derived from each of our products.


19




We are a
development stage company, have generated no revenues to date and have been
unprofitable since our inception, and, unless we consummate a transaction for
the sale of substantially all or all of our assets or a business
combination with another entity in a transaction where we would not be the
surviving entity, will incur substantial additional operating losses for at
least the foreseeable future as we continue, to the extent available, to
allocate our extremely limited resources to ongoing business operations and
other activities. We do not believe our existing cash reserves will be
sufficient to satisfy our current liabilities and other obligations before we
achieve profitability. Our ability to meet such obligations as they become due
will depend on our ability to secure debt or equity financing and/or consummate
a transaction for the sale of substantially all or all of our assets or a
business combination with another entity in a transaction where we would not be
the surviving entity. Unless we are able to obtain funds sufficient to support
our operations and to satisfy our ongoing capital requirements, as more fully
described below, we will not be able to develop any of our products, submit
510(k) notifications or PMA applications to the FDA, conduct clinical trials or
otherwise commercialize any of our products. We may not be able to
obtain needed funds on acceptable terms, or at all, and there is substantial
doubt of our ability to continue as a going concern. Accordingly, our historical
operations and financial information are not indicative of our future operating
results, financial condition, or ability to operate profitably as a commercial
enterprise.





Recent
Developments





Our
Deteriorating Financial Position and Potential Strategic
Transaction





In light
of our ongoing substantially deteriorating financial position and our immediate
need of additional financing, we have continued our efforts to streamline our
operations, including continuing some of the actions outlined below under the
caption “Restructuring Efforts”, in order to conserve any available resources.
Our management also continues to evaluate any possible strategic alternatives,
including entering into a transaction for the sale of substantially all or all
of our assets, a business combination with another entity in a transaction where
we would not be the surviving entity, licensing of certain of our intellectual
property rights, as a means to further develop our technologies, discontinuing
our operations and liquidating our assets and/or seeking protection under
bankruptcy laws.





As part
of a potential strategic transaction we have been considering, we have agreed
with a certain third party to an exclusivity period to negotiate a potential
cooperative transaction, in exchange for a non-refundable payment of $200,000
made to us by such third party. The exclusivity period will expire upon the
later of 100 calendar days from September 21, 2009 and the termination date of a
definitive agreement entered into with such third party, if any. If a definitive
agreement for the transaction is entered into prior thereto, the exclusivity
payment will be credited against the purchase price in such transaction. During
the exclusivity period, we have been providing and will continue to provide to
the third party access to our employees, properties, contracts, records and
other related materials. In addition, in the mutual interests of us and such
third party and at the direction of the third party, in connection with the
potential strategic transaction we have actively resumed research and
development of our Portable Artificial Kidney product with direct reimbursement
of related expenditures by such third party. Currently, the exclusivity period
remains in effect and negotiations continue. Among other reasons, due to the
current economic conditions and those particularly affecting healthcare related
companies, there is no assurance that any such transaction will occur or that it
would be accretive to our stockholders or result in any payment being made to
our stockholders. The financial statements filed as part of this Quarterly
Report on Form 10-Q does not include any adjustments that might result from the
outcome of this transaction, if any.





Trading
on Pink Sheets





Effective
as of September 4, 2009, our common stock commenced trading on the Pink Sheets
Electronic OTC Market, an inter-dealer electronic quotation service of
securities traded over-the-counter also known as the Pink Sheets (“Pink
Sheets”), under the symbol “XCRP.PK”. In addition, effective as of the same
date, our common stock was suspended from trading on NYSE Amex LLC (formerly
American Stock Exchange) (“Amex”).





Restructuring
Efforts





The
deterioration of the economy over the last year, coupled with the prolonged
delay in our ability to reach a resolution with respect to the consummation of
the Technology Transaction, has significantly adversely affected us. Many of the
expectations on which we had based our 2008 and 2009 business development plans
slowly eroded as a result of the lengthy arbitration proceeding with NQCI
commenced in 2006 and continuing into the second quarter of 2009. The
possibility of an adverse decision in the arbitration proceeding with respect to
our ownership right to the Technology has been a major factor in our inability
to secure debt or equity financing. Accordingly, during the first nine months of
2009, we modified certain of our activities and business and instituted a
variety of measures in an attempt to conserve cash and reduce our operating
expenses. Our actions included: termination of employment of 20 of our employees
or a reduction of approximately 77% of our labor force, deferral of compensation
for 5 of our 6 employees with continued deferral for 3 of our 6 employees,
reaching an agreement with the landlord for our operating facility in Lake
Forest, CA, to apply $88,865, in lieu of reimbursement of such amount to us
expended for the incurred improvements at such facility, toward rent payments
with $45,605 applied as of September 30, 2009, refocusing our available assets
and employee resources on the development of the PAK, agreeing to a direct
reimbursement arrangement for PAK related research and development expenses with
a certain third party with which we have agreed to an exclusivity period to
negotiate a potential cooperative transaction, continuing vigorous efforts to
minimize or defer our operating expenses, searching to obtain additional
financing to support our operations and to satisfy our ongoing capital
requirements in order to improve our liquidity position and continuing to
prosecute our patents and take other steps to perfect our intellectual property
rights. In light of the unprecedented economic slow down, lack of access to
capital markets and prolonged arbitration proceeding with NQCI, we were
compelled to undertake the efforts outlined above in order to remain in the
position to continue our operations. For a more detailed discussion of our
restructuring efforts, please see section entitled “Item 2. Management’s
Discussion and Analysis of Financial Condition and Results of Operations
— Recent Developments” in our Quarterly Report on Form 10-Q for the six
month period ended June 30, 2009, filed with the SEC on August 13,
2009.




20


Due to
our continuing substantially deteriorating financial position, we have continued
some of the actions outlined above and will continue our efforts to streamline
our operations in order to conserve any available resources. Our management
continues to evaluate any possible strategic alternatives, including entering
into a transaction for the sale of substantially all or all of our assets, a
business combination with another entity in a transaction where we would not be
the surviving entity, licensing of certain of our intellectual property rights,
as a means to further develop our technologies, discontinuing our operations and
liquidating our assets and/or seeking protection under bankruptcy laws. There is
no assurance that any such sale transaction will occur or that it would be
accretive to our stockholders or result in any payment being made to our
stockholders. Subject to continuing our business operations, we hope to be
able to obtain additional financing to meet our cash obligations as they become
due and otherwise proceed with our business plan. Our ability to execute on our
current business plan is dependent upon us continuing our business operations,
our ability to obtain equity or debt financing, develop and market our products,
and, ultimately, to generate revenue. Subject to continuing our business
operations and unless we are able to raise financing sufficient to support our
operations and to satisfy our ongoing financing requirements, we will not be
able to develop any of our products, submit 510(k) notifications to the FDA,
conduct clinical trials or otherwise commercialize any of our products. We will
make every effort however, to continue the development of the PAK. As a result
of these conditions, there is substantial doubt about our ability to continue as
a going concern. Our ability to continue as a going concern is substantially
dependent on the successful execution of many of the actions referred to above,
on the timeline contemplated by our plans and our ability to obtain
additional financing. We cannot assure you that we will be successful now or in
the future in obtaining any additional financing on terms favorable to us, if at
all. The failure to obtain financing will have a material adverse effect on our
financial condition and operations.





Management’s
Discussion and Analysis





Basis
of Presentation




This
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” section should be read in conjunction with the accompanying
unaudited interim financial statements which have been prepared assuming that we
will continue as a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business. Our
recurring losses from operations and net capital deficiency raise substantial
doubt about our ability to continue as a going concern. Our ability to continue
as a going concern is substantially dependent on the successful execution of
many of the actions referred to above and otherwise discussed in this
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” section and in Note 2, “Nature of Operations and Going Concern
Uncertainty” to our unaudited interim financial statements filed as part of this
Quarterly Report, on the timeline contemplated by our plans and our ability to
obtain additional financing. The uncertainty of successful execution of our
plans, among other factors, raises substantial doubt as to our ability to
continue as a going concern. The accompanying unaudited interim financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.





Results
of Operations for the three and nine months ended September 30,
2009.





We have
not generated any revenues since inception. We incurred a net loss of $1.5
million and $2.8 million for the three and nine months ended September 30, 2009,
respectively, compared to a net loss of $11.1 million and $22.8 million for the
three and nine months ended September 30, 2008, respectively. The decrease in
net loss was primarily due to (i) non-operating income resulting from accrual
reversals resulting from the issuance of the Partial Final Award and the
execution of the Stipulation and the Memorandum entered into with NQCI in
connection with the Proceeding, (ii) corporate restructuring, (iii) completion
and termination of the Aubrey Agreement, (iv) reduced legal fees, (v)
forfeitures of terminated employees’ unvested stock options, (vi) continuous
efforts to minimize current operating expenses, and (vi) an agreement with a
certain third party, with which we have agreed to an exclusivity period to
negotiate a potential cooperative transaction, for the direct reimbursement
of PAK related research and development expenses as well as salaries and
overhead expenses of our two engineers. At September 30, 2009, we had a negative
working capital of $3.3 million compared to a positive working capital of $1.4
million at September 30, 2008. At September 30, 2009, our total assets were $1.1
million compared to $4.4 million at December 31, 2008, which consisted primarily
of cash raised from the sale of our common stock sold in December
2006.





Interest
Income





For the
three and nine months ended September 30, 2009, respectively, we earned
interest income of $915 and $11,657 compared to $44,871 and $278,941 for the
three and nine months ended September 30, 2008, respectively. The decrease
in interest income was due to the depletion of cash held in our investment
account as a result of our use of cash for operations.





Liquidity
and Capital Resources





We expect
to incur operating losses and negative cash flows for the foreseeable future.
During the fourth quarter 2006, we raised approximately $27.3 million (net of
placement fees of $2.1 million) through a private placement. Our ability to
execute on our current business plan is dependent upon our ability to secure
additional funding, develop and market our products, and, ultimately, to
generate revenue.


21


As of
September 30, 2009, we had cash, cash equivalents and marketable securities of
approximately $0.3 million. We expended $0.2 million and
$3.0 million of cash during the three and nine months ended September 30,
2009, respectively, and we project to expend cash at a rate below
$0.1 million per month for the remainder of the 2009 fiscal year based upon
our restructuring efforts taken to date and planned going forward. However,
should our efforts to further reduce our costs and expenses not materialize, we
project to expend cash at a rate of approximately $0.1 million per month. Some
of these restructuring efforts undertaken included: deferral of compensation for
5 of our 6 employees with continued deferral for 3 of our 6 employees, reaching
an agreement with the landlord for our operating facility in Lake Forest, CA, to
apply $88,865, in lieu of reimbursement of such amount to us expended for the
incurred improvements at such facility, toward rent payments with $45,605
applied as of September 30, 2009 (after the drawdown of the 50% of the tenant
improvement allowance applicable to rent payments), reaching an agreement
with a certain third party with which we have agreed to an exclusivity period to
negotiate a potential cooperative transaction for a direct reimbursement by such
third party of our employment expenses of our two engineers, including salaries
and overhead expenses incurred by us in connection with consulting services
provided by our two engineers to such certain third party, and continuing
vigorous efforts to minimize or defer our operating expenses. For a more
detailed discussion of our restructuring efforts undertaken to date, please see
above section captioned “Recent Developments.” In addition, in accordance with
the terms of the Stipulation and the Memorandum entered into with NQCI in
connection with the Proceeding, we are obligated to pay damages, costs and legal
fees in connection with the Proceeding described above in an amount of $1.87
million.Based on
our current cash and cash equivalent resources, other current assets, current
monthly operating burn rate, and using assumptions that by nature are imprecise,
our management believes we have available liquidity to fund our limited
restructured operations approximately through the next 30 days from November 12,
2009. We will consider further reduction of our costs and expenses in the near
future, if feasible. Therefore, we must raise additional funds to be able
to continue our operations within approximately the next 30 days from November
12, 2009. We may not be successful in doing so on terms acceptable to us, and
the inability to raise capital will require us to curtail our current plans,
which will have a material adverse effect on our plan of operation or will
result in the curtailment of our operations. Our ability to execute on our
current business plan is dependent upon us continuing our
business operations and our ability to obtain equity financing, develop and
market our products, and, ultimately, to generate revenue.





As of
November 12, 2009, we had available cash of approximately $120,000, excluding
restricted cash. We currently have a monthly burn rate of approximately
$116,000. Under these current conditions, we will have sufficient cash
approximately through the next 30 days from November 12, 2009, assuming no
further cash injections are received. In addition to previously taken
restructuring efforts, including reduction of personnel, we also reduced our
cash outflows by means of deferring 50% of the monthly compensation for 5 of our
6 active employees effective July 1, 2009 and currently continue to defer 50% of
the monthly compensation for 3 of our 6 active employees. Two of our engineers
are providing consulting services to the third party with which we have agreed
to an exclusivity period to negotiate a potential cooperative transaction, and
such third party is fully reimbursing us for our employment expenses of our two
engineers, including salaries and overhead. As of September 30, 2009, we
deferred approximately a total of $172,000 in employee compensation, recognized
under “Deferred compensation” on our balance sheet. We may consider further
reducing our costs and expenses in the near future, if feasible. Therefore,
we must raise additional funds to be able to continue our operations. If we are
unable to secure additional capital within approximately the next 30 days from
November 12, 2009, we will be forced to file for bankruptcy and/or cease our
operations. The accompanying financial statements have been prepared on the
basis of a going concern and do not reflect any adjustments due to these
conditions.




We expect
to incur negative cash flows and net losses for the foreseeable future. In
addition, pursuant to the terms of the Partial Final Award, NQCI was awarded an
amount equal to approximately $1.87 million in attorneys’ fees and costs
consistent with the Arbitrator’s order issued on August 13, 2008 related to the
same and NQCI’s application for interim royalties and expenses was denied. We
intend to pay such attorneys’ fees and costs due to NQCI from the proceeds
received in connection with the consummation of the Proposed Transaction, or
another Transaction, if such transaction is consummated, or upon raising of
additional capital to sufficiently satisfy such award and or other immediate
liquidity requirements, which funds we will need to obtain within approximately
the next 30 days from November 12, 2009. Pursuant to the terms of the
Stipulation, NQCI agreed not to attempt before December 1, 2009 to execute on or
file any motion, petition or application or commence any proceeding seeking the
collection of such award of attorneys’ fees and costs, which is intended to
allow the Parties a sufficient period within which to execute a definitive
agreement in connection with the Proposed Transaction or a Transaction. Such
period shall automatically be extended for a period of 120 days from December 1,
2009 if the definitive agreement is executed in full on or before December 1,
2009. In addition, if the execution of the definitive agreement occurs on or
before December 1, 2009, the December 1, 2009 deadline shall automatically be
further extended for a period of 60 days for each amendment to a proxy or
information statement related to the transactions contemplated by the
acquisition agreement, filed by us in response to comments made by the SEC.
However, there can be no assurances that the Proposed Transaction or any other
Transaction will occur or that it would be accretive to our stockholders or
result in any payment being made to our stockholders.





As part
of a potential cooperative transaction we have been considering with a certain
third party, we have agreed to an exclusivity negotiation period with such third
party in exchange for a non-refundable payment of $200,000 made to us by such
third party, recognized under “Deferred gain” as of September 30, 2009 on our
balance sheet. The exclusivity period expires upon the later of 100 calendar
days from September 21, 2009 and the termination date of a definitive agreement
entered into with such third party, if any. However, if a definitive agreement
for the transaction is entered into prior thereto, the exclusivity payment will
be credited against the purchase price in such transaction. During the
exclusivity period, we will provide to the third party access to our employees,
properties, contracts, records and other related materials. In addition, in the
mutual interests of us and such third party and at the direction of the third
party, in connection with the potential strategic transaction, we actively
resumed research and development of our Portable Artificial Kidney product with
direct reimbursement of related expenditures by such third party. As of
September 30, 2009, we incurred and expect reimbursement of approximately
$43,000, recognized under “Expense receivable” on our balance sheet and offset
as a credit to our statement of operations for the three months ended September
30, 2009, for these expenses. Currently, the exclusivity period remains in
effect and negotiations continue.





If we are
unable to enter into a definitive agreement and otherwise comply with the
deadlines and requirements summarized above, under the terms of the Stipulation,
NQCI will have the right to execute on or file any motion, petition or
application or commence any proceeding seeking the collection of the sum of
approximately $1.87 million in attorneys’ fees and costs that have been awarded
in NQCI’s favor under the terms of the Partial Final Award, which would impact
our ability to use and develop our technologies, would have a material adverse
effect on our business and results of operations and may cause us to cease our
operations and/or file for bankruptcy.


22





Based
upon our current plans, we believe that our existing cash reserves will not be
sufficient to meet our operating expenses and capital requirements before we
achieve profitability. Accordingly, we need to seek additional funds through
public or private placement of shares of our preferred or common stock or
through public or private debt financing, or to enter into a transaction for the
sale or licensing of our assets, including the sale of substantially all or all
of our assets, or a business combination with another entity in a transaction
where we would not be the surviving entity. Our ability to meet our cash
obligations as they become due and payable depends on our ability to sell
securities, borrow funds, further reduce operating costs, sell or license our
assets, including the sale of substantially all or all of our assets or a
business combination with another entity in a transaction where we would not be
the surviving entity, or some combination thereof. We may not be successful in
obtaining necessary funds on acceptable terms, if at all. The inability to
obtain financing will require us to curtail our current plans, which will have a
material adverse effect on our plan of operations. Our ability to execute on our
current business plan is dependent upon our ability to obtain equity financing,
develop and market our products, and, ultimately, to generate revenue. As a
result of these conditions, there is substantial doubt about our ability to
continue as a going concern.





We are
currently actively considering all potential transactions, which may include the
Proposed Transaction (as described above), strategic partnership(s), disposition
of substantially all or all of our assets, a business combination with another
entity in a transaction where we would not be the surviving entity and/or
licensing of certain of our intellectual property rights, as a means to further
develop our technologies. Because of the current economic conditions and
those particularly affecting healthcare related companies and because of our
lack of liquidity, there is no assurance that any such transaction will occur or
that it would be accretive to our stockholders or result in any payment being
made to our stockholders. If we are unsuccessful in obtaining immediate debt or
equity financing on terms acceptable to us or otherwise unsuccessful in
addressing our liquidity concerns or if we are unable to enter into any such
transaction, this could have a material adverse effect on our plan of operation,
may result in the curtailment of our operations and/or require us to file for
bankruptcy.





As part
of our analysis of ways to reduce costs and in light of the high cost of
continuing to be a public reporting company under the Exchange Act and complying
with the Sarbanes-Oxley Act of 2002, we are contemplating exploring and may be
required to explore alternative platforms, such as deregistering under the
Exchange Act, or “going dark” and having our common stock continue to be quoted
on the Pink Sheets without being a reporting company under Section 12(g) of the
Exchange Act. We are continuing to evaluate our options. Our recent
move to the Pink Sheets has provided meaningful savings to us as a result
of the elimination of fees associated with being listed on a national stock
exchange and deregistering under the Exchange Act would provide substantial
savings as a result of the elimination of the costs of being registered under
the Exchange Act. Analysis of deregistering under the Exchange Act involves
not only reducing costs, but also our expected sources of future capital as well
as the number of record holders of our outstanding common stock. A move to
deregister under the Exchange Act may result in a less liquid market for our
shares, but would result in continued public trading of our common stock by
holders wishing to trade.





Our
operating activities and research and development efforts resulted in a net loss
of $23.0 million in 2008 and $1.5 million and $2.8 during the three and nine
months ended September 30, 2009, respectively. In addition, we invested $25.0
million in high grade money market funds and marketable securities of which we
sold $24.7 million of the investments, leaving a balance of $0.3 million as of
September 30, 2009.





We have
focused much of our efforts on development of the PAK, which has not been
derived from the technology covered by the License Agreement. Through the
productive research and development efforts of the PAK, we have completed
functional prototypes of our attended care and home PAKs that we hope to
commercialize after 510(k) clearance from the FDA which we hope to
submit sometime in the future. Prior to the 510(k) submission to the FDA
for clinical use under direct medical supervision, the units will undergo final
verification and validation. It generally takes 4 to 12 months from the date of
a 510(k) submission to obtain clearance from the FDA, although it may take
longer. We expect that our monthly expenditures will increase as we shift
resources towards developing a marketing plan for the PAK. This plan will be
dependant on our ability to raise funds to satisfy our current liabilities and
other obligations as they become due and obtaining additional debt or equity
financing and otherwise continuing our business operations. If we are
unsuccessful in doing so, we will not be able to submit a 510(k)
notification with the FDA for this product.




We have
used some of our resources for the development of the WAK and have demonstrated
a feasibility prototype. Commercialization of the WAK will require development
of a functional prototype and likely a full pre-market approval by the FDA,
which could take several years. Our rights to the WAK derive in part from the
License Agreement pursuant to which we obtained the exclusive rights to the
Technology. Subject to continuing our business operations and/or entering into a
transaction for the sale of substantially all or all of our assets or a
business combination with another entity in a transaction where we would not be
the surviving entity, we will determine whether to devote additional resources
to the development of the WAK.




Because
neither the PAK nor the WAK is yet at a stage where it can be marketed
commercially, we are not able to predict the portion of our future business
which will be derived from each.





Research
and Development





We
employed an interdisciplinary team of scientists and engineers who were
developing the PAK and a separate, interdisciplinary team developing the WAK. As
a result of general economic conditions in 2008 and a deterioration of our
liquidity position, coupled with the prolonged delay in our ability to reach a
resolution with respect to the consummation of the Technology Transaction, we
have been significantly adversely affected. As a result, as of September 30,
2009 we have terminated 20 employees or 77% of our staff and have deferred
compensation of approximately $172,000. However, our downsized team is
continuing limited development of the PAK and we hope to be able to in the
future to devote any then available resources to the development of the
WAK.


23





In
addition, in the interest of the potential cooperative transaction with a
certain third party that we are currently considering, we have agreed to an
exclusivity period with such third party to negotiate a potential cooperative
transaction, and in connection therewith, we have actively resumed research and
development of our Portable Artificial Kidney. Such third party has agreed to
reimburse us for our related expenditures as well as salaries and overhead
expenses of our two engineers. As of September 30, 2009, we incurred and expect
reimbursement of approximately $43,000 for these expenses, recognized under
“Expense receivable” and offset as a credit to our statement of operations for
the three months ended September 30, 2009.





The PAK
is a multifunctional device that will perform hemodialysis, hemofiltration and
ultrafiltration under direct medical supervision. A variation of this device
will be developed for chronic home hemodialysis. An initial prototype of the
PAK, capable of performing the basic functions of a hemodialysis machine, and
demonstrating our unique new fluidics circuit, was completed at the end of
2007. The first physical prototype including industrial design of the PAK was
completed in October 2008. We hope to further refine this prototype by adding to
it safety sensors and electronic controls. Subject to our ability to obtain
debt or equity financing to satisfy our current liabilities and other
obligations as they become due, as more fully described above in the section
captioned “Recent Developments,” we hope to complete the final product
design of the PAK. The PAK units will undergo final verification and validation
prior to a 510(k) submission for clinical use under direct medical supervision.
A clinical study will not be required for this submission.





In a
clinical feasibility study conducted in London in March 2007, a research
prototype of the WAK was demonstrated in eight patients with end-stage renal
disease. Patients were treated for up to eight hours with adequate clearances of
urea and creatinine. The device was well tolerated and patients were able
to conduct activities of normal daily living including walking and
sleeping. There were no serious adverse events although clotting of the dialyzer
occurred in two patients. To our knowledge, this is the first successful
demonstration of a WAK in humans.  Subject to us continuing our business
operations and further subject to us first consummating the Proposed
Transaction or another Transaction for the sale of substantially all or all of
our assets or a business combination with another entity in a transaction where
we would not be the surviving entity, and further subject to availability
of sufficient working capital to us, we hope to make substantial improvements to
the WAK. This work will result in a WAK Generation 2.0. Pending FDA approval of
an investigational Device Exemption (IDE), additional clinical studies will be
conducted upon completion of the Generation 2.0 WAK prototype.





Subject
to continuing our business operations and/or entering into a transaction for the
sale of substantially all or all of our assets, or a business combination with
another entity in a transaction where we would not be the surviving entity, if
we successfully obtain additional financing, we plan to make improvements to the
WAK design intended to move it from a feasibility prototype to a product
prototype. These include improvement of the heparin pumping system intended to
address the dialyzer clotting problem, the addition of safety sensors required
for commercial dialysis equipment, the addition of electrical controls to
provide a convenient user interface, improvements to the blood flow circuit, and
further miniaturization of the device to improve fit to the human body.
Additional clinical studies will be conducted upon completion of the
prototype.





We
incurred $0.6 million and $2.4 million in research and development costs during
the three and nine months ended September 30, 2009, respectively. This
compares to $12.7 million and $18.9 million incurred during the three and
nine months ended September 30, 2008, respectively. The decrease in research and
development costs is attributable to the completion and termination of the
Aubrey Agreement, our research and development progress, our corporate
restructuring efforts, entry into the Stipulation and the Memorandum with NQCI
and a direct reimbursement of PAK related research and development expenses
arrangement, including salaries and overhead expenses of our two engineers,
agreed to with a certain third party.





Contractual
Obligations and Commercial Commitments





The
following table sets forth a summary of our material contractual obligations and
commercial commitments as of September 30, 2009:





Contractual Obligations:
                  
                  Total
                  
                  
                  Less than 1
                    year
                  
                  
                  1 - 3 years
                  
                  
                  3 - 5 years
                  
                  
                  More than 5
                    yearsCapital
      Lease Obligations
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Operating
      Lease Obligations (1)
                  
                  
                  2,149,059
                  
                  
                  
                  137,973
                  
                  
                  
                  1,677,342
                  
                  
                  
                  333,744
                  
                  
                  
                  -Research
      & Development Contractual Commitments
                  
                  
                  5,000
                  
                  
                  
                  5,000
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Other
      Liabilities
                  
                  
                  6,515
                  
                  
                  
                  1,335
                  
                  
                  
                  5,180
                  
                  
                  
                  -
                  
                  
                  
                  -$
                  2,160,574
                  
                  
                  $
                  144,308
                  
                  
                  $
                  1,682,522
                  
                  
                  $
                  333,744
                  
                  
                  $
                  -




Off-Balance
Sheet Arrangements




As of
September 30, 2009, we had no off-balance sheet arrangements that have or are
reasonably likely to have a current or future effect on our financial condition,
results of operations or cash flows.


24





Critical
Accounting Policies and Estimates





The
discussion and analysis of our financial condition and results of operations is
based upon our unaudited interim financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United
States. Generally accepted accounting principles require management to make
estimates, judgments and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, and the disclosure of contingent assets and
liabilities. We base our estimates on experience and on various other
assumptions that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that may not be readily apparent from other sources.
Our actual results may differ from those estimates.





We
consider our critical accounting policies to be those that involve significant
uncertainties, require judgments or estimates that are more difficult for
management to determine or that may produce materially different results when
using different assumptions. We consider the following accounting policies to be
critical:





Marketable
Securities





We
classify investments with maturity dates greater than three months when
purchased as marketable securities. Investments, including certificates of
deposit with maturity dates greater than three months when purchased, and which
have readily determined fair values, are classified as available-for-sale
investments and reflected in current assets as marketable securities at fair
market value. Historically, we have complied with our investment policy
which requires that all investments be investment grade quality and no more than
ten percent of our portfolio may be invested in any one security or with one
institution. However, recently, our ability to continue to follow this policy
has not been practicable due to the small aggregate amount of investment funds
that has been remaining for investment. As a result, as of September 30, 2009,
all of our cash was held in a high grade money market fund.





Short-term
investments classified as available-for-sale were as follows:





September 30, 2009Aggregate Fair
                        Value
                      
                      
                      GrossUnrealized
                        Gains / (Losses)
                      
                      
                      Estimated Fair
                        ValueCommercial
      paper
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Corporate
      securities fixed rate
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Total
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -





We review
impairments associated with the above in accordance with ASC 320-10-35 Investments-Debt and Securities,subtopic Overall,section Subsequent
Measurement(formerly FAS 115 Accounting for Certain Investments
in Debt and Equity Securities and FSP FAS 115-1 and FAS 124-1 The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments) to determine the
classification of the impairment as temporary or other-than-temporary. However,
due to the small aggregate amount of available investment funds, we did not hold
investments in commercial paper and/or high grade marketable securities, but
rather held our cash in high grade money market funds as of September 30, 2009.
There were no short-term investments classified as available-for-sale as of
September 30, 2009 and as a result, the related impairments review was not
necessary.





There
were no gross unrealized gains or losses as of September 30, 2009.





Shares
Issuable





Pursuant
to the August 4, 2008, Second Interim Award, stating that, if the Technology
Transaction is submitted to and approved by our stockholders, 9,230,000 shares
of our common stock should be issued to NQCI to effectuate the transaction, we
accrued for the 9,230,000 shares of our common stock. As the Second Interim
Award stated that we must issue 9,230,000 shares upon the closing of the
Technology Transaction and we have been unable to consummate such transaction,
such contingency not being within our control, we have therefore, recorded the
issuance as a liability, rather than as an equity issuance. As of December 31,
2008, we accrued for the 9,230,000 shares of our common stock to be issued to
NQCI in accordance with ASC 450 Contingencies(formerly FAS 5
Accounting for
Contingencies), with the initial fair value of the shares measured on
August 4, 2008, the date of the Second Interim Award. Until issuance, the
shares were being marked to market in accordance with ASC 815-40 Derivatives and Hedging,subtopic Contracts in
Entity’s Own Equity(formerly EITF 00-19 Accounting for Derivative Financial
Instruments Indexed to and Potentially Settled in, a Company’s Own Stock
), with subsequent changes in fair value recorded as non-operating change in
fair value of shares issuable to our statement of operations. The fair value of
the shares was measured using the closing price of our common stock on the
reporting date. The measured fair value of $10,153,000 for the accrued 9,230,000
shares on August 4, 2008, the date of the Second Interim Award, was accrued
under “Shares issuable” and expensed to “Research and development.” From marking
to market, the fair value of the shares issuable was revalued at $1,569,100 as
of December 31, 2008. The resulting non-operating adjustment in fair value of
$8,583,900 to the statement of operations for the year ended December 31, 2008
was recognized as “Change in fair value of shares issuable.”The Technology
Transaction was not submitted to our stockholders for approval.




As a
result of the issuance of the Partial Final Award and the execution of the
Stipulation and the Memorandum, see Note 4, “Legal Proceedings” above, the
Technology Transaction will not occur and we will no longer be obligated to
issue the Shares to NQCI formerly required pursuant to the terms of the Second
Interim Award issued by the Arbitrator on August 4, 2008, and will no
longer be required to file a resale registration statement under the Securities
Act for the Shares. Accordingly, the net fair value of $1,569,100 for the
9,230,000 issuable shares accrued under “Shares issuable” as of December 31,
2008, was reversed resulting in an adjustment of $1,569,100 to non-operating
income in the statement of operations, recognized as “Change in and reduction of
shares issuable”, for the nine months ended September 30, 2009.


25




Stock-Based
Compensation





ASC 718
Compensation-Stock
Compensation(formerly FAS 123R Share-Based Payment) and
Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
(“SAB 107”) require the measurement and recognition of compensation expense for
all share-based payment awards made to employees and directors based on
estimated fair values. We have applied the provisions of SAB 107 in its adoption
of ASC 718.





In
determining stock-based compensation, we consider various factors in our
calculation of fair value using a black-scholes pricing model. These factors
include volatility, expected term of the options, and forfeiture rates. A change
in these factors could result in differences in the stock based compensation
expense.





Recent
Accounting Standards





In
April 2009, the FASB released ASC 825-10-65 Financial Instruments,subtopic Overall,section Transition and
Open Effective Date Information(“ASC 825-10-65”) (formerly FSP FAS
No. 107-1 and Accounting Principles Board Opinion (“APB”) 28-1Interim Disclosure about Fair Valueof Financial
Instruments) which requires interim disclosures regarding the fair values
of financial instruments that are within the scope of ASC 825-10-50 Financial Instruments,subtopic Overall,section Disclosure.  Additionally,
ASC 825-10-65 requires disclosure of the methods and significant assumptions
used to estimate the fair value of financial instruments on an interim basis as
well as changes of the methods and significant assumptions from prior periods.
ASC 825-10-65 does not change the accounting treatment for these financial
instruments and is effective for interim and annual periods ending after
June 15, 2009. We adopted ASC 825-10-65 as of June 30,
2009.





In
May 2009, the FASB issued ASC 855 Subsequent Events(“ASC
855”)(formerly
FAS 165 Subsequent
Events) which
sets forth the period after the balance sheet date during which management of a
reporting entity should evaluate events or transactions that may occur for
potential recognition or disclosure in the financial statements, the
circumstances under which an entity should recognize events or transactions
occurring after the balance sheet date in its financial statements, and the
disclosures that an entity should make about events or transactions that
occurred after the balance sheet date. ASC 855 will be effective for interim or
annual periods ending after June 15, 2009 and will be applied
prospectively. We adopted the provisions of ASC 855 as of June 30, 2009.
The adoption of ASC 855 did have a material impact on our financial position,
results of operations, and cash flows.





In
June 2009, the FASB issued ASC 105 Generally Accepted Accounting
Principles(“ASC 105”) (formerly FAS 168 The FASB Accounting Standards
Codification (Codification) and the Hierarchy of GAAP) which establishes
the Codification as the single source of authoritative U.S. GAAP recognized by
the FASB to be applied by nongovernmental entities. SEC rules and interpretive
releases are also sources of authoritative GAAP for SEC registrants. ASC 105
modifies the GAAP hierarchy to include only two levels of GAAP: authoritative
and non-authoritative. ASC 105 is effective beginning for periods ended after
September 15, 2009. As ASC 105 is not intended to change or alter existing
GAAP, it will not impact the Company’s financial position, results of operations
and cash flows.





In August
2009, the FASB issued Accounting Standard Update (“ASU”) 2009-05 under ASC 820
Fair Value Measurements and
Disclosuresconcerning measuring liabilities at fair value. The new
guidance provides clarification that in circumstances in which a quoted price in
an active market for the identical liability is not available, a reporting
entity is required to measure fair value using certain valuation techniques.
Additionally, it clarifies that a reporting entity is not required to
adjust the fair value of a liability for the existence of a restriction that
prevents the transfer of the liability. This new guidance is effective for the
first reporting period after its issuance, however earlier application is
permitted. The adoption of this guidance is not expected to have a material
impact on the Company’s consolidated financial position or results of
operations.





ITEM
3.      Quantitative and Qualitative Disclosures
about Market Risk





We invest
our cash in short term high grade commercial paper, certificates of deposit,
money market accounts, and marketable securities. We consider any liquid
investment with an original maturity of three months or less when purchased to
be cash equivalents. We classify investments with maturity dates greater than
three months when purchased as marketable securities, which have readily
determined fair values and are classified as available-for-sale securities. Our
investment policy requires that all investments be investment grade quality and
no more than ten percent of our portfolio may be invested in any one
security or with one institution. Historically, we complied with our
investment diversification policy which states that no more than ten percent of
our total marketable securities will be invested in a single, specific security.
However, our ability to continue to abide by this stipulation has not been
practicable based upon the small total amount of investment funds.




Investments
in both fixed rate and floating rate interest earning instruments carry a degree
of interest rate risk arising from changes in the level or volatility of
interest rates; however, interest rate movements do not materially affect the
market value of our portfolio because of the short-term nature of these
investments. A reduction in the overall level of interest rates may
produce less interest income from our investment portfolio. The market risk
associated with our investments in debt securities is substantially mitigated by
the frequent turnover of our portfolio.


26
  ITEM
4.      Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





Our
management, with the participation of our Chief Executive Officer and our Chief
Financial Officer, conducted an evaluation of the effectiveness of our
disclosure controls and procedures as of the end of the period covered by this
Quarterly Report, as is defined in Rules 13a-15(e) and 15d-15(e) promulgated
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Our
disclosure controls and procedures are intended to ensure that the information
we are required to disclose in the reports that we file or submit under the
Exchange Act is (i) recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms and (ii) accumulated and
communicated to our management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate, as the principal executive and financial
officer, to allow timely decisions regarding required disclosures.





Based on
that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this Quarterly Report,
our disclosure controls and procedures were effective. Our management has
concluded that the financial statements included in this Quarterly Report
present fairly, in all material respects our financial position, results of
operations and cash flows for the periods presented in conformity with generally
accepted accounting principles.





It should
be noted that any system of controls, however well designed and operated, can
provide only reasonable, and not absolute, assurance that the objectives of the
system will be met. In addition, the design of any control system is based in
part upon certain assumptions about the likelihood of future events. Because of
these and other inherent limitations of control systems, there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions.





Changes in
Internal Control overFinancial
Reporting





In
connection with the evaluation of our internal controls during our last fiscal
quarter, our Chief Executive Officer and Chief Financial Officer concluded that
there have been no changes in our internal control over financial reporting, as
defined in Rule 13a-15(f) under the Exchange Act during our most recent fiscal
quarter that have materially affected, or are reasonably likely to materially
affect our internal control over financial reporting.


27


PART
II — OTHER INFORMATION




ITEM
1.      Legal Proceedings.





From time
to time we may be a defendant or plaintiff in various legal proceedings arising
in the normal course of our business. Except as set forth below, we are
currently not a party to any material pending legal proceedings or government
actions, including any bankruptcy, receivership, or similar proceedings. In
addition, except as set forth below, our management is not aware of any known
litigation or liabilities that could affect our operations. Furthermore, with
the exception of Dr. Gura, our Chief Medical and Scientific Officer, who
according to NQCI’s preliminary Proxy Statement on Schedule 14A, Amendment No.
2, filed with the SEC on February 13, 2009, owns 15,497,250 shares of NQCI’s
common stock which includes 800,000 shares held by Medipace Medical Group,
Inc. an affiliate of Dr. Gura and includes 250,000 shares subject to warrants
held by Dr. Gura which are currently exercisable, or approximately 20.9% of its
total outstanding shares as of January 31, 2009, we do not believe that
there are any proceedings to which any of our directors, officers, or
affiliates, any owner of record who beneficially owns more than five percent of
our common stock, or any associate of any such director, officer, affiliate of
ours, or security holder is a party adverse to us or has a material interest
adverse to us.




On
December 1, 2006, Operations initiated the Proceeding against NQCI for its
breach of the License Agreement. On April 13, 2009, the Arbitrator issued a
Partial Final Award which resolved the remaining issues that were pending
for decision in the Proceeding. The Partial Final Award adopted one of the
proposals submitted to the Arbitrator by us and provides that we and Operations
shall have a perpetual exclusive license (the “Perpetual License”) in the
Technology (as defined in the Merger Agreement, dated as of September 1, 2006
(the “Merger Agreement”), among the Company, Operations and NQCI and the License
Agreement, dated as of September 1, 2006 (the “License Agreement”), between the
Company and NQCI) primarily related to the Wearable Artificial Kidney and any
other Technology contemplated to be transferred under the Technology Transaction
(as defined in the Merger Agreement). Under the terms of the Partial Final
Award, in consideration of the Perpetual License to the Company, NQCI was
awarded a royalty of 39% of all net income, ordinary or extraordinary,
received by us (the “Royalty”) and NQCI is to receive 39% of any shares received
in any merger transaction to which the Company or Operations may become a party.
NQCI’s interest as licensor under the Perpetual License shall be freely
assignable. In addition, the Partial Final Award provides that we shall pay NQCI
an amount equal to approximately $1,871,000 in attorneys’ fees and costs
previously awarded by the Arbitrator in an order issued on August 13, 2008, that
NQCI’s application for interim royalties and expenses is denied and that NQCI is
not entitled to recover any additional attorneys’ fees. Finally, the Partial
Final Award also provides that the Arbitrator shall retain jurisdiction to
supervise specific performance of the terms and obligations of the Award
including, but not limited to, any dispute between the parties over the manner
of calculation of the Royalty. The Partial Final Award was issued by the
Arbitrator as a result of each party’s request for the Arbitrator to order
alternative relief due the parties’ inability to proceed with the Technology
Transaction. For a full description of the Proceeding and the Arbitrator’s
interim awards issued in connection therewith, please see Item 3 - Legal
Proceedings of our Annual Report.





On April
17, 2009, NQCI requested that the Arbitrator correct material terms of the
Partial Final Award relating to the meaning and calculation of the Royalty
terms. We opposed the request and on May 1, 2009, the Arbitrator denied NQCI’s
request to modify the language of the Partial Final Award. The Arbitrator
further held that past expenses shall not be included in net income computations
for purposes of the Royalty, that NQCI may make an application to the Arbitrator
requesting a royalty distribution, specifying the amount sought and basis for
the claimed amount, and that NQCI is entitled to audit our financial statements,
books and records to verify our net income, on an annual basis, or more often,
if the Arbitrator permits.





Binding Memorandum of
Understanding





On August
7, 2009, to clarify, resolve and settle certain issues and any disputes that
have arisen between us and NQCI with respect to the Partial Final Award and the
Proceeding, the Xcorp Parties entered into the Memorandum with NQCI. Under the
terms of the Memorandum, among other things, the Parties agreed to: (i) assign
and transfer all of their rights, title and interest in and to the Polymer
Technology to the Joint Venture, which will be jointly owned by the Parties and
through which the Parties will jointly pursue the development and
exploitation of the Polymer Technology, and (ii) negotiate, execute and deliver
within 60 days following the Stockholder Vote Date the Operating Agreement
governing the operation of the Joint Venture based on the terms set forth in the
Memorandum.





The Xcorp
Parties and NQCI will be the initial two members of the Joint Venture (Xcorp
Parties’ interest shall be held of record by either us or Operations, as
determined by the Xcorp Parties) with NQCI and the Xcorp Parties having a 60%
and 40% membership interest (the “Membership Interests”) in the Joint Venture,
respectively. Subject to such other terms and provisions as the Parties may
agree upon, the Operating Agreement shall include the following
terms:





·
            the
      Joint Venture shall be managed by a three-member JV
  Board;




·
            until
      such time as NQCI fails to hold a greater percentage of the Membership
      Interests than the Xcorp Parties, two members of the JV Board shall be
      designated by NQCI and until such time as the Xcorp Parties fail to hold
      at least 10% of the Membership Interests and one JV Manager shall be
      designated by the Xcorp Parties;




·
            NQCI
      shall have the right to appoint a Chairman and/or a Chief Executive
      Officer of the Joint Venture, who will have day-to-day management
      authority with respect to the Joint Venture, subject to oversight by the
      JV Board and the terms and conditions of the Memorandum and the Operating
      Agreement, and a Chief Scientific Officer, who may be employed by the
      Joint Venture upon customary and reasonable terms and
      conditions;




28




·
            if
      a JV Manager provides additional services to the Joint Venture as an
      employee or a consultant, he or she may be compensated by the Joint
      Venture as is mutually reasonably approved in writing by the Parties;
      provided that with the exception of reimbursement of reasonable expenses
      incurred in connection with their services performed for the Joint Venture
      in their official officer capacity, neither Robert Snukal, the Chief
      Executive Officer of NQCI, nor Kelly McCrann, our Chairman and Chief
      Executive Officer (or such other persons as may be appointed or elected in
      their place), shall in any event receive a salary or other compensation
      from the Joint Venture;




·
            except
      as otherwise required by law, all decisions related to the operations of
      the Joint Venture shall be made by a majority of the JV Board, except that
      certain actions (as described in the Memorandum) by the Joint Venture or
      any of its subsidiaries shall require the affirmative vote or written
      consent of the holders of at least 90.1% of the Membership Interests then
      outstanding; and




·
            from
      and after August 1, 2009, the Xcorp Parties shall pay 61% and NQCI shall
      pay 39% of the reasonable costs and expenses related to protecting,
      preserving and exploiting the Licensed
  Technology.





In
addition, the Xcorp Parties agreed to contribute $500,000 in cash to the bank
account established by the Joint Venture, on the later of (x) three business
days of the consummation of the first to occur of the Proposed Transaction or
another Transaction and (y) the date on which the Joint Venture establishes such
bank account, for which the Parties (or their representatives) shall be joint
signatories. Furthermore, provided that the Proposed Transaction or a
Transaction has been consummated, NQCI agreed to contribute on the Xcorp
Parties’ behalf an additional $500,000 in cash to the Joint Venture at such time
as the JV Board reasonably determines that such funds are required
to facilitate the Joint Venture’s development of the Polymer Technology.
This additional contribution amount will be reimbursed to NQCI by the Xcorp
Parties from the first funds distributed to the Xcorp Parties by the Joint
Venture (other than pursuant to certain quarterly tax related distributions).
Additionally, with respect to the Joint Venture, the Parties agreed to certain
liquidity rights consisting of customary rights of first refusal and co-sale
rights, unlimited piggyback registration rights and the right to up to two
demand registrations (subject to lock-ups and other underwriter requirements),
customary preemptive rights (available to a member of the Joint Venture for so
long as such member holds at least 10% of the Membership Interests then
outstanding), customary anti-dilution protections and other standard
distribution and information rights.





The
Parties also agreed to cooperate as reasonably required by the Xcorp Parties in
order for us to consummate the Proposed Transaction for the sale of the Licensed
Technology or another Transaction involving the sale, license or other
disposition by us of the Licensed Technology. The Parties further agreed that
upon the consummation of a Proposed Transaction, they will allocate the
Transaction Proceeds received in such transaction in accordance with the terms
set forth in the Memorandum and summarized below, subject to the actual terms of
the Proposed Transaction, when and if such transaction is consummated. However,
there can be no assurances that the Proposed Transaction or any other
Transaction will occur or that the terms thereof will be similar to those
provided for in the Memorandum and summarized below, and the actual terms of the
Proposed Transaction or another Transaction will be provided for in the
definitive agreement entered into in connection with such
transaction.





·
            NQCI
      shall receive the NQCI Amount;


·
            The
      third party will pay the Xcorp Parties $250,000 upon the earlier of the
      signing of a letter of intent and an acquisition agreement providing for
      the Proposed Transaction, approximately 50% (less the foregoing $250,000)
      of the Transaction Proceeds payable in cash to the Xcorp Parties as the
      First Installment, approximately 25% of such proceeds as the Second
      Installment
      and 25% of such proceeds as the Third
  Installment;


·
            The
      Transaction Proceeds shall be allocated between the Parties as follows:
      (i) $250,000 to the Xcorp Parties, payable to the Xcorp Parties on the
      earlier of the signing of a letter of intent and an acquisition agreement
      providing for the Proposed Transaction, (ii) to NQCI, an amount equal to
      the NQCI Amount less the sum of the Second Installment and the Third
      Installment, payable to NQCI within seven business days of receipt of the
      First Installment, (iii) to the Xcorp Parties, the remainder of the First
      Installment, (iv) to NQCI, the amount of the Second Installment, payable
      to NQCI within three business days of receipt of the Second Installment,
      (v) to NQCI, the amount of the Third Installment, payable to NQCI within
      three business days of receipt of the Third Installment and (vi) the
      remainder of the Transaction Proceeds shall be retained by the Xcorp
      Parties; provided that under no circumstances shall NQCI be entitled to or
      receive from the Transaction Proceeds an amount greater than the NQCI
      Amount;


·
            In
      the event any of the Installments are paid by the third party in other
      than cash, NQCI shall receive its proportionate share of such
      consideration in accordance with the terms of the Memorandum;
      and


·
            The
      Xcorp Parties shall also pay to NQCI 39% of any royalty or other payments
      received by the Xcorp Parties in excess of the Transaction Proceeds in
      connection with the Proposed
Transaction.





In the
event that the timing or the amount of the payments from the third party under
the terms of the Proposed Transaction (or another Transaction) is other than as
contemplated in the Memorandum, the Parties shall make such equitable
adjustments as are required to preserve, to the maximum extent possible, the
intent of the distribution of Transaction Proceeds provisions of the Memorandum.
In the event that the Xcorp Parties do not consummate the Proposed Transaction
or if the terms of the Proposed Transaction are other than what is contemplated
under the Memorandum and the Xcorp Parties instead consummate an alternative
Transaction, the Parties shall apply the methodology specified in the Memorandum
to the maximum extent possible in order to allocate between them the proceeds of
such Transaction.





Additionally,
NQCI agreed to use its best efforts to enter into an agreement with a certain
third party pursuant to which such third party and NQCI will each (a) confirm
and acknowledge (i) their joint ownership of the Polymer Technology, (ii) the
existence and validity of the exclusive license to NQCI of the medical
applications of the Polymer Technology and (iii) the existence and validity of
the exclusive license to such third party of the non-medical applications of the
Polymer Technology; and (b) agree to prepare, execute and deliver as promptly as
practicable upon request by either of such parties a definitive license
agreement reflecting the terms and conditions of the foregoing exclusive
licenses. The Parties also agreed to certain customary representation and
warranty, indemnity and other miscellaneous terms.


29





The
foregoing summary of the Memorandum and the transactions contemplated thereby
does not purport to be complete and is subject to, and qualified in its entirety
by, the full text of the Memorandum filed as Exhibit 10.1 to our Quarterly
Report on Form 10-Q for the six month period ended June 30, 2009, filed
with the SEC on August 13, 2009.





Agreement and Stipulation
Regarding Partial Final Award





In
connection with the issuance of the Partial Final Award and the execution of the
Memorandum between the Parties, on August 7, 2009 Operations entered into the
Stipulation with NQCI, pursuant to which Operations and NQCI agreed (i) not to
challenge the terms of the Partial Final Award or any portion of such award,
(ii) that any of the Parties may, at any time, seek to confirm all but not part
of the Partial Final Award through the filing of an appropriate petition or
motion with the appropriate court and in response to such action to confirm the
Partial Final Award, no Party will oppose, object to or in any way seek to
hinder or delay the court’s confirmation of the Partial Final Award, but will in
fact support and stipulate to such confirmation, (iii) to waive any and all
right to appeal from, seek appellate review of, file or prosecute any lawsuit,
action, motion or proceeding, in law, equity, or otherwise, challenging,
opposing, seeking to modify or otherwise attacking the confirmed Partial Final
Award or the judgment thereon and (iv) subject to certain conditions, NQCI will
not attempt during the Non-Execution Period to execute on or file any motion,
petition or application or commence any proceeding seeking the collection of any
attorneys’ fees that have been awarded in NQCI’s favor under the terms of the
Partial Final Award, which is intended to allow the Parties a sufficient
period within which to execute an Acquisition Agreement in connection with the
Proposed Transaction or a Transaction; provided that such period shall
automatically be subject to an Extension Date if the Acquisition Agreement is
executed in full on or before December 1, 2009. If the execution of the
Acquisition Agreement occurs on or before December 1, 2009, the Extension Date
shall automatically be further extended for a period of 60 days for each
amendment to a proxy or information statement related to the transactions
contemplated by the Acquisition Agreement, filed by us in response to
comments made by the SEC.





In the
event we enter into an Acquisition Agreement for the Proposed Transaction
or another Transaction, we anticipate that we will call a special or annual
meeting of our stockholders at which our stockholders will be asked to vote on
the terms of such transaction, pursuant to a proxy or information statement that
we would file with the SEC in connection therewith. If and when we do file such
proxy or information statement with the SEC, our stockholders and other
investors are urged to carefully read such statement and any other relevant
documents filed with the SEC when they become available, because they will
contain important information about us and the transaction. Copies of such proxy
or information statement and other documents filed by us with the SEC will be
available at the Web site maintained by the SEC at www.sec.gov.





The
foregoing summary of the Stipulation and the transactions contemplated thereby
does not purport to be complete and is subject to, and qualified in its entirety
by, the full text of the Stipulation, filed as Exhibit 99.2 to our Quarterly
Report on Form 10-Q for the six month period ended June 30, 2009,
filed with the SEC on August 13, 2009.





As a
result of the issuance of the Partial Final Award and the execution of the
Stipulation and the Memorandum, the Technology Transaction will not occur, we
will no longer be obligated to issue the 9,230,000 shares of our common stock,
or the “Shares”, to NQCI and we will no longer be required to file a resale
registration statement under the Securities Act for the Shares.





ITEM
1A.      Risk Factors.




Investing
in our common stock involves a high degree of risk. In addition to the
information set forth in this report, you should carefully consider and evaluate
the risks described under section captioned “Risk Factors” in Part I, Item 1A of
our Annual Report, Part II, Item 1A of our Quarterly Reports and the
updated risk factors noted below. While we describe each risk separately herein
and in the Annual Report, some of these risks are interrelated and certain risks
could trigger the applicability of other risks described below. Also, the risks
and uncertainties described below and in the Annual Report are not the only ones
that we may face. Additional risks and uncertainties not presently known to us,
or that we currently do not consider significant, could also potentially impair,
and have a material adverse effect on, our business, results of operations
and financial condition. If any of these risks occur, our business, results of
operations and financial condition could be harmed, the price of our common
stock could decline, and future events and circumstances could differ
significantly from those anticipated in the forward-looking statements contained
in this Quarterly Report. As a result the trading price of our common stock may
decline, and you might lose part or all of your investment.





Except
for the updated risk factors set forth below, there have been no material
changes in our risk factors from those described in Part 1, Item 1A, “Risk
Factors”, in our Annual Report, other than those risk factors updated in Part
II, Item 1A, “Risk Factors”, in our Quarterly Reports.





We
do not have sufficient cash to fund the development of our products or maintain
our operations. If we are unable to obtain additional financing during 2009, we
will be required to substantially further curtail or cease operations, seek
bankruptcy protection and/or otherwise wind up our business.  If we
raise additional funding through sales of equity or equity-based securities,
your shares will be diluted. If we need additional funding for operations and we
are unable to raise it, we may be forced to liquidate assets and/or curtail or
cease operations.


30





We
anticipate that, based on our current operating plan and our existing cash and
cash equivalents, we will be able to fund our operations approximately through
the next 30 days from November 22, 2009. We are actively managing our liquidity
by limiting our expenses. If we are unable to raise additional capital by such
date and/or consummate a transaction for the sale of all or substantially all of
our assets, we will be required to substantially further curtail or cease
operations, seek bankruptcy protection or otherwise wind up our business. Any of
these actions will materially harm our business, results of operations and any
future prospects.





We have
been engaged in efforts to defer all significant expenditures as well as major
expenditures for the development of all of our products pending additional
financing or partnership support. We continue to evaluate opportunities to
reduce operating expenses. However, there can be no assurance that we will be
successful in these efforts. If we are forced to reduce or cease our operations
we may trigger additional obligations, including severance obligations, which
would further negatively impact our liquidity and capital
resources.





As a
result of our recurring losses from operations and a net capital deficiency, the
report from our independent registered public accounting firm regarding our
consolidated financial statements for the year ended December 31, 2008 includes
an explanatory paragraph expressing substantial doubt about our ability to
continue as a going concern. We need to obtain debt, equity or equity-based
financing (such as convertible debt). Such financing may not be available on
favorable terms, or at all. If we raise additional funds by selling additional
shares of our capital stock, or securities convertible into shares of our
capital stock, the ownership interest of our existing stockholders may be
diluted. The amount of dilution could be increased by the issuance of warrants
or securities with other dilutive characteristics, such as anti-dilution clauses
or price resets. If we need additional funding for operations and we are unable
to raise it, we may be forced to liquidate assets and/or curtail or cease
operations.





We urge
you to review the additional information about our liquidity and capital
resources in the “Management’s Discussion and Analysis of Financial Condition
and Results of Operations” section of this report. If we cease to continue as a
going concern due to lack of available capital or otherwise, you may lose your
entire investment in our company.





We
may need to liquidate in a voluntary or involuntary dissolution under Delaware
law or to seek protection under the provisions of the U.S. Bankruptcy Code, and
in that event, it is unlikely that our stockholders would receive any value for
their shares.





We have
incurred net operating losses every year since our inception. As of September
30, 2009, we had an accumulated deficit of approximately $47.4 million and have
been unable to raise the necessary capital to continue our existing operations.
We are currently evaluating our strategic alternatives with respect to the
development of any of our products and/or a transaction for the sale of a part,
all or substantially all of our assets. We cannot assure our stockholders that
any actions that we take would raise or generate sufficient capital to fully
address the uncertainties of our financial position. As a result, we may be
unable to realize value from our assets and discharge our liabilities in the
normal course of business. If we are unable to settle our obligations to our
creditors or if we are unable to consummate a transaction for the sale of all or
substantially all of our assets or another strategic transaction with respect to
the products that we have been engaged in developing, we would likely need to
liquidate in a voluntary dissolution under Delaware law or to seek protection
under the provisions of the U.S. Bankruptcy Code. In that event, we or a trustee
appointed by the court may be required to liquidate our assets. In either of
these events, we might realize significantly less value from our assets than
their carrying values on our financial statements. The funds resulting from the
liquidation of our assets would be used first to satisfy obligations to
creditors before any funds would be available to our stockholders, and any
shortfall in the proceeds would directly reduce the amounts available for
distribution, if any, to our creditors and to our stockholders.





In the
event we are required to liquidate under Delaware law or the federal bankruptcy
laws, it is highly unlikely that stockholders would receive any value for their
shares.





We
are seeking to maximize the value of our assets, and address our liabilities and
raise additional capital for our existing business. We are attempting to pursue
asset out-licenses, asset sales, mergers or similar strategic transactions with
respect to any of our product that we have been engaged in developing. We may be
unable to satisfy our liabilities and can provide no assurances that we can be
successful in completing any corporate transaction with any third party or
executing a strategic transaction with respect to our assets and/or our products
that we have been engaged in developing.





Due to
our financial position, we are unable to initiate further development of our
products, however, we have actively resumed research and development of the PAK
as a result of the direct reimbursement arrangement of the related expenditures
agreed to with a certain third party with
which we have agreed to an exclusivity period to negotiate a potential
cooperative transaction. We continue to actively consider this potential
strategic deal, as well as all other strategic alternatives, with respect to our
products that we have been engaged in developing and our assets, with the goal
of maximizing the value of those assets. There are substantial challenges and
risks which will make it difficult to successfully implement any of these
opportunities. Even if we decide to pursue a strategic transaction with respect
to our products that we have been engaged in developing and/or for the sale of
all or substantially all of our assets, we may be unable to do so on acceptable
terms, if at all. There can be no assurances that any such transaction will
occur or that it would be accretive to our stockholders or result in any payment
being made to our stockholders. In the event we are unable to complete a
strategic transaction with respect to our products that we have been engaged in
developing and/or for the sale of a part, all or substantially all of our
assets, we may be forced to liquidate in a voluntary dissolution under Delaware
law or to seek protection under the provisions of the U.S. Bankruptcy
Code.





Stockholders
should recognize that in our efforts to address our liabilities and fund future
operations and development of our products, we may pursue strategic alternatives
that result in our stockholders having little or no continuing interest in our
assets as stockholders or otherwise. In such circumstances we will continue to
evaluate our alternatives in light of our cash position, including the
possibility that we may need to liquidate in a voluntary dissolution under
Delaware law or to seek protection under the provisions of the U.S. Bankruptcy
Code.


31




As
a result of being delisted from Amex on September 4, 2009 and our common stock
commencing quotation on the Pink Sheets effective as of the same date, the
following risk factor is no longer applicable to us.





“If
we fail to meet continued listing standards of Amex or Amex commences a
proceeding to delist our common stock from the exchange, our common stock may be
delisted from Amex which would have a material adverse effect on the price
of our common stock.





Our
common stock is currently traded on the Amex under the symbol “XCR”. In order
for our securities to be eligible for continued listing on Amex, we must remain
in compliance with certain Amex continued listing standards. As of December 31,
2008, we were not in compliance with Sections 1003(a)(i),
1003(a)(ii) and 1003(a)(iii) of the Amex Company Guide (the “Company
Guide”) because our stockholders’ equity was below the level required by the
Amex continued listing standards. Our stockholders’ equity fell below the
required standard due to several years of operating losses. Amex will normally
consider suspending dealings in, or removing from the listing of, securities of
a company under Section 1003(a)(i) for a company that has stockholders’ equity
of less than $2,000,000 if such company has sustained losses from continuing
operations and/or net losses in two of its three most recent fiscal years, under
Section 1003(a)(ii) for a company that has stockholders’ equity of less than
$4,000,000 if such company has sustained losses from continuing operations
and/or net losses in three of its four most recent fiscal years or under Section
1003(a)(iii) for a company that has stockholders’ equity of less than $6,000,000
if such company has sustained losses from continuing operations and/or net
losses in its five most recent fiscal years. As of December 31, 2008, our
stockholders' equity was below that required under Sections 1003(a)(i),
1003(a)(ii) and 1003(a)(iii) of the Amex Company Guide and we have sustained net
losses in our five most recent fiscal years.





On May
15, 2009, we received notice (the “Notice”) from the staff of the Amex
indicating that we were not in compliance with certain of Amex’s continued
listing standards as set forth in Part 10 of the Company Guide. Specifically,
according to the Notice, we were not in compliance with
Section 1003(a)(iv) of the Company Guide in that we have “sustained losses
which are so substantial in relation to our overall operations or our existing
financial resources, or our financial condition has become so impaired that it
appears questionable, in the opinion of Amex, as to whether we will be able to
continue operations and/or meet our obligations as they mature.”




In order
to maintain its listing on Amex, we were required to submit a plan of compliance
(a “Plan”) to Amex by June 15, 2009, advising Amex of the actions we have
taken or intend to take to regain compliance with Section 1003(a)(iv)
by November 16, 2009. Subsequently, we submitted a Plan to Amex before the June
15, 2009 deadline and Amex is currently in the process of reviewing the Plan. If
the Plan is not accepted by Amex, we will be subject to delisting proceedings.
If Amex accepts the Plan, then we will be able to continue our listing during
the Plan period, during which time we will be subject to periodic reviews to
determine whether it is making progress consistent with the Plan. Even if the
Plan is accepted, if we are not in compliance with the continued listing
standards of the Company Guide by November 16, 2009, or if we do not make
progress consistent with the Plan during such period, Amex will initiate
delisting proceedings as appropriate.




In
accordance with the terms of the Notice, we have been included in a list of
issuers that are not in compliance with Amex’s continued listing standards,
which is posted at www.amex.com and includes the specific listing standard(s)
with which a company does not comply. Our common stock continues to trade on
Amex. Amex has advised us that Amex is utilizing the financial status
indicator fields in the Consolidated Tape Association’s Consolidated Tape System
(“CTS”) and Consolidated Quote Systems (“CQS”) Low Speed and High Speed Tapes to
identify companies that are noncompliant with NYSE Amex’s continued listing
standards and/or delinquent with respect to a required federal securities law
periodic filing. Accordingly, we have become subject to the trading symbol
extension “.BC” to denote our noncompliance. The indicator will not change our
trading symbol itself, but will be disseminated as an extension of our symbol on
the CTS and CQS whenever our trading symbol is transmitted with a quotation or
trade.





If Amex
does not accept our Plan or we receive notification from the Amex that we are no
longer in compliance with other continued listing requirements and if we fail to
regain compliance with such continued listing requirements, our common
stock may be delisted which would have a material adverse affect on the price
and liquidity of our common stock.





Furthermore, we cannot assure you that
we will continue to satisfy other requirements necessary to remain listed on the
Amex or that the NYSE Amex will not take additional actions to delist our common
stock. If for any reason, our common stock were to be delisted from the Amex, we
may not be able to list our common stock on another national exchange or market.
If our common stock is not listed on a national exchange or market, the trading
market for our common stock may become illiquid.”





ITEM
2.        Unregistered Sales of Equity
Securities; Use of Proceeds from Registered Securities.




Except as
set forth below, for the nine months ended September 30, 2009, we did not have
any other unregistered sales of equity securities or use of proceeds from
registered securities.





In
September 2009, we issued 400,000 shares of restricted common stock to a certain
third party as compensation for consulting services. We issued the shares in
reliance upon the exemption from registration provided by Section 4(2) of the
Securities Act, in a transaction not involving any public
offering.


32





ITEM
6.       Exhibits.





No.
              
              Description of
      Exhibit10.1
              
              Binding
      Memorandum of Understanding, dated August 7, 2009. (1)31.1
              
              Certification
      of Chief Executive Officer Pursuant to Rule 13a-14 or 15d-14 of the
      Securities Exchange Act of 1934, as Adopted Pursuant to Section 302
      of the Sarbanes-Oxley Act of 2002.*31.2
              
              Certification
      of Chief Financial Officer Pursuant to Rule 13a-14 or 15d-14 of the
      Securities Exchange Act of 1934, Adopted Pursuant to Section 302 of
      the Sarbanes-Oxley Act of 2002.*32.1
              
              Certification
      of Chief Executive Officer Pursuant to 18 U.S.C Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.**32.2
              
              Certification
      of Chief Financial Officer Pursuant to 18 U.S.C Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.**99.1
              
              Agreement
      and Stipulation Regarding Partial Final Award, dated August 7, 2009.
      (2)


______________





*
            Filed
      herewith.


**
            Furnished
      herewith.


(1)
            Incorporated
      by reference to Exhibit 10.1 of our Quarterly Report on Form 10-Q, filed
      with the SEC on August 13, 2009.


(2)
            Incorporated
      by reference to Exhibit 99.2 of our Quarterly Report on Form 10-Q, filed
      with the SEC on August 13,
2009.


33


SIGNATURES




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





XCORPOREAL,
      INC.Date:
      November 16, 2009
              By:
              /s/Robert
      WeinsteinRobert
      WeinsteinChief
      Financial Officer(Principal
      Financial Officer andPrincipal
      Accounting Officer)


34