UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM
10-Q xQUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006 or oTRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission
file number 0-11550 Pharmos Corporation(Exact name of registrant as specified in its
charter)  Nevada

36-3207413(State or other jurisdiction of
  incorporation or organization)

(IRS Employer Id. No.) 99
Wood Avenue South, Suite 311
Iselin, NJ 08830(Address of principal executive offices) Registrants telephone number, including area
code:(732) 452-9556 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  x  No
o. Indicate by
check mark whether registrant is a large accelerated filer, an accelerated
filer or a non-accelerated filer (as defined in Rule 12b-2 of the Act). Large accelerated filer o
     Accelerated
filer o     Non-accelerated
filer x Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act).Yes o  No
x. As of May 12,
2006, the Registrant had outstanding 19,065,783 shares of its $.03 par value
Common Stock. 1    Part I. Financial InformationItem 1 Financial StatementsPHARMOS
CORPORATION(Unaudited)Condensed
Consolidated Balance SheetsMarch
        31,
        2006
    
    December
        31,
        2005AssetsCash
        and cash equivalents
    
    $
    5,139,887
    
    $
    10,289,127Short-term
        investments
    
    
    36,477,828
    
    
    35,748,343Restricted
        cash
    
    
    80,245
    
    
    79,527Research
        and development grants receivable
    
    
    952,953
    
    
    734,237Prepaid
        expenses and other current assets
    
    
    1,484,046
    
    
    543,109Total
        current assets
    
    
    44,134,959
    
    
    47,394,343Capitalized
        merger costs
    
    
    741,468
    
    
    Fixed
        assets, net
    
    
    760,472
    
    
    742,860Restricted
        cash
    
    
    63,114
    
    
    62,874Severance
        pay funded
    
    
    803,754
    
    
    772,199Other
        assets
    
    
    18,496
    
    
    18,496Total
        assets
    
    $
    46,522,263
    
    $
    48,990,772Liabilities
        and Shareholders EquityAccounts
        payable
    
    $
    561,280
    
    $
    519,404Accrued
        expenses
    
    
    535,439
    
    
    575,222Warrant
        liability
    
    
    24,776
    
    
    38,880Accrued
        wages and other compensation
    
    
    1,457,857
    
    
    1,497,781Total
        current liabilities
    
    
    2,579,352
    
    
    2,631,287Other
        liability
    
    
    122,246
    
    
    110,904Severance
        pay
    
    
    1,104,749
    
    
    1,014,647Total
        liabilities
    
    
    3,806,347
    
    
    3,756,838Commitments
        and contingenciesShareholders EquityPreferred
        stock, $.03 par value, 1,250,000 shares authorized, none issued and outstanding
    
    
    
    
    
    Common
        stock, $.03 par value; 60,000,000 shares authorized, 19,065,783 issued
    
    
    571,973
    
    
    571,973Deferred
        compensation
    
    
    
    
    
    (529,393
    )Paid-in
        capital in excess of par
    
    
    191,048,613
    
    
    191,093,338Accumulated
        deficit
    
    
    (148,904,244
    )
    
    (145,901,558
    )Treasury
        stock, at cost, 2,838 shares
    
    
    (426
    )
    
    (426
    )Total
        shareholders equity
    
    
    42,715,916
    
    
    45,233,934Total
        liabilities and shareholders equity
    
    $
    46,522,263
    
    $
    48,990,772The accompanying notes are an integral part
of these condensed consolidated financial statements.

2

PHARMOS
CORPORATION(Unaudited)CondensedConsolidated
Statements of Operations

Three
        months ended
        March 31,2006
    
    
    2005ExpensesResearch
        and development, gross
    
    $
    1,867,114
    
    
    $
    2,504,639Grants
    
    
    (300,635
    )
    
    
    (19,576
    )Research
        and development, net of grants
    
    
    1,566,479
    
    
    
    2,485,063Selling,
        general and administrative
    
    
    1,813,221
    
    
    
    1,794,711Depreciation
        and amortization
    
    
    78,484
    
    
    
    114,925Total
        operating expenses
    
    
    3,458,184
    
    
    
    4,394,699Loss
        from operations
    
    
    (3,458,184
    )
    
    
    (4,394,699
    )Other
        income (expense)Bausch
        & Lomb payment
    
    
    
    
    
    
    10,725,688Interest
        income
    
    
    465,704
    
    
    
    269,496Interest
        expense
    
    
    
    
    
    
    (160,546
    )Change
        in value of warrants
    
    
    14,104
    
    
    
    230,931Other
        (expense) income
    
    
    (24,310
    )
    
    
    6,657Other
        income, net
    
    
    455,498
    
    
    
    11,072,226Net
        income (loss)
    
    ($
    3,002,686
    )
    
    $
    6,677,527Net
        income (loss) per share-
        basic
    
    ($
    0.16
    )
    
    $
    0.35-
        diluted
    
    ($
    0.16
    )
    
    $
    0.35Weighted
        average shares outstanding-
        basic
    
    
    19,037,628
    
    
    
    18,973,944-
        diluted
    
    
    19,037,628
    
    
    
    19,140,613The accompanying
notes are an integral part of these condensed consolidated financial
statements.

3

Pharmos
Corporation(Unaudited)CondensedConsolidated
Statements of Cash Flows

Three
        months ended March 31,2006
    
    2005Cash
        flows from operating activitiesNet
        income (loss)
    
    $
    (3,002,686
    )
    $
    6,677,527Adjustments
        to reconcile net income (loss) loss to net cash used in operating activities:Depreciation
        and amortization
    
    
    78,484
    
    
    114,925Provision
        for severance pay
    
    
    90,102
    
    
    (8,002
    )Change
        in the value of warrants
    
    
    (14,104
    )
    
    (230,931
    )Amortization
        of debt discount and issuance costs
    
    
    
    
    
    126,256Amortization
        of stock options issuances below fair market value
    
    
    
    
    
    17,952Option
        expense  consultant compensation
    
    
    
    
    
    1,244Stock
        based compensation
    
    
    219,957
    
    
    Amortization
        of restricted shares issuance
    
    
    264,712
    
    
    275,739Income
        from Bausch & Lomb milestone payment, net
    
    
    
    
    
    (10,725,688
    )Changes
        in operating assets and liabilities:Research
        and development grants receivable
    
    
    (218,716
    )
    
    972,102Prepaid
        expenses and other current assets
    
    
    (940,937
    )
    
    (795,459
    )Severance
        pay funding
    
    
    (31,555
    )
    
    (21,804
    )Accounts
        payable
    
    
    41,876
    
    
    32,218Accrued
        expenses
    
    
    (39,783
    )
    
    (483,776
    )Accrued
        wages and other compensation
    
    
    (39,924
    )
    
    164,371Other
        liabilities
    
    
    11,342
    
    
    22,059Net
        cash used in operating activities
    
    
    (3,581,232
    )
    
    (3,861,267
    )Cash
        flows from investing activitiesPurchases
        of fixed assets
    
    
    (96,097
    )
    
    (22,503
    )Proceeds
        from Bausch & Lomb milestone payment
    
    
    
    
    
    12,275,000Payment
        to Bausch & Lomb related to sale of ophthalmic business
    
    
    
    
    
    (1,532,528
    )Royalty
        payment and grant reimbursement related to Bausch & Lomb milestone
        payment
    
    
    
    
    
    (1,549,312
    )Costs
        associated with anticipated acquisition
    
    
    (741,468
    )
    
    Purchase
        of short-term investments
    
    
    (2,929,485
    )
    
    Proceeds
        from sale of short-term investments
    
    
    2,200,000
    
    
    Decrease
        in restricted cash
    
    
    (958
    )
    
    4,845,568Net
        cash (used in) provided by investing activities
    
    
    (1,568,008
    )
    
    14,016,225Cash
        flows from financing activities
        Repayment of convertible debentures
    
    
    
    
    
    (4,846,148
    )Net
        cash used in financing activities
    
    
    
    
    
    (4,846,148
    )Net
        increase (decrease) in cash and cash equivalents
    
    
    (5,149,240
    )
    
    5,308,810Cash
        and cash equivalents at beginning of year
    
    
    10,289,127
    
    
    49,014,530Cash
        and cash equivalents at end of period
    
    $
    5,139,887
    
    $
    54,323,340Supplemental
        information:Interest
        paid
    
    $
    
    
    $
    32,308The accompanying
notes are an integral part of these condensed consolidated financial
statements.

4

Basis of
Presentation

The accompanying unaudited interim financial
  statements have been prepared in accordance with accounting principles
  generally accepted in the United States of America for interim financial
  information pursuant to the instructions to Form 10-Q and Article 10 of
  Regulation S-X. Accordingly, they do not include all of the information and
  footnotes required by accounting principles generally accepted in the United
  States of America for complete financial statements. In the opinion of management,
  all adjustments, consisting of normal recurring accrual adjustments,
  considered necessary for a fair statement have been included. Operating
  results and cash flows for the three month period ended March 31, 2006 are
  not necessarily indicative of the results that may be expected for the year
  ending December 31, 2006. The year-end condensed balance sheet was derived
  from audited financial statements but does not include all disclosures
  required by accounting principles generally accepted in the United States of
  America and included in the Form 10-K filing.1. The CompanyPharmos Corporation (the Company or Pharmos) is a
  specialty pharmaceutical company that discovers and develops novel
  therapeutics to treat a range of indications including pain, inflammation,
  autoimmunity and select central nervous system (CNS) disorders. The Company
  has a portfolio of drug candidates and compounds in various development
  stages, including clinical, preclinical and discovery. The Companys core
  proprietary technology platform focuses on the discovery and development of
  synthetic cannabinoid compounds. Collaborative research as well as in-house
  research at Pharmos over the last decade has served as a cornerstone of our
  scientific foundation, and through such efforts, we have extensively
  characterized many of the key variables involved in cannabinoid receptor
  activation and modulation. On March 15, 2006, the Company announced an
  agreement to acquire Vela Pharmaceuticals, Inc., which has a Phase II product
  candidate, dextofisopam, in development to treat irritable bowel syndrome. The
  acquisition will require shareholder approval. The Company intends to
  dedicate substantial resources to complete clinical development of this
  product candidate. The Vela acquisition also includes additional compounds in
  preclinical and/or clinical development for neuropathic pain, inflammation
  and sexual dysfunction.  The Company
  has executive offices in Iselin, New Jersey and conducts research and
  development through its wholly owned subsidiary, Pharmos, Ltd., in Rehovot,
  Israel.2. Liquidity and Business RisksThe Company was not profitable in 2002 through 2005
  and the first quarter of 2006. At March 31, 2006, the Company had an
  accumulated deficit of $148.9 million and expects to continue to incur losses
  going forward. Such losses have resulted principally from costs incurred in
  research and development and from general and administrative expenses. The
  Company has financed its operations with public and private offerings of
  securities, advances and other funding pursuant to a marketing agreement with
  Bausch & Lomb, grants from the Office of the Chief Scientist of Israel,
  research contracts, the sale of a portion of its New Jersey net operating
  loss carryforwards, and interest income. Management believes that the current
  cash, cash equivalents and short term investments, totaling $41.6 million as
  of March 31, 2006, will be sufficient to support the Companys continuing
  operations beyond March 31, 2007.The Company is continuing to actively pursue various
  funding options, including equity offerings, strategic corporate alliances,
  business combinations and the establishment of product related research and
  development limited partnerships, to obtain additional financing to continue
  the development of its products and bring them to commercial markets. Should
  the Company be unable to raise adequate financing or generate revenue in the
  future, long-term operations will need to be scaled back or discontinued.5

3. Significant
Accounting Policies


Basis of
consolidation


The accompanying consolidated
financial statements include the accounts of the Company and its wholly owned
subsidiary, Pharmos Ltd. All significant intercompany balances and transactions
are eliminated in consolidation. The functional currency for Pharmos Ltd is the
US dollar.

Reverse
Stock Split

On May 26, 2005, Pharmos Corporation filed a
Certificate of Change with the Nevada Secretary of State which served to
effect, as of May 31, 2005, a 1-for-5 reverse split of Pharmos common stock.
As a result of the reverse stock split, every five shares of Pharmos common
stock were combined into one share of common stock; any fractional shares
created by the reverse stock split were rounded up to whole shares. The reverse
stock split affected all of Pharmos common stock, stock options and warrants
outstanding immediately prior to the effective date of the reverse stock split.
The reverse split reduced the number of shares of Pharmos common stock
outstanding from 95,137,076 shares to 19,027,809 shares, and the number of
authorized shares of common stock was reduced from 150,000,000 shares to
30,000,000 shares. All references to common share and per common share amounts
for all periods presented have been retroactively restated to reflect this reverse
split. At the Annual Meeting in September 2005, the shareholders voted to
increase the number of authorized shares of common stock to 60,000,000 shares.

Revision

The consolidated statement of
cash flows for the three months ended March 31, 2005 includes in cash flows
from investing activities a $1.5 million payment made during the three months
ended March 31, 2005 to Bausch & Lomb related to the sale of the ophthalmic
business. For the three months ended March 31, 2005 such payment was included
in cash flow used in operating activities. This revision was recorded in the
three month period ended June 30, 2005 and had no impact on the Consolidated
Balance Sheet or Consolidated Statement of Operations for any period.

Research
and development grants receivable

As of March 31, 2006 and December 31, 2005, research
and development grant receivables consist of grants for research and
development relating to certain projects. Research and development grants are
recognized as a reduction of research and development expenses.

Investments

The Company considers all investments that are not
considered cash equivalents and with a maturity of less than one year from the
balance sheet date to be short-term investments. The Company considers all
investments with a maturity of greater than one year to be long-term
investments. All investments are considered as held-to-maturity and are carried
at amortized cost, as the Company has both the positive intent and ability to
hold them to maturity. The Company invests in a variety of instruments such as
commercial paper, US Government securities and corporate securities with an
effective maturity of less than one year. Interest income includes interest,
amortization of investment purchases premiums and discounts, and realized gains
and losses on sales of securities. Realized gains and losses on sales of
investment securities are determined based on the specific identification
method.

March 31,

December 31,2006

2005Securities
  greater than 90 days

$
25,527,828

$
22,598,343Auction Rate
  Securities


10,950,000


13,150,000Total Short Term
Investments

$
36,477,828

$
35,748,343Restricted
cash

Both short term and long term restricted cash
represents deposits held for or by landlords.

6

Impairment
of Long-Lived Assets

The Company reviews long-lived assets for impairment
whenever events or changes in business circumstances indicate that the carrying
amount of the assets may not be fully recoverable or that the useful lives of
these assets are no longer appropriate. Each impairment test is based on a
comparison of the undiscounted cash flow to the recorded value of the asset.
Subsequent impairment assessments could result in future impairment charges.
Any impairment charge would result in the reduction in the carrying value of
long-lived assets to its fair market value and would reduce its operating
results in the period in which the charge arose.

Tax
Provision

No tax provision is required at
this time since the company expects to be in a tax loss position at year-end
December 31, 2006 and has net operating losses from previous years. The Company
has established a 100% valuation allowance against the deferred tax asset.

Capitalized Merger Costs

During the first quarter of
2006, Pharmos expended approximately $742,000 of costs related to the pending
acquisition of Vela Pharmaceuticals, Inc. These costs were comprised of costs
for a fairness opinion, accounting and legal costs related to due diligence
efforts and other legal costs associated with the merger. Upon the closing of the acquisition, these costs
will be included as a component of the purchase price.
The Company expects most of the purchase price will be allocated to purchased
in-process research and development (IPR&D) representing the value assigned
to research and development projects of Vela Pharmaceuticals, Inc. that have
commenced but will not be completed at the date of acquisition and which have no
alternative future use. In accordance with SFAS No. 2, "Accounting for Research
and Development Costs," as clarified by FASB Interpretation No. 4, amounts
assigned to IPR&D meeting the above-stated criteria must be charged to
expense as part of the allocation of the purchase price of the business
combination if the acquisition is not
approved by the shareholders or is otherwise not consummated, these costs would
be expensed.

Foreign exchange

The Companys foreign operations
are principally conducted in U.S. dollars. Any transactions or balances in
currencies other than U.S. dollars are remeasured and any resultant gains and
losses are included in other (expense) income. To date, such gains and losses
have been insignificant.
7

Equity
based compensation

The Company has stock-based compensation plans under
which employees and outside directors receive stock options and other
equity-based awards. The plans provide for the granting of stock options,
restricted stock awards, and other stock unit awards. The maximum number of
shares of Common Stock available for issuance under the 2000 Plan, as amended,
is 2,700,000 shares. At December 31, 2005, awards relating to 1,198,299 shares
were outstanding. Pharmos stock options are granted with an exercise price
equal to 100% of the market value of a share of common stock on the date of the
grant, generally have 10 year terms, and vest no later than four years from the
date of grant.

Under the terms of the Pharmos
Employee Stock Purchase Plan, all full-time and part-time employees of the
Company who have completed a minimum of 6 months of employment are eligible to
participate. The price of the Common Stock is calculated at 85% of the lower of
either the mean between the highest and lowest prices at which Pharmos common
stock trades on the first business day of the month, or the mean between the
highest and lowest trading prices on the day of exercise (the last day of the
month). A participant can purchase shares not to exceed 10% of ones annualized
base pay; $25,000; or 5% or more of shares outstanding. The total number of
shares reserved for issuance under the 2001 Plan is 100,000 shares. During the
three months ended March 31, 2006, no shares were purchased under the ESPP and 87,440
shares remain for issuance under the 2001 Plan.

Effective January 1, 2006, the Company adopted the
provisions of Statement of Financial Accounting Standards No. 123R, Share-Based
Payment (SFAS 123R), which establishes the financial accounting and
reporting standards for stock-based compensation plans. SFAS 123R requires the
measurement and recognition of compensation expense for all stock-based awards
made to employees and directors, including employee stock options and
restricted stock units, and employee stock purchases related to the ESPP. Under
the provisions of SFAS 123R, stock-based compensation cost is measured at
the grant date, based on the fair value of the award, and is recognized as an
expense over the requisite service period of the entire award (generally the
vesting period of the award). The Company has elected to expense these awards
on a straight line basis over the life of the awards. As a result of adopting
SFAS 123R, the Companys net loss before income taxes and net loss for the
three months ended March 31, 2006 was $181,455 more than if the Company had
continued to account for stock-based compensation under Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25)
and its related interpretations. Basic and diluted net loss per share for the
three months ended March 31, 2006 of $(0.16) is $0.01 more than if the Company
had not adopted SFAS 123R.

The Company elected to use the modified prospective
transition method as permitted by SFAS 123R and, therefore, financial results
for prior periods have not been restated. Under this transition method,
stock-based compensation expense for the three months ended March 31, 2006
includes expense for all equity awards granted prior to, but not yet vested as
of January 1, 2006, based on the grant date fair value estimated in accordance
with the original provisions of SFAS No. 123, Accounting for
Stock-Based Compensation (SFAS 123,) as amended by SFAS 148, Accounting for
Stock-Based CompensationTransition and Disclosure. Since the adoption of SFAS
123R, there have been no changes to the Companys stock compensation plans or
modifications to outstanding stock-based awards which would increase the value
of any awards outstanding. Compensation expense for all stock-based
compensation awards granted subsequent to January 1, 2006 was based on the
grant-date fair value determined in accordance with the provisions of SFAS
123R. During the quarter ended March 31, 2006, the Company recognized
compensation expense of $181,455 for stock options which was recognized in the
Condensed Consolidated Statement of Operations. As of March 31, 2006, the total
compensation costs related to non-vested awards not yet recognized is $2.0
million which will be recognized over the next four years.

8

Prior to January 1, 2006, the Company accounted for
stock-based compensation in accordance with APB 25 and also followed the
disclosure requirements of SFAS 123. Under APB 25, the Company accounted
for stock-based awards to employees and directors using the intrinsic value
method as allowed under SFAS 123. The following table sets forth the
computation of basic and diluted loss per share for the three months ended
March 31, 2005 and illustrates the effect on net loss and loss per share as if
the Company had applied the fair value recognition provisions of SFAS 123 to
its stock plans:
Three months endedMarch 31,2005Net income as
reported

$
6,677,527Add: Stock-based
employee compensation expense included in reported
  net income


293,691Deduct: Total
stock-based employee compensation expense determined
  under fair value based method for all awards (1)


(626,875
)Pro forma net
income

$
6,344,343
)Earnings per
share:Basic - as
reported

$
.07Diluted - as
reported

$
.07Basic - pro
forma

$
.07Diluted 
pro forma

$
.07
(1)
The pro forma stock-based compensation expense was
  not tax-effected due to the recording of a full valuation allowance against
  U.S. net deferred tax assets.

The
following table presents the total stock-based compensation expense resulting
from stock options and restricted stock awards, and the ESPP included in the
Statement of Operations:



Three
        Months EndedMarch
        31, 2006Research
        and development costs
    
    $
    50,973Selling,
        general and administrative costs
    
    
    130,482Stock-based
        compensation costs before income taxes
    
    
    181,455Benefit
        for income taxes (1)
    
    
    Net
        compensation expense
    
    $
    181,455(1)
The stock-based compensation expense has not been
  tax-effected due to the recording of a full valuation allowance against U.S.
  net deferred tax assets.
9

The fair value of each stock option grant is estimated
on the grant date using the Black-Scholes option-pricing model with the
following assumptions:

Three months ended March 31,2006

2005Risk-free interest rate


4.35
%


3.71
%Expected lives (in years)


5



5Dividend yield


0
%


0
%Expected volatility


103
%


99
%Expected
Volatility. The Company calculates the expected volatility of
its stock options using historical volatility of weekly stock prices.

Expected
Term.The expected term is based on historical observations
of employee exercise patterns during the Companys history.

Risk-Free
Interest Rate. The interest rate used in valuing awards is
based on the yield at the time of grant of a U.S. Treasury security with an
equivalent remaining term.

Dividend
Yield. The Company has never paid cash dividends, and does
not currently intend to pay cash dividends, and thus has assumed a 0% dividend
yield.

Pre-Vesting
Forfeitures. Estimates of pre-vesting option forfeitures are
based on Company experience. The Company will adjust its estimate of
forfeitures over the requisite service period based on the extent to which
actual forfeitures differ, or are expected to differ, from such estimates.
Changes in estimated forfeitures will be recognized through a cumulative
catch-up adjustment in the period of change and will also impact the amount of
compensation expense to be recognized in future periods.

During the first quarter of fiscal 2006 and 2005,
employees and outside directors of the Company were granted stock options under
the Pharmos 2000 Stock Option Plan in the amount of 676,000 options, or a fair
value of $1,128,920, and 240,310 options, or a fair value of $699,302,
respectively. The fair value of options that vested during the first quarter of 2006 and 2005,
without considering forfeitures, was $220,678 and $393,878, respectively. The
Companys policy is to issue new shares upon exercise and use the cash to
support operating costs.

10

Stock Options

Presented
below is a summary of the status of Pharmos stock options as of March 31, 2006,
and related transactions for the quarter then ended:

Shares
    
    Weighted
        Average
        Exercise
        Price
    
    Weighted-
        Average
        Remaining
        Contractual
        Term
    
    Aggregate
        Intrinsic
        ValueStock
        OptionsOutstanding
        at December 31, 2005
    
    
    1,198,299
    
    
    
    $
    8.63
    
    
    
    6.5
        years
    
    
    $
    **Granted**
    
    
    **676,000**
    ****
    ****
    ****
    **$**
    **2.15****Exercised**
    
    
    ****
    ****
    ****
    ****
    ****
    ******Forfeited
        or Expired**
    
    
    **(41,490**
    **)**
    ****
    ****
    **$**
    **11.76******
    ****
    ****
    ****
    ****Outstanding
        at March 31, 2006
    
    
    **1,832,809**
    ****
    ****
    ****
    **$**
    **6.17**
    
    
    
    6.0
        years
    
    
    $
    110,190****
    ****
    ****
    ****
    ****
    ****Non-vested
        Options
    
    
    ****
    ****
    ****
    ****
    ****
    ******Non-vested
        options at December 31, 2005**
    
    
    **575,966**
    ****
    ****
    ****
    **$**
    **3.03**
    
    
    
    9.4
        years
    
    
    $
    **Granted**
    
    
    **676,000**
    ****
    ****
    ****
    **$**
    **2.15****Vested
        in 1Q06**
    
    
    **(83,384**
    **)**
    ****
    ****
    **$**
    **3.58****Forfeited**
    
    
    **(11,380**
    **)**
    ****
    ****
    **$**
    **3.85**Non-vested
        options at March 31, 2006
    
    
    1,157,202
    
    
    
    $
    2.47
    
    
    
    9.2
        years
    
    
    $
    106,590Exercisable
        Options at March 31, 2006
    
    
    675,607
    
    
    
    $
    12.50
    
    
    
    6.3
        years
    
    
    $
    3,600Restricted
        StockNon-vested
        Restricted Stock at December 31, 2005
    
    
    63,292
    
    
    
    $
    15.80
    
    
    
    8.2
        years**Granted**
    
    
    
    
    
    
    
    **Vested**
    
    
    
    
    
    
    
    **Forfeited
        or Expired**
    
    
    
    
    
    
    
    Non-vested
        Restricted Stock at March 31, 2006
    
    
    63,292
    
    
    
    $
    15.80
    
    
    
    8.2
        years11

4. Net
  Income (Loss) Per Common Share

Basic and diluted net
income (loss) per common share was computed by dividing the net income (loss)
for the period by the weighted average number of shares of common stock issued
and outstanding. For the period ending March 31, 2006, other potential common
stock has been excluded from the calculation of diluted net loss per common
share, as their inclusion would be anti-dilutive. In accordance with the
requirements of Statement of Financial Accounting Standards No. 128, a limited
number of the stock options and warrants as of March 31, 2005 were in the
money or would be considered other potential common stock and have been
included in the calculation of diluted net earnings per share. The basis for
the shares used in determining the diluted shares included in the calculation
of diluted income per share for March 31, 2005 is illustrated below.

March 31,
  2005Weighted average shares
  outstanding basic


18,973,944Restricted shares  non-vested


126,583Weighted average of options
  that are in the money


19,413Weighted average shares
  outstanding  diluted


19,119,940The following table sets
forth the number of potential shares of common stock that have been excluded
from diluted income (loss) per share because the exercise price was greater
than the average market price of our common stock, and therefore, the effect on
diluted income (loss) per share would have been anti-dilutive.

March 31,
  2006

March 31,
  2005Stock options


1,832,809



993,696Warrants


1,176,310



1,377,938Restricted stock  non
vested


63,292



126,583Total potential dilutive
securities not included in loss (income) per
  share


3,072,411



2,498,21712

5. Collaborative
Agreements

In October
2001, the Company sold its ophthalmic product line to Bausch & Lomb. Future
payments were subject to certain milestones related to product approvals by the
FDA and the royalties on the sales of these products.

At the time of
the sale in 2001, Pharmos received gross proceeds of approximately $25 million
in cash. In January 2005, Pharmos received additional gross proceeds of
approximately $12.275 million from Bausch & Lomb in connection with their
successful commercial launch of the Zylet product. The net proceeds to Pharmos
from this payment were approximately $9.2 million, after making the payments to
Bausch & Lomb, Dr. Nicholas Bodor and the Israel-U.S. Binational Industrial
Research and Development Foundation as described below. In addition, Pharmos
may receive a royalty payment of up to $10 million if actual Zylet sales
during the first two years after commercialization exceed agreed-upon amounts.

As part of the
original agreement with Bausch & Lomb, Pharmos agreed to pay up to $3.75
million of the costs of developing Zylet. In January 2005, Pharmos paid
approximately $1.56 million (included in accounts payable on December 31, 2004)
which was the remaining balance owed to Bausch & Lomb for the Zylet
project development under the terms of the agreement.

Dr. Nicholas
Bodor, a former director of and consultant to Pharmos, is the patent owner and
licensor of the technology underlying the ophthalmic product line sold to
Bausch & Lomb. In January 2005, Pharmos paid Dr. Bodor approximately $1.338
million in connection with the commercialization of Zylet, per the license
agreement with Dr. Bodor. Pharmos owes Dr. Bodor an additional 14.3% of any
payments the Company may receive from Bausch & Lomb in the event that certain
sales levels are exceeded in the first two years following commencement of
Zylet sales in the U.S.

In February
2005, the Company paid the Israel-U.S. Binational Industrial Research and
Development Foundation (BIRDF) $.212 million, which represented the maximum
amount the Company owed the foundation for Zylet.

Pharmos
subsidiary, Pharmos Ltd., licensed its patents related to the oral delivery of
lipophilic substances in the limited field of use of nutraceuticals to
Herbamed, Ltd., a company in Israel controlled by the Chairman and Chief
Executive Officer of Pharmos. In the three months ending March 31, 2006 and
March 31, 2005, the Company recorded in other income royalties of $991 and
$12,202, respectively, per the licensing agreement with Herbamed.

13

6. Private Placement
of Convertible Debt

On September
26, 2003, the Company completed a private placement of convertible debentures
and warrants to six institutional investors, generating total gross proceeds of
$21.0 million. Five million dollars of the proceeds was to be used for working
capital purposes, and $16.0 million was to be available to fund acquisitions
upon the approval of the investors. The convertible debentures were convertible
into common stock of the Company at a fixed price of $20.20, or 205% above the
closing bid price of the stock for the five days preceding the closing date.
The debentures, which bore an interest rate of 4%, were redeemed in 13
substantially equal monthly increments which began March 31, 2004. Amounts
converted into shares of Pharmos common stock reduced the monthly redemption
amount in inverse order of maturity. The $16.0 million earmarked for
acquisition activity was to be held in escrow until used or repaid. In
connection with the financing, the Company also issued 1,102,941 three-year
warrants (including 102,941 placement agent warrants) to purchase 1,102,941
shares of common stock at an exercise price of $10.20 per share. The issuance
costs related to the convertible debentures of approximately $1,229,000 in cash
and $434,000 for the value of the placement agent warrants were capitalized and
amortized over the life of the debt. The Company calculated the value of the
warrants at the date of the transaction, including the placement agent
warrants, as being approximately $4,652,877 under the Black-Scholes
option-pricing method (assumption: volatility 75%, risk free rate 1.59% and
zero dividend yield). The Company allocated the $21.0 million in gross proceeds
between the convertible debentures and the warrants based on their relative
fair values. The Company has reported the debt discount as a direct reduction
to the face amount of the debt in accordance with APB 21. The discount had
accreted over the life of the outstanding debentures. The issuance costs
allocated to the convertible debentures were deferred and amortized to interest
expense over the life of the debt. APB 21 also requires the Company to allocate
the warrant costs between the convertible debentures and the transaction
warrants. The issuance costs allocated to the warrants were recorded as a debit
to additional paid in capital. During the first quarter of 2004, one of the
investors from the September 2003 Convertible Debentures private placement
converted a total of $2 million plus interest. The Company issued 99,532 shares
of common stock. As of March 31, 2005, the Convertible Debentures were repaid.

7. Common Stock
Transactions

In the three
months ended March 31, 2006, there were no shares of common stock issued
pursuant to the Pharmos Corporation 2001 Employee Stock Purchase Plan or
options exercised under the Companys Stock Option Plans.

On May 26, 2005, Pharmos
Corporation filed a Certificate of Change with the Nevada Secretary of State
which served to effect, as of May 31, 2005, a 1-for-5 reverse split of Pharmos
common stock. As a result of the reverse stock split, every five shares of
Pharmos common stock were combined into one share of common stock; any
fractional shares created by the reverse stock split were rounded up to whole
shares. The reverse stock split affected all of Pharmos common stock, stock
options, restricted shares and warrants outstanding immediately prior to the
effective date of the reverse stock split. The reverse split reduced the number
of shares of Pharmos common stock outstanding from 95,137,076 shares to
19,027,809 shares, and the number of authorized shares of common stock was
reduced from 150,000,000 shares to 30,000,000 shares. The authorized shares of
common stock were increased to 60,000,000 shares at the Annual Meeting held in
September 2005.

On September
6, 2004, the Board of Directors approved the Retention Award Agreements and
Pharmos entered into Retention Award Agreements with each of Dr. Haim Aviv,
Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its then
President and Chief Operating Officer. The Company granted retention awards of
$300,000 cash and 75,950 restricted stock units to Dr. Aviv and $200,000 cash
and 50,633 shares of restricted stock to Dr. Riesenfeld (the Awards). Under
the agreement, one-half of the Awards vested on December 31, 2005 and the
balance of Dr. Avivs Awards shall vest and become non-forfeitable on June 30,
2007, subject to certain accelerated vesting provisions. Under the terms of Dr.
Riesenfelds severance agreement, the balance of his Awards vested on his
departure from the Company on April 2, 2006 and the expense of those awards was
accelerated through April 2, 2006. The fair value of the restricted shares was
based on the fair value of the stock on the issuance date. The aggregate fair
value of the restricted stock awards totaled $2 million. For financial
reporting purposes, the cash awards and the fair value of the restricted stock
awards, which totaled $2,500,000, are being expensed pro rata over the vesting
periods. During the quarter ended March 31, 2006, the Company recorded an
expense of approximately $265,000 in connection with the Awards including the
accelerated vesting of Dr. Riesenfelds awards.

14

On March 4,
2003, the Company raised $4.3 million from the placement of common stock and
warrants. The private placement offering was completed by issuing 1,011,765
shares of common stock at a price of $4.25 per share and approximately 200
thousand warrants at an exercise price of $6.25 per share. Additionally, the remaining
balance of the September 2000 Convertible Debenture offering was redeemed for
cash. The original face amount of $3.5 million was redeemed for approximately
$4.0 million, which included accrued and unpaid interest. According to EITF
00-19, the issued warrants meet the requirements of and are being accounted for
as a liability since registered shares must be delivered upon settlement. The
Company calculated the initial value of the warrants, including the placement
agent warrants, as being approximately $394,000 under the Black-Scholes
option-pricing method (assumption: volatility 75%, risk free rate 2.88% and
zero dividend yield). The value of the warrants is being marked to market each
reporting period as a gain/loss until exercised or expiration and
amounted to $24,776 at March 31, 2006. Upon exercise of each of the warrants,
the related liability is reduced by recording an adjustment to additional
paid-in-capital.

The fair value of the warrants is being marked to market using the Black-Scholes option-pricing model with the following assumptions:




Three
        months ended March 31,2006
    2005Risk-free
        interest rate
    4.77%
    3.73%Expected
        lives (in years)
    1
    2Dividend
        yield
    0%
    0%Expected
        volatility
    103%
    93%

8. Segment and
Geographic Information

The Company is
active in one business segment: designing, developing, selling and marketing
pharmaceutical products. The Company maintains development operations in the
United States and Israel. The Companys selling operations are maintained in
the United States.

Geographic
information for the three months ending March 31, 2006 and 2005 are as follows:Three
  months ended March 31,2006

2005Net (loss) incomeUnited
States

$
(2,928,140
)
$
6,752,687Israel


(74,546
)

(75,160
)$
(3,002,686
)
$
6,677,527Capital ExpendituresUnited
States

$


$
3,945Israel


96,097


18,558$
96,097

$
22,5032006

2005Total AssetsUnited
States

$
42,613,531

$
54,222,038Israel


3,908,732


3,613,137$
46,522,263

$
57,835,175Long Lived Assets, netUnited
States

$
73,947

$
122,724Israel


686,525


772,305$
760,472

$
895,029



15

9. Subsequent Events

The Company and James A.
Meer, Chief Financial Officer, have agreed that when his current employment
agreement expires in July 2006, it will not be renewed. Mr. Meer will remain in
his current role until the engagement of his successor.

10. Commitments and
Contingencies

The Company
and certain current officers have been named as defendants in several purported
shareholder class action lawsuits alleging violations of federal securities
laws. These lawsuits were filed beginning in January 2005 and are pending in
the U.S. District Court for the District of New Jersey. These lawsuits assert
claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934
and Rule 10b-5 thereunder. The complaints allege generally that the defendants
knowingly or recklessly made false or misleading statements regarding the
effectiveness of dexanabinol in treating TBI (Traumatic Brain Injury) which had
the effect of artificially inflating the price of the Companys common stock.
The complaints seek unspecified damages. These class actions have been
consolidated by order of the court and lead plaintiffs and lead plaintiffs
counsel have been appointed. An amended complaint was filed in September 2005.
In November 2005, the Company moved to dismiss the litigation, and the motion
was fully briefed on February 10, 2006. Decision on the motion is pending.

In addition,
two purported shareholders of the Companys common stock have commenced
derivative actions against the Companys directors and against certain current
and former officers. The first derivative lawsuit was commenced in February
2005 in the U.S. District Court for the District of New Jersey, and has been
consolidated for pretrial purposes with the class actions. An amended complaint
in the federal derivative lawsuit was filed in September 2005. The Company also
moved to dismiss this litigation, and briefing on the motion was completed on
February 10, 2006. Decision on the motion is pending. The second lawsuit was
filed in April 2005 in the Superior Court of New Jersey, County of Middlesex.
An amended complaint in the state court case was filed in November 2005. This
action has been stayed pending decisions on the motions to dismiss in the
Federal actions. Both lawsuits allege generally, on behalf of the Company
(which has been named as a nominal defendant), breaches of fiduciary duty and
other state law violations arising from the same set of underlying facts as the
class actions. The complaints seek unspecified damages.

Management intends to defend
these lawsuits vigorously. However, we cannot assure you that we will prevail
in these actions, and, if the outcome is unfavorable to Pharmos, our
reputation, profitability and share price could be adversely affected.

16

Item 2.  Managements Discussion and Analysis
of Financial Condition and Results of Operations

This discussion and analysis of our financial condition and results of
operations contains forward-looking statements that involve risks and
uncertainties. The Company has based these forward-looking statements on our
current expectations and projections of future events. Such statements reflect
our current views with respect to future events and are subject to unknown
risks, uncertainty and other factors that may cause results to differ
materially from those contemplated in such forward looking statements.
Statements made in this document related to the development, commercialization
and market expectations of the Companys drug candidates, to the establishment
of corporate collaborations, and to the Companys operational projections are
forward-looking and are made pursuant to the safe harbor provisions of the
Securities Litigation Reform Act of 1995. Among the factors that could result
in a materially different outcome are the inherent uncertainties accompanying
new product development, action of regulatory authorities and the results of
further trials. Additional economic, competitive, governmental, technological,
marketing and other factors identified in Pharmos filings with the Securities
and Exchange Commission could affect such results. In addition, the following
discussion should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this report.

Executive
Summary

Pharmos Corporation is a specialty pharmaceutical company that
discovers and develops novel therapeutics to treat a range of indications
including pain, inflammation, autoimmunity and select central nervous system
(CNS) disorders. We have a portfolio of drug candidates and compounds in
various development stages, including clinical, preclinical and discovery. The
Companys core proprietary technology platform focuses on the discovery and
development of synthetic cannabinoid compounds. Collaborative research as well
as in-house research at Pharmos over the last decade has served as a
cornerstone of our scientific foundation, and through such efforts we have
extensively characterized many of the key variables involved in cannabinoid
receptor activation and modulation. In order to identify and optimize promising
drug candidates quickly and efficiently, we combine:


Our extensive knowledge of the cannabinoid pathways we believe are
  responsible for therapeutic effects and strategies for minimizing potential
  adverse effects
Our comprehensive library of well-annotated cannabinoid potential
  drug candidates
Our interdisciplinary drug discovery and development approach
Manufacturing capability of clinical material, including a
  cGMP-compliant pilot plant
Pharmaceutical formulation expertise, which has provided additional
  opportunities for developing novel drug delivery systems which can be
  employed both for internal programs in pain and inflammation and which also
  provide partnering opportunities for areas outside of our therapeutic focusThe Companys discovery efforts are focused primarily on CB2-selective
compounds which are small molecule cannabinoid receptor agonists that bind
preferentially to CB2 receptors found primarily in peripheral immune cells.
Cannabinor, the lead CB2-selective receptor agonist candidate, has completed
Phase I testing and is scheduled for preliminary proof-of-principle Phase IIa
testing in various pain indications during the first half of 2006. Other compounds
from Pharmos proprietary synthetic cannabinoid library are in pre-clinical
studies targeting nociceptive, neuropathic and visceral pain, as well as
autoimmune diseases, including multiple sclerosis, rheumatoid arthritis and
inflammatory bowel disease.

The Company also has a family of synthetic cannabinoid compounds that
do not bind to cannabinoid receptors. Unlike the CB2-selective agonists such as
cannabinor, the pharmacologic activity of these compounds is mediated by
processes other than CB receptor signaling. The Company is seeking to partner
dexanabinol, its lead compound from this family, as a preventive agent against
cognitive impairment following cardiac surgery.

The Companys NanoEmulsion drug delivery system, a proprietary asset
derived from our formulation expertise, is in clinical development for topical
application of analgesic and anti-inflammatory agents. In 2006, the Company
expects to complete a second Phase I trial of this delivery technology to
confirm the excellent local tolerability as well as pharmacokinetic parameters
of a more optimized formulation. The NanoEmulsion technology has demonstrated
additional potential applications, including vaccine formulation as well as
targeted delivery of such molecules as antibiotics. The Company is interested
in partnering this technology in these areas.

17

The Company intends to acquire later stage product candidates for
treating diseases in line with its research and development expertise and
targeted areas of interest, including pain, gastrointestinal inflammation,
autoimmunity and select CNS disorders.

On March 15, 2006, the Company announced an agreement to acquire Vela
Pharmaceuticals, Inc., which has a Phase II product candidate, dextofisopam, in
development to treat irritable bowel syndrome. The acquisition will require
shareholder approval. The Company intends to dedicate substantial resources to
complete clinical development of this product candidate. The Vela acquisition
also includes additional compounds in preclinical and/or clinical development
for neuropathic pain, inflammation and sexual dysfunction.

The Company continues to refine its commercialization and business
development strategy with the intention of capitalizing on internal resources
through strategic alliances and scientific and academic collaborations,
out-licensing and co-development opportunities, as well as balancing the
portfolio with strategic acquisitions and in-licensing opportunities.

2006 Business
Objectives

During late 2005, the Company commenced a Phase I trial for its lead
candidate for treating pain, a CB-2 selective agonist, cannabinor, which was
completed in January 2006. The Company expects to enter Phase II testing in
pain indications in the first half of 2006. The Companys NanoEmulsion drug
delivery system is in development for the topical application of analgesic and
anti-inflammatory agents. The Company expects to commence a clinical program in
the second quarter of 2006. From the dextrocannabinoid family, the
neuroprotective drug candidate dexanabinol completed a Phase IIa trial as a
preventive agent against post-surgical cognitive impairment in the fourth
quarter of 2004. Results of the exploratory Phase II trial of dexanabinol as a
preventive agent for cognitive impairment (CI) in coronary artery bypass graft
(CABG) patients have been reviewed internally and with the FDA. The Company
announced in March 2006 that it will seek a partner to further develop this
product. The Company intends to complete the acquisition of Vela
Pharmaceuticals, Inc., subject to shareholders approval, during the third
quarter of 2006.

The results for the three months ended March 31, 2006 and 2005 were a
net loss of $3.0 million and a net profit of $6.7 million or a (loss) income
per share of $(0.16) and $0.35, respectively.

Except for 2001, the Company has experienced operating losses every
year since inception in funding the research, development and clinical testing
of our drug candidates. As of March 31, 2006, the Companys accumulated deficit
was approximately $148.9 million. The Company expects to incur additional
losses over the next several years as the Companys research and development
and clinical trial programs continue. The Companys ability to achieve
profitability, if ever, is dependent on its ability to develop and obtain
regulatory approvals for its product candidates, to enter into agreements for
product development and commercialization with strategic corporate partners and
contract to develop or acquire the capacity to manufacture and sell its
products. See Managements Discussion and Analysis of Financial Condition and
Results of Operations  Liquidity and Capital Resources.

18

Results of Operations

Quarters
ended March 31, 2006 and 2005

Total operating expenses for the first quarter of 2006 decreased by $936,515
or 21%, from $4,394,699 in 2005 to $3,458,184 in 2006. The Company will enter
Phase II testing in pain indications with cannabinor in the second quarter of
2006. The Companys NanoEmulsion drug delivery system is in clinical stage
development for the topical application of analgesic and anti-inflammatory
agents. The Company expects to commence a clinical program in the first half of
2006 for its NanoEmulsion drug delivery system. During the first quarter of
2006, the Company incurred higher compensation costs related to severance costs
for the departure of two executives and the implementation of the equity based
compensation of SFAS 123(R) which were offset by lower costs for clinical
studies, lower legal fees, and lower salaries related to a reduction in
workforce, as compared with the first quarter of 2005.

Research efforts in the first quarter of 2006 have been focused on the
completion of cannabinor toxicology, scale-up manufacturing, technology
transfer to the active ingredient supplier, and clinical trial finished
material at Pharmos facility in Rehovot, Israel, as well as continuing to
identify new, potentially more potent, CB2 agonists.

The Company considers major research & development projects to be
those projects that have reached at least Phase II level of clinical
development. At this time, there are no projects that are in Phase II. We
expect that Cannabinor will be in Phase II by the end of the second quarter.

Gross expenses for other research and development projects in early
stages of development for the first quarters of 2006 and 2005 were $1,130,495
and $1,469,985, respectively. Over 65% of the spending in both 2006 and 2005
was related to cannabinor and other CB2 compounds. Research & development
(R&D) gross expenses decreased by $637,525 or 26% from $2,504,639 in 2005
to $1,867,114 in 2006, related to a reduction in clinical activities which are
expected to pick up in the second quarter of 2006. The Company recorded research and development grant receivables
from the Office of the Chief Scientist of Israels Ministry of Industry and
Trade of $300,635 and $19,576 during the first quarter of 2006 and 2005,
respectively, which reduced the research and development expenses. Total
research and development expenses, net of grants, decreased by $918,584 or 37%
from $2,485,063 in 2005 to $1,566,479 in 2006.

General and administrative expenses increased by $18,510 or 1% to
$1,813,221 in 2006 from $1,794,711 in 2005 in total; however, there were
offsetting variances within the major expense categories. The increase in
general and administrative expenses is due to higher compensation costs of
$252,959 made up of an accrual of severance costs for the departure of two
executives and the implementation of the equity based compensation related to
implementation of SFAS 123(R) in the first quarter of 2006 compared to the first
quarter of 2005 offset by lower salaries related to a reduction in workforce and
by reduced amortization related to the 50% share of the Retention Awards which
vested on December 31, 2005. Other decreases in general and administrative
expenses are due to lower professional fees by $181,737, related to reduced
costs for legal fees in 2006 related to the class action suits.

Depreciation and amortization expenses decreased by $36,441, or 32%,
from $114,925 in 2005 to $78,484 in 2006. The decrease is due to fixed assets
which have become fully depreciated.

19

Other income (expense), net, decreased by $10,616,728 from income of
$11,072,226 in 2005 to income of $455,498 in 2006. The majority of the decrease
is from the non-recurring receipt of the Bausch & Lomb milestone payment
received in the first quarter of 2005. Interest expense decreased by $160,546
to $0 in 2006 from $160,546 in 2005 related to the retirement of the September
2003 Convertible Debentures during the first quarter of 2005. Interest income
increased by $196,208, or 73%, to $465,704 in 2006 from $269,496 in 2005 as a
result of higher interest rates. The gain related to the valuation of warrants
decreased by $216,827 to $14,104 in 2006 from $230,931 in 2005. During the
quarter, the Company recorded in other income royalties of $991 compared with
$12,202 in the first quarter of 2005 per the licensing agreement with Herbamed
Ltd, a company controlled by Dr. Haim Aviv, the Companys CEO.

No tax provision is required at this time since the company expects to
be in a tax loss position at year-end December 31, 2006 and has net operating
losses from previous years. The Company has established a 100% valuation
allowance against the deferred tax asset.

20

Liquidity
and Capital Resources

The Company incurred cumulative operating losses since 2002 and had an
accumulated deficit of $148.9 million at March 31, 2006. The Company has
financed its operations with public and private offerings of securities, advances
and other funding pursuant to a marketing and asset agreement with Bausch &
Lomb, grants from the Office of the Chief Scientist of Israel, research
contracts, the sale of a portion of its New Jersey State Net Operating Loss
carryforwards, and interest income. Should the Company be unable to raise
adequate financing or generate revenue in the future, operations will need to
be scaled back or discontinued.

The following table describes the Companys liquidity and financial
position on March 31, 2006, and on December 31, 2005:

March 31, 2006

December 31, 2005Working capital


$
41,555,607



$
44,763,056Cash and cash
equivalents


$
5,139,887



$
10,289,127Short term
investments


$
36,477,828



$
35,748,343Total cash, cash equivalents
and short
  term       investments


$
41,617,715



$
46,037,470Current working capital position

As of March 31, 2006, the Company had working capital of $41.6 million
consisting of current assets of $44.1 million and current liabilities of $2.6
million. This represents a decrease of $3.2 million from its working capital of
$44.8 million on current assets of $47.4 million and current liabilities of
$2.6 million as of December 31, 2005. This decrease in working capital of $3.2
million was principally associated with the funding of R&D and G&A
activities.

Current and future liquidity position

Management believes that the current cash, cash equivalents and short
term investments, totaling $41.6 million as of March 31, 2006, will be
sufficient to support the Companys continuing operations beyond March 31,
2007. The Company is continuing to actively pursue various funding options,
including additional equity offerings, strategic corporate alliances, business
combinations and the establishment of product related research and development
limited partnerships, to obtain additional financing to continue the
development of its products and bring them to commercial markets. Should the
Company be unable to raise adequate financing or generate revenue in the
future, long-term operations will need to be scaled back or discontinued.

In regard to the Vela acquisition, Management believes that the current
cash, cash equivalents and short term investments, totaling $41.6 million as of
March 31, 2006, will be sufficient to support the Companys continuing
operations for the combined company of Pharmos and Vela beyond March 31, 2007.

Cash

At March 31, 2006, cash and cash equivalents totaled $5.1 million. At
December 31, 2005 cash and cash equivalents totaled $10.3 million. This net
decrease in cash of $5.2 million was due to the net investment of cash in short
term investments in the amount of $.7 million, $3.8 million for normal
operating requirements and capital expenditures, and $.7 million for merger
related expenses. The cash, cash equivalents short term investments will be
used to finance future growth.

21

Operating activities

Net cash used in operating activities through the first quarter of 2006
was $3.6 million compared to net cash used of $3.9 million through the first
quarter of 2005. The decrease in cash used of $0.3 million is primarily due to
lower R&D spending related to the clinical trials and the timing of the of
grants.

Investing activities

The Company invested cash of approximately $.7 million in merger
related costs during the three months ended March 31, 2006 and an increased net
investment in short term investments of $.7 million.

Capital expenditures for property, plant and equipment for the three
months ended March 31, 2006 and 2005 totaled approximately $96,000 and $23,000,
respectively for normal replacements and improvements.

Financing activities

There were no financing activities in the first quarter of 2006. In the
first quarter of 2005, the repayment of the remainder of the September 2003
Convertible Debentures was made.

Other Proceeds

In October 2001, the Company sold its ophthalmic product line to Bausch
& Lomb. Future payments were subject to certain milestones related to
product approvals by the FDA and the royalties on the sales of these products.

At the time of the sale in 2001, Pharmos received gross proceeds of
approximately $25 million in cash. In January 2005, Pharmos received additional
gross proceeds of approximately $12.275 million from Bausch & Lomb in
connection with their successful commercial launch of the Zylet product and
income from the Office of the Chief Scientist of Israel. The net proceeds to
Pharmos from this payment were approximately $9.2 million, after making the
payments to Bausch & Lomb, Dr. Nicholas Bodor and the Israel-U.S.
Binational Industrial Research and Development Foundation as described below.
In addition, Pharmos may receive a royalty payment of up to $10 million if
actual Zylet sales during the first two years after commercialization exceed
agreed-upon amounts.

As part of the original agreement with Bausch & Lomb, Pharmos
agreed to pay up to $3.75 million of the costs of developing Zylet. In January
2005, Pharmos paid approximately $1.56 million (included in accounts payable on
December 31, 2004) which was the remaining balance owed to Bausch & Lomb
for the Zylet project development under the terms of the agreement.

Dr. Nicholas Bodor, a former director of and consultant to Pharmos, is
the patent owner and licensor of the technology underlying the ophthalmic product
line sold to Bausch & Lomb. In January 2005, Pharmos paid Dr. Bodor
approximately $1.338 million in connection with the commercialization of
Zylet, per the license agreement with Dr. Bodor. Pharmos owes Dr. Bodor an
additional 14.3% of any payments the Company may receive from Bausch & Lomb
in the event that certain sales levels are exceeded in the first two years
following commencement of Zylet sales in the U.S.

In February 2005, the Company paid the Israel-U.S. Binational
Industrial Research and Development Foundation (BIRDF) $.212 million, which
represented the maximum amount the Company owed the foundation for Zylet.

22

Commitment and Contingencies

As of March
31, 2006, the Company had the following contractual commitments and long-term
obligations:

Total

Less than
  1 Year

1  3
  Years

3  5
  Years

More than 5 Years

UndeterminedOperating Leases

$
1,190,058

$
537,604

$
479,124

$
173,330

$


$
Other long-term liabilities
reflected on
  our balance sheet*


1,104,749














1,104,749Other Commitment**


250,000


100,000


150,000








Total

$
2,544,807

$
637,604

$
629,124

$
173,330

$


$
1,104,749*
Consists of
  severance benefits payable under Israeli law. Because these benefits are paid
  only upon termination of employment, it is not possible to allocate the
  liability across future years. The Company has funded $803,754.**
Represents
  cash portion of the September 2004 Retention Award Agreement given to the CEO
  and former President. The Company has accrued $183,824 through March 31,
  2006.Subsequent Events

The Company
and James A. Meer, Chief Financial Officer, have agreed that when his current
employment agreement expires in July 2006, it will not be renewed. Mr. Meer
will remain in his current role until the engagement of his successor.

23

Item 3. Quantitative
and Qualitative Disclosures About Market Risk

We assessed
our vulnerability to certain market risks, including interest rate risk
associated with financial instruments included in cash, cash equivalents, short
term investments and the currency impact in Israel. Due to the relatively
short-term nature of these investments the Company has determined that the
risks associated with interest rate fluctuations related to these financial
instruments do not pose a material risk to us. The value of the warrant
liability is generally based upon the Companys stock price.

Item 4. Controls And Procedures

(a)
  Evaluation of Disclosure Controls and Procedures: An evaluation of Pharmos
  disclosure controls and procedures (as defined in Section13a - 15(e) of the
  Securities Exchange Act of 1934 (the Act)) was carried out under the
  supervision and with the participation of Pharmos Chief Executive Officer
  and Chief Financial Officer and several other members of Pharmos senior
  management at March 31, 2006. Based on this evaluation, Pharmos Chief
  Executive Officer and Chief Financial Officer concluded that as of March 31,
  2006, Pharmos disclosure controls and procedures were effective, at a
  reasonable level of assurance, in ensuring that the information required to
  be disclosed by Pharmos in the reports it files or submits under the Act is
  (i) accumulated and communicated to Pharmos management (including the Chief
  Executive Officer and Chief Financial Officer) in a timely manner, and (ii)
  recorded, processed, summarized and reported within the time periods
  specified in the SECs rules and forms.(b) Changes
  in Internal Control Over Financial Reporting: There were no changes in our
  internal control over financial reporting (as defined in Rule 13a-15(f) under
  the Securities Exchange Act of 1934, as amended) during our last fiscal
  quarter that has materially affected, or is reasonably likely to materially
  affect, our internal control over financial reporting.24

Part II

Other Information

Item 1 Legal ProceedingsThe Company
  and certain current officers have been named as defendants in several
  purported shareholder class action lawsuits alleging violations of federal
  securities laws. These lawsuits were filed beginning in January 2005 and are
  pending in the U.S. District Court for the District of New Jersey. These
  lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
  Exchange Act of 1934 and Rule 10b-5 thereunder. The complaints allege
  generally that the defendants knowingly or recklessly made false or
  misleading statements regarding the effectiveness of dexanabinol in treating
  TBI (Traumatic Brain Injury) which had the effect of artificially inflating
  the price of the Companys common stock. The complaints seek unspecified
  damages. These class actions have been consolidated by order of the court and
  lead plaintiffs and lead plaintiffs counsel have been appointed. An amended
  complaint was filed in September 2005. In November 2005, the Company moved to
  dismiss the litigation, and the motion was fully briefed on February 10,
  2006. Decision on the motion is pending.In addition,
  two purported shareholders of the Companys common stock have commenced
  derivative actions against the Companys directors and against certain
  current and former officers. The first derivative lawsuit was commenced in
  February 2005 in the U.S. District Court for the District of New Jersey, and
  has been consolidated for pretrial purposes with the class actions. An
  amended complaint in the federal derivative lawsuit was filed in September
  2005. The Company also moved to dismiss this litigation, and briefing on the
  motion was completed on February 10, 2006. Decision on the motion is pending.
  The second lawsuit was filed in April 2005 in the Superior Court of New
  Jersey, County of Middlesex. An amended complaint in the state court case was
  filed in November 2005. This action has been stayed pending decisions on the
  motions to dismiss in the Federal actions. Both lawsuits allege generally, on
  behalf of the Company (which has been named as a nominal defendant), breaches
  of fiduciary duty and other state law violations arising from the same set of
  underlying facts as the class actions. The complaints seek unspecified
  damages.Management
  intends to defend these lawsuits vigorously. However, we cannot assure you
  that we will prevail in these actions, and, if the outcome is unfavorable to
  Pharmos, our reputation, profitability and share price could be adversely
  affected.Item 1A Risk FactorsThere are no material changes from the risk factors previously
  disclosed in our Annual Report on Form 10-K for the year ended December 31,
  2005.Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
NONEItem 3 Defaults upon Senior Securities
NONEItem 4 Submission of Matters to Vote of Security Holders
NONE25

Item 5 Other Information(a) The
  Company and James A. Meer, Chief Financial Officer, have agreed that when his
  current employment agreement expires in July 2006, it will not be renewed.
  Mr. Meer will remain in his current role until the engagement of his
  successor.(b) NONEItem 6 ExhibitsNumber
Exhibit2.1
Agreement
  and Plan of Merger by among Pharmos Corporation, Vela Acquisition Corporation
  and Vela Pharmaceuticals Inc. dated March 14, 2006 (incorporated by reference
  to exhibit 2.1 to the registrants Current Report on Form 8-K filed March 15,
  2006)10.1
Amendment of Employment Agreement
with Haim
  Aviv, dated as of January 25, 2006.31.1
Certification of Chief Executive
  Officer pursuant to Exchange Act Rules 13a-14(a) and 15(d)-14(a), adopted
  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
Certification of Chief Financial
  Officer pursuant to Exchange Act Rules 13a-14(a) and 15(d)-14(a), adopted pursuant
  to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
Certification
  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted
  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
Certification
  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted
  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.26

SIGNATURE
PAGE

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.

PHARMOS CORPORATIONDated: May 12, 2006by: /s/
  James A. MeerJames A.
  MeerSenior Vice
  President and ChiefFinancial
  Officer(Principal
  Accounting andFinancial Officer)27