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
March 31,
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.    Yes R 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)
                R 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
 ̈ No R





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 May 11,
    2009Common
      Stock, $0.0001 par value
              14,754,687
      shares











INDEX





PART
      I — FINANCIAL INFORMATION
              2Item
      1. Financial Statements
              2Balance
      Sheets at March 31, 2009 (unaudited) and December 31, 2008
              2Statements
      of Operations (unaudited) for the three months ended March 31, 2009 and
      March 31, 2008 and the period from inception (May 4, 2001) to March 31,
      2009
              3Statements
      of Cash Flows (unaudited) for the three months ended March 31, 2009 and
      March 31, 2008 and the period from inception (May 4, 2001) to March 31,
      2009
              4Statement
      of Stockholders Equity (Deficit) for the three months ended March 31, 2009
      and the period from inception (May 4, 2001) to March 31, 2009
      (unaudited)
              5Notes
      to the Interim Financial Statements
              6Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
              13Item
      3. Quantitative and Qualitative Disclosures about Market
    Risk
              20Item
      4. Controls and Procedures
              20PART
      II — OTHER INFORMATION
              21Item
      1. Legal Proceedings
              21Item
      1A. Risk Factors
              21Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
              22Item
      6. Exhibits
              23Signatures
              24




1





PART
I — FINANCIAL INFORMATION





ITEM
1. Financial Statements





XCORPOREAL,
INC.


(a
Development Stage Company)


BALANCE
SHEETS


(Unaudited)





March
      31,
                  
                  
                  December
      31,2009
                  
                  
                  2008ASSETSCurrentCash
      and cash equivalents
                  
                  $
                  44,774
                  
                  
                  $
                  407,585Marketable
      securities, at fair value
                  
                  
                  1,306,654
                  
                  
                  
                  2,955,714Restricted
      cash
                  
                  
                  304,169
                  
                  
                  
                  301,675Prepaid
      expenses and other current assets
                  
                  
                  234,017
                  
                  
                  
                  260,024Tenant
      improvement allowance receivable
                  
                  
                  88,865
                  
                  
                  
                  87,658Total
      Current Assets
                  
                  
                  1,978,479
                  
                  
                  
                  4,012,656Property
      and equipment, net
                  
                  
                  309,076
                  
                  
                  
                  337,554Other
      assets
                  
                  
                  848
                  
                  
                  
                  863Total
      Assets
                  
                  $
                  2,288,403
                  
                  
                  $
                  4,351,073LIABILITIESCurrentAccounts
      payable
                  
                  $
                  825,777
                  
                  
                  $
                  789,827Accrued
      legal fees and licensing expense
                  
                  
                  1,871,430
                  
                  
                  
                  2,873,396Accrued
      royalties
                  
                  
                  645,833
                  
                  
                  
                  583,333Accrued
      professional fees
                  
                  
                  415,591
                  
                  
                  
                  211,820Accrued
      compensation
                  
                  
                  109,528
                  
                  
                  
                  149,664Accrued
      other liabilities
                  
                  
                  53,269
                  
                  
                  
                  54,429Payroll
      liabilities
                  
                  
                  608
                  
                  
                  
                  7,448Deferred
      rent
                  
                  
                  192,173
                  
                  
                  
                  148,651Total
      Current Liabilities
                  
                  
                  4,114,209
                  
                  
                  
                  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, 14,754,687 and
      14,754,687 issued and outstanding on March 31, 2009 and December 31, 2008,
      respectively
                  
                  
                  1,475
                  
                  
                  
                  1,475Additional
      paid-in capital
                  
                  
                  42,934,642
                  
                  
                  
                  42,547,023Deficit
      accumulated during the development stage
                  
                  
                  (44,761,923
                  )
                  
                  
                  (44,585,093
                  )Total
      Stockholders' Deficit
                  
                  
                  (1,825,806
                  )
                  
                  
                  (2,036,595
                  )Total
      Liabilities & Stockholders' Deficit
                  
                  $
                  2,288,403
                  
                  
                  $
                  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
                  
                  
                  of
      Inception) toMarch 31,
                  
                  
                  March
      31,2009
                  
                  
                  2008
                  
                  
                  2009Operating
      Expenses:Selling,
      general and administrative
                  
                  $
                  1,506,896
                  
                  
                  $
                  3,749,639
                  
                  
                  $
                  24,911,407Research
      and development
                  
                  
                  1,217,229
                  
                  
                  
                  2,732,492
                  
                  
                  
                  30,560,546Other
      expenses
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,871,430Depreciation
      and amortization
                  
                  
                  30,849
                  
                  
                  
                  22,508
                  
                  
                  
                  167,834Loss
      before other income, income taxes, and other expenses
                  
                  
                  (2,754,974
                  )
                  
                  
                  (6,504,639
                  )
                  
                  
                  (57,511,217
                  )Reduction
      of liabilities due to arbitrators ruling
                  
                  
                  1,001,966
                  
                  
                  
                  -
                  
                  
                  
                  1,001,966Interest
      and other income
                  
                  
                  7,907
                  
                  
                  
                  155,874
                  
                  
                  
                  1,598,386Change
      in and reduction of shares issuable
                  
                  
                  1,569,100
                  
                  
                  
                  -
                  
                  
                  
                  10,153,000Loss
      before income taxes and other expenses
                  
                  
                  (176,001
                  )
                  
                  
                  (6,348,765
                  )
                  
                  
                  (44,757,865
                  )Income
      taxes
                  
                  
                  829
                  
                  
                  
                  1,600
                  
                  
                  
                  4,058Net
      loss
                  
                  $
                  (176,830
                  )
                  
                  $
                  (6,350,365
                  )
                  
                  $
                  (44,761,923
                  )Basic
      and diluted loss per share
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.44
                  )Weighted
      average number of shares outstanding
                  
                  
                  14,754,687
                  
                  
                  
                  14,383,461





See
accompanying notes to interim financial statements.


3




XCORPOREAL,
INC.


(a
Development Stage Company)


STATEMENTS
OF CASH FLOWS


(Unaudited)





May
      4, 2001 (DateThree
      Months Ended
                      
                      
                      of
      Inception) toMarch 31,
                      
                      
                      March
      31,2009
                      
                      
                      2008
                      
                      
                      2009Cash
      flows used in operating activitiesNet
      loss for the period
                      
                      $
                      (176,830
                      )
                      
                      $
                      (6,350,365
                      )
                      
                      $
                      (44,761,923
                      )Adjustments
      to reconcile net loss to net cash (used in) operating
      activities:Directors,
      officers, employees stock based compensation
                      
                      
                      385,848
                      
                      
                      
                      1,121,118
                      
                      
                      
                      9,075,624Consultants
      stock based compensation
                      
                      
                      1,771
                      
                      
                      
                      75,489
                      
                      
                      
                      5,172,997Common
      stock issuance for consulting services rendered
                      
                      
                      -
                      
                      
                      
                      722,000
                      
                      
                      
                      912,000Increase
      in shares issuable
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      10,153,000Mark
      to market of shares issuable
                      
                      
                      (1,569,100
                      )
                      
                      
                      -
                      
                      
                      
                      (10,153,000
                      )Depreciation
                      
                      
                      30,835
                      
                      
                      
                      22,493
                      
                      
                      
                      167,682Net
      change in assets and liabilities:Increase
      in Receivables
                      
                      
                      (1,207
                      )
                      
                      
                      
                      
                      
                      
                      (88,865
                      )Decrease
      (increase) in prepaid expenses and other current assets
                      
                      
                      26,007
                      
                      
                      
                      (72,129
                      )
                      
                      
                      (234,017
                      )Decrease
      (increase) in other assets
                      
                      
                      15
                      
                      
                      
                      15
                      
                      
                      
                      (848
                      )(Decrease)
      increase in accounts payable and accrued liabilities
                      
                      
                      (747,881
                      )
                      
                      
                      1,009,962
                      
                      
                      
                      3,884,665Increase
      in deferred rent
                      
                      
                      43,522
                      
                      
                      
                      -
                      
                      
                      
                      192,173Net
      cash used in operating activities
                      
                      
                      (2,007,020
                      )
                      
                      
                      (3,471,417
                      )
                      
                      
                      (25,680,512
                      )Cash
      flows from investing activitiesCapital
      expenditures
                      
                      
                      (2,357
                      )
                      
                      
                      (64,974
                      )
                      
                      
                      (476,759
                      )Restricted
      cash
                      
                      
                      (2,494
                      )
                      
                      
                      73
                      
                      
                      
                      (304,169
                      )Purchase
      of marketable securities
                      
                      
                      (22,044,286
                      )
                      
                      
                      (8,598,102
                      )
                      
                      
                      (55,642,388
                      )Sale
      of marketable securities
                      
                      
                      23,693,346
                      
                      
                      
                      12,047,860
                      
                      
                      
                      54,335,734Net
      cash provided by (used in) investing activities
                      
                      
                      1,644,209
                      
                      
                      
                      3,384,857
                      
                      
                      
                      (2,087,582
                      )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
                      
                      
                      (362,811
                      )
                      
                      
                      (86,560
                      )
                      
                      
                      44,774Cash
      at beginning of the period
                      
                      
                      407,585
                      
                      
                      
                      106,495
                      
                      
                      
                      -Cash
      at end of the period
                      
                      $
                      44,774
                      
                      
                      $
                      19,935
                      
                      
                      $
                      44,774Supplemental
      disclosure of cash flow information; cash paid for:Interest
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Income
      taxes
                      
                      $
                      829
                      
                      
                      $
                      1,600
                      
                      
                      $
                      4,058





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 March 31, 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
                                                                      )





See
accompanying notes to interim financial statements.


5




XCORPOREAL, INC.


(a
Development Stage Company)


NOTES
TO INTERIM FINANCIAL STATEMENTS


March
31, 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 March 31, 2009 are not necessarily
indicative of the results that can be expected for the year ended 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 shareholders 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.





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, 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. Our ability to meet such obligations
will depend on our ability to sell securities, borrow funds, reduce operating
costs, or some combination thereof. We may not be successful in obtaining
necessary financing on acceptable terms, if at all. As of March 31, 2009, we had
negative working capital of $2,135,730, accumulated deficit of $44,761,923 and
total stockholders’ deficit of $1,825,806. Cash used in operations for the three
months ended March 31, 2009 was $2,007,020. As a result of these conditions,
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.




Upon
receipt of approximately $27.3 million raised through a private placement of our
common stock which was completed in the fourth quarter of 2006, we strategically
began our operating activities and research and development efforts which
resulted in a net loss of $23.0 million in 2008 and $0.2 million in the three
months ended March 31, 2009, including a reduction in arbitration liabilities of
approximately $1.0 million and change in and reduction of shares issuable of
$1.6 million as a result of the Partial Final Award issued in the arbitration
proceeding with NQCI discussed in Note 4, “Legal Proceedings” below. Both the
$1.0 million and $1.6 million were non-cash items. In addition, we invested
$25.0 million in high grade money market funds and marketable securities in the
first quarter of 2007 and since then, we sold $23.7 million of these investments
leaving a balance of $1.3 million as of March 31, 2009.




We are a
medical device company 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 three initial products: (i) a
Portable Artificial Kidney (PAK) for hospital 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 National Quality Care, Inc. (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.




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 our
research and development efforts, we have completed functional prototypes of our
hospital and home PAKs that we plan to commercialize after 510(k) notification
clearance from the Food and Drug Administration (FDA) which we plan to seek 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.




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. Once the results of the arbitration proceeding
described in Note 4, “Legal Proceedings” are final, we will determine whether to
devote available resources to the development of the WAK.


6




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





On
December 1, 2006, Operations initiated the arbitration proceeding (Proceeding)
against NQCI for its breach of the License Agreement. On April 13, 2009, the
arbitrator (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 adopted one of the proposals submitted to
the Arbitrator by us and provides 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 (Merger Agreement), among the
Company, 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 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 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.





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 a $1.0 million
non-operating reduction in arbitration liabilities to the statement of
operations for the three months ended March 31, 2009.  The $1.87
million expenditure recognized as “Other expenses” in the year ended December
31, 2008, remains accrued under “Accrued legal fees & licensing expense” as
of March 31, 2009.





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.





We intend to file a Petition to confirm
the portions of the Partial Final Award relating to the grant of the
Perpetual License in the Technology to us, including the Royalty terms, in Los
Angeles Superior Court. NQCI will have the opportunity to object to such
confirmation and to appeal the terms of the Award.





As a result of the issuance of the
Partial Final Award, subject to its confirmation, the Technology Transaction
will not occur, we will no longer be obligated to issue 9,230,000 shares
(Shares) of our common stock to NQCI formerly required pursuant to the terms of
the Second Interim Award issued by the Arbitrator on August 4, 2008, and we will
no longer be 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 9,230,000 issuable shares accrued under “Shares
issuable” as of December 31, 2008, was reversed resulting in a $1,569,100
non-operating income to the statement of operations, recognized as “Change in
and reduction of shares issuable”, for the three months ended March 31,
2009.





Should the Arbitrator order a material
change to the Partial Final Award or an unfavorable result arises out of
NQCI’s challenge of the Partial Final Award or in the pending
confirmation of the Partial Final Award, this could have a material adverse
effect on our capital structure, business and financial
condition.


7





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. 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. At March 31, 2009, all of our cash was held in high grade
money market funds and marketable securities.





Restricted
cash represents deposits secured as collateral for a letter of credit pursuant
to our operating facility lease agreement at March 31, 2009.





Note
6 – Fair Value Measurements





Effective
January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements,” (“SFAS
157”). SFAS 157 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 pronouncements that require or permit fair value measurements. In
February 2008, FSP FAS 157-2, “Effective Date of FASB Statement
No. 157”, was issued, which delays the effective date of SFAS 157 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 SFAS 157 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. SFAS 157 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 SFAS 157,
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 March 31, 2009
for assets and liabilities measured at fair value on a recurring
basis:





Level I
                  
                  
                  Level II
                  
                  
                  Level III
                  
                  
                  TotalCash
      and cash equivalents
                  
                  $
                  44,774
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  44,774Marketable
      securities:Commercial
      paper
                  
                  
                  249,850
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  249,850Corporate
      securities fixed rate
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Money
      market fund
                  
                  
                  1,056,804
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,056,804Restricted
      cash
                  
                  
                  304,169
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  304,169Total
      assets
                  
                  $
                  1,655,597
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,655,597





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





March 31, 2009Aggregate Fair
                      Value
                    
                    
                    Gross Unrealized
                      Gains / (Losses)
                    
                    
                    Estimated Fair
                      ValueCommercial
      paper
                    
                    $
                    249,850
                    
                    
                    $
                    -
                    
                    
                    $
                    249,850Corporate
      securities fixed rate
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    249,850
                    
                    
                    $
                    -
                    
                    
                    $
                    249,850




8





We review
impairments associated with the above in accordance with SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” and FASB
Staff Position 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. We
consider these investments not to be impaired as of March 31, 2009.





There
were no gross unrealized gains or losses as of March 31, 2009.





Note
7 – Property and Equipment





Property
and equipment consist of the following at March 31, 2009:





Property
      and equipment
                
                $
                476,758Accumulated
      depreciation
                
                
                (167,682
                )Property
      and equipment, net
                
                $
                309,076




Depreciation
expense for the three months ended March 31, 2009 and 2008 was $30,835 and
$22,493, respectively.





Note
8 – Shares Issuable





Formerly,
pursuant to the terms of the Second Interim Award issued on August 4, 2008,
which stated that, if the Technology Transaction is submitted to and approved by
our stockholders, 9,230,000 shares of our common stock were required to be
issued to NQCI to effectuate the transaction, we accrued for the issuance of
9,230,000 shares of our common stock to NQCI. As the Second Interim Award stated
that we must issue 9,230,000 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 9,230,000 shares
of our common stock to be issued to NQCI in accordance with FASB 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 Emerging Issues Task Force
No. 00-19, Accounting for
Derivative Financial Instruments Indexed to and Potentially Settled in, a
Company’s Own Stock (“EITF 00-19”), 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 change 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 of March 31, 2009, the Technology Transaction was not
submitted to our stockholders for approval.





As a
result of the issuance of the Partial Final Award, see Note 4, “Legal
Proceedings” above, subject to its confirmation, the Technology Transaction will
not occur, we will no longer be obligated to issue the Shares to NQCI formerly
required pursuant to the terms of the Second Interim Award 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 due to the arbitrator’s Partial Final Award, resulting in a $1,569,100
non-operating income to the statement of operations, recognized as “Change in
and reduction of shares issuable”, for the three months ended March 31,
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 March 31, 2009, our remaining total
lease payments for our corporate office are $904,694.





The
following is a schedule by years of future minimum lease payments required under
the 5-year corporate office lease as of March 31, 2009:





Year
      ending December 31:2009
                      
                      $
                      162,939
                      ( 1
      )2010
                      
                      
                      224,6502011
                      
                      
                      233,5282012
                      
                      
                      242,8422013
                      
                      
                      40,735
                      ( 2
      )Total
      minimum payments required
                      
                      $
                      904,694




( 1 )
excludes lease payments made through March 31, 2009


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




9





In
October 2008, we entered into a 5-year lease agreement through November 26,
2013, for our new 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 March 31, 2009, we expended $88,865 in improvement
and related expenses for which reimbursement is pending in accordance with the
tenant improvement allowance. The $88,865 was recognized under “Tenant
improvement allowance receivable” as of March 31, 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 March 31, 2009,
our remaining total lease payments for our operating facility are
$1,317,288.





The
following is a schedule by years of future minimum lease payments required under
the 5-year operating facility lease as of March 31, 2009:





Year
      ending December 31:2009
                      
                      
                      112,297
                      ( 1
      )2010
                      
                      
                      293,7222011
                      
                      
                      303,9942012
                      
                      
                      314,2662013
                      
                      
                      293,009
                      ( 2
      )Total
      minimum payments required
                      
                      $
                      1,317,288




( 1 )
excludes lease payments made through March 31, 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
March 31, 2009, we continued to utilize both locations.





Note
10 – Interest Income





Interest
income of $7,907 and $152,468 was reported for the three months ended March 31,
2009 and 2008, respectively.





Note
11 – Related Party Transactions





In
connection with the contribution of the assets to our company, on August 31,
2006we issued to
Consolidated National, LLC (CNL) of which Terren Peizer, a member of our Board
of Directors, who beneficially owns 42.2% of our outstanding common stock as of
March 31, 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.





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 March 31
2009, we reimbursed Dr. Gura $1,912 and $44,960 for 50% 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.  For more information, see Note 4, “Legal
Proceedings” above.


10





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. Until the portions of the Partial Final Award
relating to the grant of the Perpetual License in the Technology to us,
including the Royalty terms, are confirmed, we will continue to accrue for the
minimum royalty under the terms of the License Agreement.





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 March 31, 2009, there
were outstanding options to purchase 739,500 shares of our common stock and
3,160,500 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 1,476,000 have since been forfeited, canceled, or
expired, and therefore, options to purchase 2,404,000 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.





In the
three months ended March 31, 2009, an aggregate of 734,000 options were
forfeited pursuant to the reductions in our labor force that occurred on March
13, 2009. The exercise period of an aggregate of 173,500 vested stock options
expired May 12, 2009, 60 days from termination, upon which time the stock
options were unexercised and forfeited.





We
reported $385,848 and $1,121,118 in stock-based compensation expense for
employees, officers, and directors for the three months ended March 31, 2009 and
2008, respectively.





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 three months endedMarch 31, 2009Expected dividend yields
                  
                  
                  
                  zeroExpected
      volatility
                  
                  
                  
                  130%Risk-free
      interest rate
                  
                  
                  
                  3.53-3.81%Expected
      terms in years
                  
                  
                  
                  2.62
      - 9.51 years




Warrants
and Stock Options to Non-Employees





During
the three months ended March 31, 2009, we did not issue any warrants. As of
March 31, 2009, there were 551,721 warrants outstanding, which were fully vested
and exercisable.





We reported $1,771 and $75,489 in
stock-based compensation expenses for consultants for the three months ended
March 31, 2009 and 2008, respectively.





Compensation
for options granted to non-employees has been determined in accordance with SFAS
No. 123R, EITF 96-18, and EITF 00-18, “Accounting for Equity Instruments that
are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services.” 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 Financial Accounting and Standards Board
(FASB) Emerging Issues Task Force No. 96-18 “Accounting For Equity Instruments
That Are Issued To Other Than Employees For Acquiring or In Conjunction With
Selling Goods Or Services.”


11





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 three months endedMarch 31, 2009Expected dividend
      yields
                      
                      
                      
                      zeroExpected
      volatility
                      
                      
                      
                      130%Risk-free
      interest rate
                      
                      
                      
                      1.05-2.69%Expected
      terms in years
                      
                      
                      
                      0.64-8.12
      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 three months ended March 31, 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
                        
                        
                        (734,000
                        )
      (1)
                        
                        
                        (2,915,283
                        )Expensed
      in the period
                        
                        
                        -
                        
                        
                        
                        (817,411
                        )Exercised
      in the period
                        
                        
                        -
                        
                        
                        
                        -March
      31, 2009
                        
                        
                        3,695,221
                        
                        
                        $
                        6,359,415





(1) As
part of streamlining our operations, we terminated 19 employees on March 13,
2009. As a result, the terminated employees’ unvested options
forfeited.




Number of
                      Options and
                      Warrants
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceStock Options and WarrantsBalance
      at January 1, 2009
                    
                    
                    4,429,221
                    
                    
                    $
                    5.62Granted
                    
                    
                    -
                    
                    
                    
                    -Exercised
                    
                    
                    -
                    
                    
                    
                    -Forfeited
      & Cancelled
                    
                    
                    (734,000
                    )
                    
                    
                    7.00Balance
      at March 31, 2009
                    
                    
                    3,695,221
                    
                    
                    $
                    5.34




Note
14 – Stockholders’ Deficit





Our
“Total Stockholders’ Deficit” as of March 31, 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 April 13, 2009, the Arbitrator
issued a Partial Final Award which resolved the remaining issues that were
pending for decision in the Proceeding. 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. See Part
II, Item 1 “Legal Proceedings” below.






12





ITEM
2.         Management’s Discussion and Analysis
of Financial Condition and Results 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 and in the section
captioned “Risk Factors” of our Annual Report on Form 10-K, or the “Annual
Report”, filed with the United States Securities and Exchange Commission, or the
“SEC”, on March 31, 2009, 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;


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


·      the
results of the arbitration proceeding with National Quality Care, Inc., or
“NQCI”, and our ability to successfully confirm the portions of the Partial
Final Award relating to the grant of the Perpetual License in the Technology to
us including the Royalty terms (each capitalized term as defined
below);


·      our
ability to meet continued listing standards of NYSE Amex (formerly American
Stock Exchange);


·      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 for a more complete discussion of these and other
factors that may affect our business.





Overview




We are a
medical device company 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. The platform leads to three initial
products:


13





·
            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





We have
completed functional prototypes of our attended care and home PAKs that we plan
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. Unless 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, as more fully described below under “Recent
Developments”, 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. Unless 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, 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. Unless 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, 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. Assuming we are able to successfully confirm the
portions of the Partial Final Award as described below and 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, we will evaluate the
feasibility of furthering our development of this product over the next 12
months.





In 2009,
to the extent we have or are able to obtain sufficient funds to do so, we plan
to continue testing and developing the technology for ourextra-corporeal  platform.
We will also implement our validation and verification strategy including bench
testing, clinical testing and regulatory strategy in the U.S. and
abroad.





While we
may eventually exploit our technology’s potential Congestive Heart Failure, or
“CHF”, applications through licensing or strategic arrangements, we will focus
initially on the renal replacement applications described above.





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,” assuming we are able to successfully confirm the portions of
the Partial Final Award and the results of the arbitration proceeding are final,
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.





We are a
development stage company, have generated no revenues to date and have been
unprofitable since our inception, and will incur substantial additional
operating losses for at least the next twelve months as we continue, to the
extent available, to allocate resources to research, development, clinical
trials, commercial 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. 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.


14





Recent
Developments





Issuance of the Partial Final Award and
NQCI’s Request to Correct Material Terms of the Award





On April
13, 2009, the arbitrator (the “Arbitrator”) in the arbitration proceeding (the
“Proceeding”) between us, Operations and NQCI issued a Partial Final Award (the
“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 (the “Perpetual
License”) in the Technology (as defined in the Merger Agreement, dated as of
September 1, 2006, or the “Merger Agreement”, among us, Operations and NQCI and
the License Agreement, dated as of September 1, 2006, or the “License
Agreement”, between us and NQCI) primarily related to the WAK and any other
Technology contemplated to be transferred under the Technology Transaction.
Under the terms of the Partial Final Award, in consideration of the award of the
Perpetual License to us, NQCI was awarded a royalty of 39% of all net income,
ordinary or extraordinary, to be received by us (the “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 is denied and that NQCI is not entitled to recover any additional
attorneys’ fees. Finally, the Partial Final Award also provided that the
Arbitrator shall retain jurisdiction to supervise specific performance of the
terms and obligations of the Partial Final 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 to the parties’
inability to proceed with the Technology Transaction.





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.





We intend to file a Petition to confirm
the portions of the Partial Final Award relating to the grant of the
Perpetual License in the Technology to us, including the Royalty terms, in Los
Angeles Superior Court. NQCI will have the opportunity to object to such
confirmation and to appeal the terms of the Award.





As a result of the terms of the Partial
Final Award, subject to its confirmation, 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 formerly required pursuant to the terms
of the Second Interim Award issued by the Arbitrator on August 4, 2008, and we
will no longer be required to file a resale registration statement under the
Securities Act for the Shares.





Subject to the confirmation of the
Partial Final Award by the court, we intend to continue to explore various
strategic alternatives, which may include the license of certain of our
intellectual property rights as a means to further develop our technologies,
among other possible transactions.





Corporate Restructuring





The deterioration of the economy over
the last year, coupled with the prolonged and continuing delay in consummating
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 and continues to be a major
factor in our inability to secure debt or equity financing. Accordingly, we have
had to modify our activities and business. In response to the general economic
downturn affecting the development of our products and liquidity condition, we
have instituted a variety of measures in an attempt to conserve cash and reduce
our operating expenses. Our actions included:





·
            Reductions in our labor
      force – On March 13, 2009, we gave notice of employment
      termination to 19 employees. This represents a total work-force reduction
      of approximately 73%. We paid accrued vacation benefits of approximately
      $70,000 to the terminated employees. The layoffs and our other efforts
      focused on streamlining our operations designed to reduce our annual
      expenses by approximately $3.5 million to a current operating burn rate of
      approximately $200,000 per month. These actions had to be
      carefully and thoughtfully executed and we will take additional
      actions, if necessary. Most important to us in making these difficult
      decisions is to give as much consideration as possible to all of our
      employees, whom we greatly value. We hope to be in the financial position
      in the near future to offer re-employment to certain of our terminated
      employees.


·
            Refocusing
      our available assets and employee resources on the development of the
      PAK.


·
            Continuing
      vigorous efforts to minimize or defer our operating
    expenses.


·
            Exploring
      various strategic alternatives, which may include the license of certain
      of our intellectual property rights, as a means to further develop our
      technologies, among other possible transactions and
      alternatives.


·
            Intensifying
      our search to obtain additional financing to support our operations and to
      satisfy our ongoing capital requirements in order to improve our liquidity
      position.


15





·
            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. 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 our ability to obtain equity or debt
financing, develop and market our products, and, ultimately, to generate
revenue. 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.





Other
Considerations – Royalty and Other Payments Under the License
Agreement





Initially,
as consideration for entering into the License Agreement, we agreed to pay to
NQCI a minimum annual royalty of $250,000, or 7% of net sales. Although we have
previously asserted that NQCI’s breaches of the License Agreement excused our
obligation to make the minimum royalty payments, we recorded $645,833 in royalty
expenses, covering the minimum royalties, from commencement of the License
Agreement through March 31, 2009. Pursuant to the terms of the Partial Final
Award issued on April 13, 2009, subject to its confirmation, we will obtain
a Perpetual License in the Technology, the License Agreement will not be
terminated and transfer of the Technology will not occur. In addition, under the
terms of the Partial Final Award, the Arbitrator denied the royalty payments
requested by NQCI to be awarded in the Proceeding; however, the Arbitrator did
not indicate whether any minimum royalties will be due going forward. Until the
terms of the License Agreement are firmly assessed in the Proceeding, we will
continue to accrue for the minimum royalty.





The License Agreement also requires us
to reimburse NQCI’s reasonable and necessary expenses incurred in the ordinary
course of business consistent with past practices, or the “Licensor Expenses”,
until the closing or the termination of the Merger Agreement. Under the terms of
the Partial Final Award, the Arbitrator denied NQCI’s request for award of any
additional Licensor Expenses. For a complete description of the License
Agreement and the Proceeding please see Item 3 - “Legal Proceedings”
below.





Stockholder
Approval of the Technology Transaction





As of March 31, 2009, we were in the
process of seeking approval from our stockholders to permit the issuance of the
Shares to NQCI in order to obtain ownership of the Technology, or the
“Technology Transaction”. The stockholder approval was being sought in
accordance with the terms of the Interim Award issued by the Arbitrator on June
9, 2008, or the “Interim Award”, as modified by the Arbitrator’s later
decisions, including the Amended Order Re Interim Relief Etc. issued on January
30, 2009. However, due to the issuance of the Partial Final Award on April 13,
2009, subject to its confirmation, the Technology Transaction will not occur, we
will no longer be obligated to issue the Shares to NQCI and we will no longer be
required to obtain such stockholder approval.




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 months ended March 31, 2009.





We have
not generated any revenues since inception. We incurred a net loss of $0.18
million for the three months ended March 31, 2009, compared to a net loss of
$6.35 million for the three months ended March 31, 2008. The decrease in net
loss was primarily due to (i) non-operating income resulting from accrual
reversals pursuant to the Partial Final Award, (ii) corporate restructuring,
(iii) completion and termination of the Aubrey Agreement, (iv) less legal fees,
and (v) forfeitures of terminated employees’ unvested stock options. At March
31, 2009, we had a negative working capital of $2.1 million compared to a
positive working capital of $10.4 at March 31, 2008. At March 31, 2009, our
total assets were $2.3 million compared to $13.8 million at March 31, 2008,
which consisted primarily of cash raised from the sale of our common stock sold
in December 2006.


16





Interest
Income





For the three months ended March 31,
2009, we earned interest income of $7,907 compared to $152,468 for the
three months ended March 31, 2008. 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.





As of
March 31, 2009, we had cash, cash equivalents and marketable securities of
approximately $1.4 million. We expended $2.0 million in cash in the first
quarter of 2009 and we project to expend cash at a rate of approximately $0.2
million per month for the remainder of the 2009 fiscal year based upon the
recent restructuring effected by us going forward. See above section captioned
“Recent Developments - Corporate Restructuring”. In addition, subject to the
confirmation of the Partial Final Award, we are obligated to pay damages, costs
and legal fees in connection with the Proceeding described above in an amount of
$1.87 million.At
present rates, we will have to obtain additional debt or equity financing during
the next several months. We may not be successful in doing so on terms
acceptable to us, and the inability to raise capital could require us to curtail
our current plans in order to decrease spending, which could have a material
adverse effect on our plan of operation. 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.





We expect
to incur negative cash flows and net losses for the foreseeable future. In
addition, depending on the results of the proceeding to confirm the Partial
Final Award, as more fully explained above, we may become obligated to pay
damages, costs and legal fees in connection with the ongoing arbitration with
NQCI. 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 will be required to seek
additional funds through public or private placement of shares of our preferred
or common stock or through public or private debt financing. Our ability to meet
our cash obligations as they become due and payable will depend on our ability
to sell securities, borrow funds, reduce operating costs, or some combination
thereof. We may not be successful in obtaining necessary funds on acceptable
terms, if at all. The inability to obtain financing could require us to curtail
our current plans in order to decrease spending, which could 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.




Upon
receipt of approximately $27.3 million raised through a private placement in the
fourth quarter of 2006, we strategically began our operating activities and
research and development efforts which resulted in a net loss of $23.0 million
in 2008 and $0.2 million in the three months ended March 31, 2009. In addition,
we invested $25.0 million in high grade money market funds and marketable
securities of which we sold $23.7 million of the investments, leaving a balance
of $1.3 million as of March 31, 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 plan to
commercialize after 510(k) clearance from the FDA which we plan to submit in
2010. 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.




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. Assuming we are able to successfully confirm the portions of the
Partial Final Award as described above and the results of the Proceeding are
final, we will determine whether to devote additional resources to the
development of the WAK.




If we
become obligated to reimburse $1.87 million in NQCI’s attorneys’ fees incurred
in the Proceeding awarded under the Interim Award issued on August 15, 2008 and
order to be paid by us under the terms of the Partial Final Award, subject to
its confirmation, this obligation could have a material adverse effect on our
liquidity and financial ability to continue with ongoing operations as currently
planned.




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 employ
an interdisciplinary team of scientists and engineers who are developing the PAK
and a separate, interdisciplinary team developing the WAK. However, as a result
of general economic conditions in 2008 and a deterioration of our liquidity
position, coupled with the prolonged and continuing delay in our ability to
consummate the Technology Transaction, we have been significantly adversely
affected. As a result, on March 13, 2009 we terminated 19 employees or 73% of
our staff. We hope to be in the financial position in the near future to offer
re-employment to certain of our terminated employees.


17





In
addition, we had previously retained Aubrey Group, Inc. (“Aubrey”), an
FDA-registered third-party contract developer and manufacturer of medical
devices, to assist with the design and development of subsystems of the PAK,
referred to herein as the “Aubrey Agreement.” As of December 31, 2008, Aubrey
substantially completed its work and we terminated the agreement as of March 31,
2009. A variation of this device will be developed for chronic home
hemodialysis. At the inception of the Aubrey Agreement, total labor and material
costs over the term of the agreement were budgeted to amount to approximately
$5.1 million and as of March 31, 2009, the agreement was completed under the
budgeted amount at a cost of $3.2 million.





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. Assuming that the Technology Transaction closes and sufficient
working capital is available 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.





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 $1.2 million in research and development costs in the three months
ended March 31, 2009. This compares to $2.7 million incurred in the three months
ended March 31, 2008. The decrease in research and development costs for the
three months ended March 31, 2009 from the same period in 2008 is attributable
to the completion and termination of the Aubrey Agreement and our research and
development progress.





Contractual
Obligations and Commercial Commitments





The
following table sets forth a summary of our material contractual obligations and
commercial commitments as of March 31, 2009:





Contractual Obligations:
                        
                        Total
                        
                        
                        Less than 1
                          Year
                        
                        
                        1 - 3 years
                        
                        
                        3 - 5 years
                        
                        
                        More than 5
                          yearsCapital Lease Obligations
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -Operating
      Lease Obligations (1)
                        
                        
                        2,323,380
                        
                        
                        
                        312,294
                        
                        
                        
                        1,677,342
                        
                        
                        
                        333,744
                        
                        
                        
                        -Research
      & Development Contractual Commitments
                        
                        
                        45,000
                        
                        
                        
                        45,000
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Other
      Liabilities
                        
                        
                        10,490
                        
                        
                        
                        10,490
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -$
                        2,378,870
                        
                        
                        $
                        367,784
                        
                        
                        $
                        1,677,342
                        
                        
                        $
                        333,744
                        
                        
                        $
                        -





(1)
Operating lease commitments for our corporate office, operating facility, Dr.
Gura’s office (a related party transaction), equipment, and one corporate
apartment for which the lease has expired and which we vacated on April 18,
2009. On March 31, 2009, the lease for our other corporate apartment expired and
vacated accordingly.





Off-Balance
Sheet Arrangements





As of
March 31, 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.





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.


18





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.  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.





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





March
      31, 2009Aggregate
      Fair
                        
                        
                        Gross
      Unrealized
                        
                        
                        Estimated
      FairValue
                        
                        
                        Gains
      / (Losses)
                        
                        
                        ValueCommercial
      paper
                        
                        $
                        249,850
                        
                        
                        $
                        -
                        
                        
                        $
                        249,850Corporate
      securities fixed rate
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Total
                        
                        $
                        249,850
                        
                        
                        $
                        -
                        
                        
                        $
                        249,850





We review
impairments associated with the above in accordance with SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” and FASB
Staff Position 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. We
consider these investments not to be impaired as of March 31, 2009.





There
were no gross unrealized gains or losses as of March 31, 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 upon the closing of the Technology
Transaction and we have been unable to consummate such transaction, such
contingency not within our control and 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 FASB 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 Emerging Issues Task Force
No. 00-19, Accounting for
Derivative Financial Instruments Indexed to and Potentially Settled in, a
Company’s Own Stock (“EITF 00-19”), 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 change 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 of March 31, 2009,
the Technology Transaction was not submitted to our stockholders for
approval.





As a
result of the issuance of the Partial Final Award, see Note 4, “Legal
Proceedings” above, subject to its confirmation, 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 a $1,569,100 non-operating income to the statement of operations,
recognized as “Change in and reduction of shares issuable”, for the three months
ended March 31, 2009.





Stock-Based
Compensation





Statements
of Financial Accounting Standards (SFAS) No. 123 (revised 2004),Share-Based Payment, (SFAS
123(R)) and Securities and Exchange Commission issued Staff Accounting Bulletin
(SAB) 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 SFAS 123(R).


19





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.





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.





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.





ITEM
4.      Controls and Procedures





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 Rule 13a-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 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





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.


20





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.





We intend to file a Petition to confirm
the portions of the Partial Final Award relating to the grant of the Perpetual
License in the Technology to us, including the Royalty terms, in Los Angeles
Superior Court. NQCI will have the opportunity to object to such confirmation
and to appeal the terms of the Award.





As a result of the issuance of the
Partial Final Award, subject to its confirmation, 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.





Should the Arbitrator order a material
change to the Partial Final Award or an unfavorable result arises out of NQCI’s
challenge of the Partial Final Award or in the pending confirmation of
the Partial Final Award, this could have a material adverse effect on our
capital structure, business and financial condition.





ITEM
1A.      Risk Factors.




Investing
in our common stock involves a high degree of risk. In addition to the
information 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  and the revised 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


21





We
intend to seek confirmation of the portions of the Partial Final Award
relating to the grant of the Perpetual License in the Technology to us,
including the Royalty terms by filing a petition in Los Angles Superior Court.
NQCI will have the opportunity to oppose the petition and appeal the
confirmation of the petition, if granted.  If our petition to confirm
portions of the Partial Final Award is denied, or if NQCI successfully
appeals the confirmation, these outcomes could have a material adverse effect on
our capital structure, business and financial condition and may result in a
material change to the Partial Final Award.





On April
13, 2009, the Arbitrator in the Proceeding issued the Partial Final
Award which resolved the remaining issues that were pending for
decision in the Proceeding. 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. We
intend to seek confirmation of the portions of the Partial Final Award relating
to the grant of the Perpetual License in the Technology to us, including the
Royalty terms, and plan to file a petition with respect thereto in Los Angeles
Superior Court. 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.





As of the
date of this Quarterly Report, the Proceeding with NQCI continues and the
subject matter of the Proceeding has not been fully resolved. A party to the
arbitration could challenge the interim award in court, even after the issuance
of a final award. As the arbitrator retained jurisdiction to supervise specific
performance of the obligations decreed in the Partial Final Award,
including, but not limited to any dispute over the manner of calculation of the
Royalty terms, the arbitrator could again change the award by granting different
or additional remedies. Until the Partial Final Award is confirmed by a
competent court, we cannot guarantee that the arbitrator will not modify or
change the terms of the Partial Final Award. Arbitrators have broad equitable
powers, however, and arbitration awards are difficult to challenge in
court, even if the arbitrator makes rulings that are inconsistent or not in
accordance with the law or the evidence.





Should
the Arbitrator order a material change to the Partial Final Award or an
unfavorable result arises out of NQCI’s challenge of the Partial Final Award or
in the pending confirmation of the Partial Final Award, this could have a
material adverse effect on our capital structure, business and financial
condition.





As a result of the issuance of the
Partial Final Award, subject to its confirmation, the following risk factor
included in the section captioned “Risk Factors” in Part I, Item 1A of our
Annual Report is no longer applicable to us as the Technology Transaction will
not occur, we will no longer be required to issue 9,230,000 shares of our common
stock to NQCI and NQCI will not become our largest stockholder:




Pursuant
to the terms of the Second Interim Award, as modified by the Order, if we desire
to close the Technology Transaction, we will be required to issue 9,230,000
shares of our common stock to NQCI and a result, NQCI would own approximately
39% of our total outstanding shares, making NQCI our largest stockholder and
giving NQCI the ability to substantially influence the election of directors and
the outcome of matters submitted to our stockholders.




On August
4, 2008, the arbitrator issued a Second Interim Award, modifying the initial
Interim Award, stating that, if we desire to close the Technology Transaction,
we must, among other things, issue to NQCI 9,230,000 shares of our common stock.
Accordingly, following the closing of the Technology Transaction, NQCI would own
approximately 39% of our total outstanding shares, making NQCI our largest
stockholder. As a result, NQCI would have the ability to determine the outcome
of issues submitted to our stockholders. The interests of NQCI may not always
coincide with our interests or the interests of our other stockholders and it
may act in a manner that advances its best interests and not necessarily those
of our stockholders. The ownership position of NQCI may make it difficult for
our stockholders to remove our management from office should they choose to do
so. It could also deter unsolicited takeovers, including transactions in which
our stockholders might otherwise receive a premium for their shares over then
current market prices.





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




For the
three months ended March 31, 2009, we did not have unregistered sales of equity
securities or use of proceeds from registered securities.


22


ITEM
6.       Exhibits.





No.
                
                Description of Exhibit31.1
                
                Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.*31.2
                
                Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.*32.1
                
                Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002.*32.2
                
                Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002.*99.1
                
                Amended
      Order Re Interim Relief Etc., dated January 30, 2009.
  (1)99.2
                
                Partial
      Final Award, dated April 13, 2009.
(2)







*   Filed
herewith.


(1)
Incorporated by reference to Exhibit 99.1 to our Current Report on Form 8-K
filed February 5, 2009.





(2)
Incorporated by reference to Exhibit 99.1 to our Current Report on Form 8-K
filed April 16, 2009.


23





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.





Date:
      May 15, 2009
                By:
                /s/Robert
      WeinsteinRobert
      WeinsteinChief
      Financial Officer(Principal
      Financial Officer andPrincipal
      Accounting Officer)




24