**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-Q**








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





**For
      the quarterly period ended September 30, 2006**





**or**





**o** **TRANSITION
      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 filero
            
            Accelerated
                filero
            
            Non-accelerated
                filerx




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
      November 10, 2006, the Registrant had outstanding 25,565,783 shares of its
      $.03
      par value Common Stock.







1




**Part
                I.**
            **Financial
                Information**


**Item
                1**
            **Financial
                Statements**


**PHARMOS
                CORPORATION****(Unaudited)****Condensed
                Consolidated Balance Sheets****September
                30, 2006**
            
            **December
                31, 2005****Assets**Cash
                and cash equivalents
            
            $
            9,122,377
            
            $
            10,289,127Short-term
                investments
            
            
            26,209,172
            
            
            35,748,343Restricted
                cash
            
            
            82,009
            
            
            79,527Research
                and development grants receivable
            
            
            211,730
            
            
            734,237Prepaid
                expenses and other current assets
            
            
            810,986
            
            
            543,109**Total
                current assets**
            
            
            36,436,274
            
            
            47,394,343Advance
                to Vela
            
            
            527,302
            
            
            -Capitalized
                merger costs
            
            
            885,315
            
            
            -Fixed
                assets, net
            
            
            647,297
            
            
            742,860Restricted
                cash
            
            
            63,631
            
            
            62,874Severance
                pay funded
            
            
            928,488
            
            
            772,199Other
                assets
            
            
            18,496
            
            
            18,496**Total
                assets**
            
            $
            39,506,803
            
            $
            48,990,772**Liabilities
                and Shareholder's Equity**Accounts
                payable
            
            $
            493,529
            
            $
            519,404Accrued
                expenses
            
            
            1,794,337
            
            
            575,222Warrant
                liability
            
            
            10,101
            
            
            38,880Accrued
                wages and other compensation
            
            
            958,656
            
            
            1,497,781**Total
                current liabilities**
            
            
            3,256,623
            
            
            2,631,287Other
                liability
            
            
            34,637
            
            
            110,904Severance
                pay
            
            
            1,257,910
            
            
            1,014,647**Total
                liabilities**
            
            
            4,549,170
            
            
            3,756,838Commitments
                and contingencies**Shareholder's
                Equity**Preferred
                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
            
            
            191,630,271
            
            
            191,093,338Accumulated
                deficit
            
            
            (157,244,185
            )
            
            (145,901,558
            )Treasury
                stock, at cost, 2,838 shares
            
            
            (426
            )
            
            (426
            )**Total
                shareholders' equity**
            
            
            34,957,633
            
            
            45,233,934**Total
                liabilities and shareholders' equity**
            
            $
            39,506,803
            
            $
            48,990,772





The
                accompanying notes are an integral part of these condensed****consolidated
                financial statements.




2




**PHARMOS
      CORPORATION**


**(Unaudited)**


**Condensed** **Consolidated
      Statements of Operations**





**Three
                months ended**
              **September
                30,**
            
            **Nine
                months ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****Expenses**Research
                and development, gross
            
            $
            2,338,392
            
            $
            2,180,137
            
            $
            6,587,480
            
            $
            7,225,373Grants
            
            
            (415,203
            )
            
            (284,185
            )
            
            (1,083,464
            )
            
            (1,015,640
            )Research
                and development, net of grants
            
            
            1,923,189
            
            
            1,895,952
            
            
            5,504,016
            
            
            6,209,733General
                and administrative
            
            
            2,730,064
            
            
            1,734,493
            
            
            7,038,607
            
            
            5,265,239Depreciation
                and amortization
            
            
            77,034
            
            
            87,841
            
            
            241,912
            
            
            301,518**Total
                operating expenses**
            
            
            4,730,287
            
            
            3,718,286
            
            
            12,784,535
            
            
            11,776,490**Loss
                from operations**
            
            
            (4,730,287
            )
            
            (3,718,286
            )
            
            (12,784,535
            )
            
            (11,776,490
            )**Other
                income (expense)**Bausch
                & Lomb milestone payment
            
            
            **-**
            
            
            -
            
            
            -
            
            
            10,725,688Interest
                income
            
            
            482,907
            
            
            416,267
            
            
            1,407,237
            
            
            1,043,283Interest
                expense
            
            
            -
            
            
            (2,219
            )
            
            -
            
            
            (165,591
            )Change
                in value of warrants
            
            
            7,051
            
            
            11,562
            
            
            28,779
            
            
            254,246Other
                (expense) income
            
            
            (1,224
            )
            
            0
            
            
            5,904
            
            
            (34,723
            )**Other
                income, net**
            
            
            488,734
            
            
            425,610
            
            
            1,441,920
            
            
            11,822,903**Net
                income (loss)**
            
            
            ($4,241,553
            )
            
            ($3,292,676
            )
            
            ($11,342,615
            )
            $
            46,413**Net
                income (loss) per share**-
                basic
            
            
            ($0.22
            )
            
            ($0.17
            )
            
            ($0.60
            )
            $
            0.00-
                diluted
            
            
            ($0.22
            )
            
            ($0.17
            )
            
            ($0.60
            )
            $
            0.00**Weighted
                average shares outstanding**-
                basic
            
            
            19,062,945
            
            
            18,974,338
            
            
            19,054,413
            
            
            18,974,120-
                diluted
            
            
            19,062,945
            
            
            18,974,338
            
            
            19,054,413
            
            
            18,974,954




The
      accompanying notes are an integral part of these c ondensed consolidated
      financial statements.




3




**Pharmos
      Corporation**


**(Unaudited)**


**Condensed** **Consolidated
      Statements of Cash Flows**


Nine
                  months ended September 30,2006
              
              2005Cash
                  flows from operating activitiesNet
                  income (loss)
              
              $
              (11,342,615
              )
              $
              46,413Adjustments
                  to reconcile net income (loss) loss to net cash used in operating
                  activities:Depreciation
                  and amortization
              
              
              241,912
              
              
              301,518Provision
                  for severance pay
              
              
              243,263
              
              
              (148,970
              )Change
                  in the value of warrants
              
              
              (28,779
              )
              
              (254,246
              )Amortization
                  of debt discount and issuance costs
              
              
              -
              
              
              126,256Amortization
                  of stock options issuances below fair market value
              
              
              -
              
              
              68,772Stock
                  based compensation
              
              
              695,724
              
              
              1,244Amortization
                  of restricted shares issuance
              
              
              370,604
              
              
              827,217Gain
                  from Bausch & Lomb milestone payment, net
              
              
              -
              
              
              (10,725,688
              )Changes
                  in operating assets and liabilities:Research
                  and development grants receivable
              
              
              522,507
              
              
              948,386Prepaid
                  expenses and other current assets
              
              
              (267,877
              )
              
              (700,229
              )Other
                  assets
              
              
              -
              
              
              450Accounts
                  payable
              
              
              (25,875
              )
              
              (634,186
              )Accrued
                  expenses
              
              
              1,219,115
              
              
              (244,724
              )Accrued
                  wages and other compensation
              
              
              (539,125
              )
              
              407,989Other
                  liabilities
              
              
              (76,267
              )
              
              98,385Net
                  cash used in operating activities
              
              
              (8,987,413
              )
              
              (9,881,413
              )Cash
                  flows from investing activitiesPurchases
                  of fixed assets
              
              
              (146,363
              )
              
              (126,761
              )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
              )Capitalized
                  merger costs
              
              
              (885,315
              )
              
              -Advance
                  to Vela
              
              
              (527,302
              )
              
              -Purchase
                  of short-term investments
              
              
              (21,812,980
              )
              
              (13,551,278
              )Proceeds
                  from sale of short-term investments
              
              
              31,352,151
              
              
              -Severance
                  pay funding
              
              
              (156,289
              )
              
              32,106Decrease
                  (increase) in restricted cash
              
              
              (3,239
              )
              
              4,844,186Net
                  cash provided by investing activities
              
              
              7,820,663
              
              
              391,413Cash
                  flows from financing activitiesRepayment
                  of convertible debentures
              
              
              -
              
              
              (4,846,148
              )Net
                  cash used in financing activities
              
              
              -
              
              
              (4,846,148
              )Net
                  decrease in cash and cash equivalents
              
              
              (1,166,750
              )
              
              (14,336,148
              )Cash
                  and cash equivalents at beginning of year
              
              
              10,289,127
              
              
              49,014,530Cash
                  and cash equivalents at end of period
              
              $
              9,122,377
              
              $
              34,678,382Supplemental
                  information:Interest
                  paid
              
              $
              -
              
              $
              39,042






The
      accompanying notes are an integral part of these c ondensed 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 nine month period ended
      September 30, 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
                Company**





Pharmos
      Corporation (the Company or Pharmos) is a biopharmaceutical 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, has
      extensively characterized many of the key variables involved in cannabinoid
      receptor activation and modulation.





**Recent
      Events**





On
      March
      15, 2006, the Company announced an agreement to acquire Vela Pharmaceuticals,
      Inc. (“Vela”), which has a Phase II product candidate, dextofisopam, in
      development to treat irritable bowel syndrome. Under the March 15th Merger
      Agreement, Pharmos agreed to issue 11,500,000 shares of our common stock to
      Vela’s stockholders and agreed to pay $5.0 million in cash to Vela. In April
      2006, Lloyd I. Miller, III, a shareholder who then beneficially owned
      approximately 10.3% of our common stock, indicated his opposition to the
      transaction with Vela because he believed that the transaction would be unduly
      dilutive to Pharmos’ shareholders and would increase Pharmos’ requirements for
      cash in its operations.





In
      May
      2006, Mr. Miller commenced a proxy contest to solicit proxies in opposition
      to
      our proposal to issue shares of our common stock in connection with the Merger
      and to elect his own slate of directors. After extensive discussions and
      negotiations with Mr. Miller and with Vela during July and August, the Company
      agreed with Vela to restructure some of the terms of the Merger, and on August
      31, 2006, the Company signed an amendment to the Merger Agreement to reflect
      the
      revised terms. As amended, the number of shares of Pharmos common stock to
      be
      issued to Vela shareholders at closing was reduced from 11.5 million shares
      to
      6.5 million shares and the cash payable by Pharmos at closing was increased
      from
      $5 million to $6 million. The amended Merger Agreement also includes additional
      performance-based milestone payments related to the development of dextofisopam
      aggregating up to an additional $8 million in cash and the issuance of up to
      an
      additional 13,500,000 shares of Pharmos common stock. Pharmos also agreed to
      reimburse Mr. Miller up to $680,000 for legal and related expenses incurred
      by
      him in connection with the proxy contest and the lawsuit against a former
      executive of Pharmos. In connection with the settlement agreement with Mr.
      Miller, the Company agreed to dismiss the lawsuit. The actual reimbursement
      to
      Mr. Miller was approximately $490,000 which was expensed in the third quarter
      of
      2006.





5




At
      the
      Annual Shareholder’s meeting on October 25, 2006, Pharmos’ shareholders approved
      the issuance of up to 20 million shares of Pharmos' common stock in connection
      with the proposed acquisition of Vela. The Company then closed on the
      acquisition of Vela later that day following the Annual Meeting and ratification
      of the voting results.





The
      transaction included an initial payment of $6.0 million in cash and the issuance
      of 6.5 million shares of Pharmos common stock. The combined value is
      approximately $17.5 million. The fair value of the Pharmos shares used in
      determining the purchase price was $1.67 per share, which is the implied price
      of Pharmos common stock based on the average closing price of Pharmos common
      stock on the two trading days immediately before, the day of, and two trading
      days immediately after the final amended merger agreement was announced on
      September 5, 2006. The transaction also includes the issuance of up to 13.5
      million additional Pharmos shares and $8 million in cash, contingent on
      achieving specific clinical milestones. 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 Risks**





The
      Company was not profitable in 2002 through 2005 and through the first three
      quarters of 2006. At September 30, 2006, the Company had an accumulated deficit
      of $157.2 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 $35.3 million as of September 30, 2006, will be sufficient
      to support the Company’s continuing operations beyond September 30, 2007,
      including the effect of the Vela acquisition.





The
      Company routinely actively pursues various funding options, including equity
      offerings, equity-like financing, 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.





**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.





***Reclassifications***





The
      consolidated statement of cash flows for the nine months ended September 30,
      2006 and September 30, 2005 includes in cash flows from investing activities the
      amounts of $ (156,289)
      and $ 32,106,
      respectively, for the
      funding of severance payments. For the nine months ended September 30, 2005
      such
      payments were included in cash flow used in operating activities. This reclass
      was recorded in the nine month period ended September 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
      September 30, 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.





6




***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. Some of the Company’s investments are in auction-rate securities (ARS)
      that are held as investments available for sale. Auction rate securities are
      instruments with long-term underlying maturities, but for which an auction
      is
      conducted periodically, as specified, to reset the interest rate and allow
      investors to buy or sell the instruments. Because auctions generally occur
      more
      often than annually, and because the Company holds these instruments in order
      to
      meet short-term liquidity needs, the auction rate securities are classified
      as
      short-term investments in the Condensed Consolidated Balance Sheet. 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. The Condensed Consolidated Statement of Cash
      Flows reflects the gross amount of the purchases of short term investments
      and
      the proceeds from maturities of short term securities and sales of auction
      rate
      securities.





September
                30,
            
            December
                31,2006
            
            2005Securities
                greater than 90 days
            
            $
            14,809,172
            
            $
            22,598,343Auction
                Rate Securities
            
            
            11,400,000
            
            
            13,150,000Total
                Short Term Investments
            
            $
            26,209,172
            
            $
            35,748,343





***Restricted
      cash***





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





***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.




7





***Capitalized
      Merger Costs***





During
      the first three quarters of 2006, Pharmos expended approximately $885,000 of
      costs related to the acquisition of Vela. 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 were included as a component of the
      purchase price. In addition, in accordance with the final merger agreement
      between Pharmos and Vela, Pharmos reimbursed Vela for its monthly operating
      expenses incurred since July 1, 2006. These costs have been included as an
      Advance to Vela on the Condensed Consolidated Balance Sheet.





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 that have commenced but were not
      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.




***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.





***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 (ESPP), 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 and nine months ended September 30,
      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 and nine
      months ended September 30, 2006 was $196,710 and $574,101 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 and nine months ended September 30, 2006 of $(0.22) and $(0.60)
      is
      $0.01 and $0.03, respectively, more as a result of adopting SFAS
      123R.




8




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 and nine months ended September 30, 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 three months and nine months ended September
      30, 2006, the Company recognized compensation expense of $196,710 and $574,101,
      respectively, for stock options which was recognized in the Condensed
      Consolidated Statement of Operations. As of September 30, 2006, the total
      compensation costs related to non-vested awards not yet recognized is $1.6
      million which will be recognized over the next three and one-half
      years.




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 and nine months ended September 30, 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 ended
              September
                30,
            
            Nine
                months ended
              September
                30,2005
            
            2005Net
                (loss) income as reported
            
            
            ($3,292,676
            )
            $
            46,413Add:
                Stock-based employee compensation expense included in reported net
                income
            
            
            274,199
            
            
            895,989Deduct:
                Total stock-based employee compensation expense determined under
                fair
                value based method for all awards (1)
            
            
            (352,097
            )
            
            (4,168,379
            )Pro
                forma net (loss) income
            
            
            ($3,370,574
            )
            
            ($3,225,977
            )Earnings
                per share:Basic
                - as reported
            
            
            ($.17
            )
            $
            0.00Diluted
                - as reported
            
            
            ($.17
            )
            $
            0.00Basic
                - pro forma
            
            
            ($.18
            )
            
            ($0.17
            )Diluted
                - pro forma
            
            
            ($.18
            )
            
            ($0.17
            )





(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.





9




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 Ended**
                **September
                  30,****2006**
              
              **Nine
                  months Ended**
                **September
                  30,****2006**Research
                  and development costs
              
              $
              53,742
              
              $
              157,462General
                  and administrative costs
              
              
              142,968
              
              
              416,639Stock-based
                  compensation costs before income taxes
              
              
              196,710
              
              
              574,101Benefit
                  for income taxes (1)
              
              
              -
              
              
              -Net
                  compensation expense
              
              $
              196,710
              
              $
              574,101




(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.




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:





**Nine
                months ended September 30,**2006
            
            2005Risk-free
                interest rate
            
            4.35%
            
            3.71-3.72%Expected
                lives (in years)
            
            5%
            
            5%Dividend
                yield
            
            0%
            
            0%Expected
                volatility
            
            103%
            
            99-107%





No
      options were granted in the third quarter of 2006 or 2005.




*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.




10




During
      the first three quarters of fiscal 2006 and 2005, employees and outside
      directors of the Company were granted stock options under the Pharmos 2000
      Stock
      Option Plan per the table below:





Period
                Ended
            
            Grants
                Issued
            
            Weighted
                AverageExercise
                Price
            
            Weighted
                Average
              Fair
                ValueSeptember
                30, 2006
            
            
            676,000
            
            $
            2.15
            
            $
            1.67September
                30, 2005
            
            
            250,310
            
            $
            3.79
            
            $
            2.87





The
      fair
      value of options that vested during the first three quarters of 2006 and 2005
      was $772,000 and $951,000, respectively. The Company’s policy is to issue new
      shares upon exercise and use the cash to support operating costs.





11




***Stock
      Options***




Presented
      below is a summary of the status of Pharmos stock options as of September 30,
      2006, and related transactions for the quarter then ended:




**Shares**
            
            **Weighted
                Average Exercise Price**
            
            **Weighted-Average
                Remaining Contractual Term**
            
            **Aggregate
                Intrinsic Value****Stock
                Options****Outstanding
                at December 31, 2005**
            
            
            **1,198,299**
            
            **$**
            **8.63**
            
            
            **7.6
                years**
            
            **$**
            **0**Granted
            
            
            676,000
            
            $
            2.15Exercised
            
            
            -
            
            
            -Forfeited
                or Expired
            
            
            (41,490
            )
            $
            11.76**Outstanding
                at March 31, 2006**
            
            
            **1,832,809**
            
            **$**
            **6.17**
            
            
            **8.2
                years**
            
            **$**
            **290,300**Granted
            
            
            -
            
            
            -Exercised
            
            
            -
            
            
            -Forfeited
                or Expired
            
            
            (56,448
            )
            $
            3.36**Outstanding
                at June 30, 2006**
            
            
            **1,776,361**
            
            **$**
            **6.26**
            
            
            **8.0
                years**
            
            **$**
            **0**Granted
            
            
            -Exercised
            
            
            -Forfeited
                or Expired
            
            
            (53,976
            )
            $
            12.21**Outstanding
                at September 30, 2006**
            
            
            **1,722,385**
            
            $
            **6.07**
            
            
            **7.5
                years**
            
            **$**
            **0****Non-vested
                Options****Non-vested
                options at December 31, 2005**
            
            
            **575,966**
            
            **$**
            **3.03**
            
            
            **9.3
                years**
            
            **$**
            **0**Granted
            
            
            676,000
            
            $
            2.15Vested
                in 1Q06
            
            
            (85,264
            )
            $
            3.55Forfeited
            
            
            (9,500
            )
            $
            4.11**Non-vested
                options at March 31, 2006**
            
            
            **1,157,202**
            
            **$**
            **2.47**
            
            
            **9.5
                years**
            
            **$**
            **279,500**Granted
            
            
            -
            
            
            -Vested
                in 2Q06
            
            
            (70,009
            )
            $
            3.55Forfeited
            
            
            (49,178
            )
            $
            2.67**Non-vested
                options at June 30, 2006**
            
            
            **1,038,015**
            
            **$**
            **2.39**
            
            
            **9.4
                years**
            
            **$**
            **0**Granted
            
            
            -
            
            
            -Vested
                in 3Q06
            
            
            (75,540
            )
            $
            2.93Forfeited
            
            
            (669
            )
            $
            3.99**Non-vested
                options at September 30, 2006**
            
            
            **961,806**
            
            $
            **2.34**
            
            
            **9.2
                years**
            
            **$**
            **0****Exercisable
                Options at September 30, 2006**
            
            
            **760,579**
            
            **$**
            **10.78**
            
            
            **5.3
                years**
            
            **$**
            **0**




12




**Shares**
            
            **Weighted
                Average Exercise Price**
            
            **Weighted-Average
                Remaining Contractual Term**
            
            **Fair
                Market Value at Vesting****Restricted
                Stock****Non-vested
                Restricted Stock at December 31, 2005**
            
            
            **63,292**
            
            **$**
            **15.80**
            
            
            **8.5
                years**Granted
            
            
            -
            
            
            -Vested
            
            
            -
            
            
            -
            
            
            
            
            
            -Forfeited
                or Expired
            
            
            -
            
            
            -**Non-vested
                Restricted Stock at March 31, 2006**
            
            
            **63,292**
            
            **$**
            **15.80**
            
            
            **8.3
                years**Granted
            
            
            -
            
            
            -Vested
                (4/2/06)
            
            
            25,317
            
            
            -
            
            
            
            
            $
            62,027Forfeited
                or Expired
            
            
            -
            
            
            -**Non-vested
                Restricted Stock at June 30, 2006**
            
            
            **37,975**
            
            **$**
            **15.80**
            
            
            **8.0
                years**Granted
            
            
            -
            
            
            -Vested
            
            
            -
            
            
            -
            
            
            
            
            
            -Forfeited
                or Expired
            
            
            -
            
            
            -**Non-vested
                Restricted Stock at September 30, 2006**
            
            
            **37,975**
            
            **$**
            **15.80**
            
            
            **7.7
                years**





13




***Recent
      Accounting Pronouncements***




In
      July
      2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
      No. 48, “ *Accounting
      for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
      109* ”
(“FIN
      48”), which clarifies the accounting for uncertainty in tax positions. This
      Interpretation requires an entity to recognize the impact of a tax position
      in
      its financial statements if that position is more likely than not to be
      sustained on audit based on the technical merits of the position. The provisions
      of FIN 48 are effective as of the beginning of fiscal year 2007, with the
      cumulative effect of the change in accounting principle recorded as an
      adjustment to opening retained earnings. Early application of FIN 48 is
      encouraged.  The Company is evaluating the timing of its adoption of FIN 48
      and the potential effects of implementing this Interpretation on its financial
      condition and results of operations.





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS
      157"). SFAS 157 establishes a single authoritative definition of fair value,
      sets out a framework for measuring fair value, and requires additional
      disclosures about fair-value measurements. SFAS 157 applies only to fair value
      measurements that are already required or permitted by other accounting
      standards (except for measurements of share-based payments) and is expected
      to
      increase the consistency of those measurements. Accordingly, SFAS 157 does
      not
      require any new fair value measurements. However, for some entities, the
      application of SFAS 157 will change current practice. SFAS 157 is effective
      for
      fiscal years beginning after November 15, 2007, and interim periods within
      those
      fiscal years. The Company does not expect the adoption of SFAS 157 to have
      a
      material impact on our consolidated financial statements.





In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin 108, "Considering the Effects of Prior Year Misstatements When
      Quantifying Misstatements in Current Year Financial Statements" ("SAB 108").
      SAB
      108 clarifies the staff's views regarding the process of quantifying financial
      statement misstatements. SAB 108 allows registrants to adjust prior year
      financial statements for immaterial errors in the carrying amount of assets
      and
      liabilities as of the beginning of this fiscal year, with an offsetting
      adjustment being made to the opening balance of retained earnings. SAB 108
      is
      effective for fiscal years ending on or after November 15, 2006 with earlier
      adoption encouraged. The Company does not expect that the adoption of SAB 108
      to
      have a material impact on our consolidated financial statements.




14





**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 September 30, 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 September 30, 2005 were
      “in the money” and were considered other potential common stock and 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 September 30, 2005 is illustrated below.





**September
                30,**
              **2005**Weighted
                average shares outstanding -basic
            
            
            18,974,120Restricted
                shares - non-vested
            
            
            -Weighted
                average of options that were “in the money”
            
            
            834Weighted
                average shares outstanding - diluted
            
            
            18,974,954





The
      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.





**September
                30,**
            
            **September
                30,****2006**
            
            **2005**Stock
                options
            
            
            1,760,360
            
            
            909,158Warrants
            
            
            424,769
            
            
            1,176,310Restricted
                stock - non vested
            
            
            37,975
            
            
            126,582Total
                potential dilutive securities not included in loss (income) per share
            
            
            2,223,104
            
            
            2,212,050





**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 ZyletTM 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 TM 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 ZyletTM. 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 ZyletTM 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 ZyletTM, 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 ZyletTM sales in the U.S.





15





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 ZyletTM.





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 and nine months ending September 30, 2006, the Company
      recorded in other income royalties of $2,190 and $3,838, compared with $2,219
      and $22,710 for the same periods in 2005, respectively, per the licensing
      agreement with Herbamed.





**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 and nine months ended September 30, 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.




During
      the first three quarters of 2006, the Company incurred a non-cash charge of
      $121,622 for the acceleration of unvested options for two executives (Dr.
      Riesenfeld and J. Meer) whose contracts were not renewed in accordance with
      their respective employment agreements.




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.




16





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 nine month period ended September 30, 2006, the Company recorded
      an
      expense of approximately $194,000 in connection with the Awards.





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 $10,101 at September 30, 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**
                **September
                  30,**
              
              **Nine
                  months ended**
                **September
                  30,**2006
              
              2005
              
              2006
              
              2005Risk-free
                  interest rate
              
              4.97%
              
              3.95%
              
              4.97%-5.21%
              
              3.64%-3.95%Expected
                  lives (in years)
              
              1
              
              2
              
              1
              
              2Dividend
                  yield
              
              0%
              
              0%
              
              0%
              
              0%Expected
                  volatility
              
              100%
              
              106%
              
              100%-103%
              
              93%-107%


17




**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 and nine months ending September 30, 2006 and 2005
      are
      as follows:




**Three
                months ended September 30,**
            
            **Nine
                months ended September 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**United
                States
            
            $
            (4,194,203
            )
            $
            (3,224,696
            )
            $
            (11,204,537
            )
            $
            300,778Israel
            
            
            (47,350
            )
            
            (67,980
            )
            
            (138,078
            )
            
            (254,365
            )$
            (4,241,553
            )
            $
            (3,292,676
            )
            $
            (11,342,615
            )
            $
            46,413**Capital
                Expenditures**United
                States
            
            $
            2,467
            
            $
            -
            
            $
            2,467
            
            $
            3,945Israel
            
            
            13,593
            
            
            16,091
            
            
            143,896
            
            
            122,816$
            16,060
            
            $
            16,091
            
            $
            146,363
            
            $
            126,761





Geographic
      information as of September 30, 2006 and December 31, 2005 are as
      follows:




**Total
                Assets**
            
            
            
            
            
            **2006**
            
            **2005**United
                States
            
            
            
            
            
            
            
            $
            37,030,868
            
            $
            45,752,574Israel
            
            
            
            
            
            
            
            
            2,475,935
            
            
            3,238,198$
            39,506,803
            
            $
            48,990,772**Long
                Lived Assets, net**United
                States
            
            
            
            
            
            
            
            $
            49,204
            
            $
            86,505Israel
            
            
            
            
            
            
            
            
            598,093
            
            
            656,355$
            647,297
            
            $
            742,860




18





**9.**
            **Subsequent
                Events**





**Appointment
      of new Chief Financial Officer**


On
      October 5, 2006, Pharmos announced the appointment of S. Colin Neill as Senior
      Vice President, Chief Financial Officer, Secretary, and Treasurer. Mr. Neill
      will be located at Pharmos' Iselin, New Jersey headquarters.





**Activities
      related to Vela acquisition by shareholders and subsequent closing of Vela
      acquisition**




On
      September 25, 2006, the Board of Directors of Pharmos Corporation granted to
      Haim Aviv and Alan Rubino a special cash bonus subject to the completion of
      the
      Vela acquisition in the amounts of $120,000 and $60,000, respectively. These
      payments will be expensed during the 4th quarter of 2006.




On
      October 17, 2006, Dr. Georges Anthony Marcel and Dr. Lawrence F. Marshall each
      resigned from the Company’s Board in order to enable three current directors of
      Vela to join the Company’s Board following the closing of the Company’s pending
      acquisition of Vela. Dr. Marcel and Dr. Marshall each agreed to serve as a
      consultant to the Board’s Clinical Development and Scientific Committee and the
      Company’s senior management, for the period from November 1, 2006 through May 1,
      2008, on matters relating to drug discovery, pre-clinical and clinical
      development and general business development in their areas of scientific and
      medical expertise. In consideration for such consulting services, the Company
      will pay each of these former directors a fee of $45,000, payable in three
      equal
      installments of $15,000 on November 1, 2006, May 1, 2007 and November 1, 2007.
      In addition, all stock options currently held by Dr. Marcel and Dr. Marshall
      became fully vested as of October 17, 2006; the respective exercise prices
      and
      expiration dates of such stock options remain unchanged.




On
      October 18, 2006, the Board of Directors of Pharmos Corporation approved payment
      of a fee of $50,000 to Mony Ben Dor for his service as chair of the Board’s
      Proxy Contest Steering Committee.




At
      the
      Annual Shareholder’s meeting on October 25, 2006, Pharmos’ shareholders approved
      the issuance of up to 20 million shares of Pharmos' common stock in connection
      with the proposed acquisition of Vela. The Company then closed on the
      acquisition of Vela later that day following the Annual Meeting and ratification
      of the voting results.




Pharmos
      acquired 100 percent of the shares of **** Vela.
      Vela was a privately-held, drug development company specializing in the
      rediscovery and development of medicines related to the nervous system,
      including what is known as the “brain-gut axis” — links between the nervous
      system and the digestive system. Vela’s lead drug candidates include
      dextofisopam and tianeptine for the treatment of irritable bowel syndrome
      (“IBS”) and VPI-013 for the treatment of neuropathic pain and female hypoactive
      sexual desire disorder.




The
      assets and liabilities of Vela will be recorded as of the acquisition date
      at
      their estimated fair values. The results of operations of Pharmos will include
      the results of operations from Vela from the date of acquisition. The
      transaction is expected to qualify as a reorganization within the meaning of
      Section 368(a) of the Internal Revenue Code.




Under
      the
      terms of the agreement, Pharmos made a cash payment of $6,000,000 and issued
      6,500,000 shares of Pharmos common stock upon the cancellation of all shares
      of
      Vela capital stock outstanding. In addition, Pharmos reimbursed Vela for
      approximately $600,000 its cost of operation from July 1, 2006 through the
      date
      of Closing.




The
      aggregate purchase price is estimated to be $19.5 million, including $6.6
      million of cash and common stock valued at $10.9 million. The fair value of
      the
      6,500,000 Pharmos shares used in determining the purchase price was $1.67 per
      share, which is the implied price of Pharmos common stock based on the average
      closing price of Pharmos common stock on the two trading days immediately
      before, the day of, and two trading days immediately after the amended merger
      terms were announced on September 5, 2006.




The
      following table summarizes the estimated fair values of the assets acquired
      and
      liabilities assumed at the date of acquisition. Pharmos is in the process of
      obtaining third-party valuations of certain intangible assets; thus, the
      allocation of the purchase price is subject to refinement.




19




A
      preliminary estimate of the purchase price is as follows (table in
      $000s):




Fair
                value of Pharmos shares to be issued at closing
            
            $
            10,900Cash
                to be paid
            
            
            6,60017,500Estimated
                merger costs incurred by Pharmos
            
            
            2,000Estimated
                purchase price
            
            $
            19,500




The
      estimated purchase price has been allocated based on a preliminary valuation
      of
      Vela’s tangible and intangible assets and liabilities based on their estimated
      fair values (table in $000s):




Total
                current assets
            
            $
            32Property
                and equipment and other assets
            
            
            22In-process
                technology
            
            
            19,546Total
                current liabilities
            
            
            (100
            )Total
            
            $
            19,500




The
      purchase price allocation will remain preliminary until Pharmos completes a
      valuation of any significant identifiable intangible assets acquired, including
      in-process research and development, and determines the fair values of other
      assets and liabilities acquired. The final determination of the purchase price
      allocation is expected to be completed as soon as practicable after completion
      of the merger. The final amounts allocated to assets and liabilities acquired
      could differ significantly from these amounts presented in the unaudited pro
      forma condensed combined financial statements.




20




**10.**
            **Legal
                Proceedings**





Class
      Action Lawsuits




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
      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
      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. 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. An agreement was reached
      to settle both of the derivative cases and a stipulation and agreement of
      settlement was filed with the federal court on October 4, 2006. The settlement
      is subject to court approval. Any direct financial impact of the proposed
      settlement is expected to be borne by the Company’s insurer. There is no
      assurance that the settlement will be approved by the court.





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.





Proxy
      Contest





In
      April
      2006, Lloyd I. Miller, III, a shareholder who then beneficially owned
      approximately 10.3% of our common stock, indicated his opposition to the
      transaction with Vela because he believed that the transaction would be unduly
      dilutive to Pharmos’ shareholders and would increase Pharmos’ requirements for
      cash in its operations. In May 2006, Mr. Miller commenced a proxy contest to
      solicit proxies in opposition to our proposal to issue shares of our common
      stock in connection with the Merger and to elect his own slate of directors.
      After extensive discussions and negotiations with Mr. Miller and with Vela
      during July and August, the Company agreed with Vela to restructure some of
      the
      terms of the Merger, and on August 31, 2006, the Company signed an amendment
      to
      the Merger Agreement to reflect the revised terms. As amended, the number of
      shares of Pharmos common stock to be issued to Vela shareholders at closing
      was
      reduced from 11.5 million shares to 6.5 million shares and the cash payable
      by
      Pharmos at closing was increased from $5 million to $6 million. The amended
      Merger Agreement also includes additional performance-based milestone payments
      related to the development of dextofisopam aggregating up to an
      additional $8,000,000 in cash and the issuance of up to an
      additional 13,500,000 shares of Pharmos common stock. Pharmos also agreed
      to reimburse Mr. Miller up to $680,000 for legal and related expenses incurred
      by him in connection with the proxy contest and the lawsuit against a former
      executive of Pharmos. In connection with the settlement agreement with Mr.
      Miller, the Company agreed to dismiss the lawsuit. The actual reimbursement
      to
      Mr. Miller was approximately $490,000 which was expensed in the third quarter
      of
      2006.





Other


On
      June
      20, 2006, the Company filed a lawsuit against Dr. Raymond E. McKee, a former
      officer of the Company, in the United States District Court for the District
      of
      Connecticut. The lawsuit alleged that Dr. McKee wrongfully disclosed
      confidential information about the Company in breach of his fiduciary duty
      while
      an officer of the Company and asserted other related claims concerning Dr.
      McKee’s conduct while an officer of the Company and thereafter. The complaint
      sought damages and injunctive relief. In connection with the settlement
      agreement with Mr. Miller, the Company dismissed the lawsuit in September
      2006.





21





**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 biopharmaceutical 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
                focus




The
      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
      commenced dosing for its Phase IIa testing in two pain indications in the second
      quarter of 2006 which are expected to be completed prior to March 2007. 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 probably 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. 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 prior to March 2007. 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.





22




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. (“Vela”), which has a Phase II product candidate, dextofisopam, in
      development to treat irritable bowel syndrome. Under the March 15th Merger
      Agreement, at the closing of the Merger, we agreed to issue 11,500,000 shares
      of
      our common stock to Vela’s stockholders and agreed to pay $5.0 million in cash
      to Vela. In April 2006, Lloyd I. Miller, III, a shareholder who then
      beneficially owned approximately 10.3% of our common stock, indicated his
      opposition to the transaction with Vela because he believed that the transaction
      would be unduly dilutive to Pharmos’ shareholders and would increase Pharmos’
requirements for cash in its operations.





In
      May
      2006, Mr. Miller commenced a proxy contest to solicit proxies in opposition
      to
      our proposal to issue shares of our common stock in connection with the Merger
      and to elect his own slate of directors. After extensive discussions and
      negotiations with Mr. Miller and with Vela during July and August, the Company
      we agreed with Vela to restructure some of the terms of the Merger, and on
      August 31, 2006, the Company signed an amendment to the Merger Agreement to
      reflect the revised terms. As amended, the number of shares of Pharmos common
      stock to be issued to Vela shareholders at closing was reduced from 11.5 million
      shares to 6.5 million shares and the cash payable by Pharmos at closing was
      increased from $5 million to $6 million. The amended Merger Agreement also
      includes additional performance-based milestone payments related to the
      development of dextofisopam aggregating up to an additional $8,000,000 in cash
      and the issuance of up to an additional 13,500,000 shares of Pharmos common
      stock. Pharmos also agreed to reimburse Mr. Miller up to $680,000 for legal
      and
      related expenses incurred by him in connection with the proxy contest and the
      lawsuit against a former executive of Pharmos. In connection with the settlement
      agreement with Mr. Miller, the Company agreed to dismiss the
      lawsuit.





At
      the
      Annual Shareholder’s meeting on October 25th, 2006, Pharmos’ shareholders
      approved the issuance of up to 20 million shares of Pharmos' common stock
      in connection with the proposed acquisition of Vela. The Company then closed
      on
      the acquisition of Vela later that day following the Annual Meeting and
      ratification of the voting results.





The
      transaction included an initial payment of $6.0 million in cash and the issuance
      of 6.5 million shares of Pharmos common stock. The combined value is
      approximately $17.5 million. The fair value of the Pharmos shares used in
      determining the purchase price was $1.67 per share, which is the implied price
      of Pharmos common stock based on the average closing price of Pharmos common
      stock on the two trading days immediately before, the day of, and two trading
      days immediately after the final amended merger agreement was announced on
      September 5, 2006. The transaction also includes the issuance of up to 13.5
      million additional Pharmos shares and $8 million in cash, contingent on
      achieving specific clinical milestones. 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.





23





***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 has entered Phase II testing in two pain indications
      in the second quarter of 2006 which are expected to be completed prior to March
      2007. The Company’s NanoEmulsion drug delivery system is in development for the
      topical application of analgesic and anti-inflammatory agents. The Company
      commenced a clinical program in the third quarter of 2006 that is expected
      to be
      completed prior to March 2007. 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
      results for the three and nine months ended September 30, 2006 and 2005 were
      a
      net loss of $4.2 million and $3.3 million and a net loss of $11.3 million and
      a
      net profit of $0.05 million, respectively. On a (loss) income per share basis,
      this equates to of $(0.22) and $(0.17) for the quarter and $(0.60) and $0.00
      for
      the first three quarters, 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 September 30, 2006, the Company’s accumulated deficit was
      approximately $157.2 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.”





24




**Results
      of Operations**


**Three
      Months ended September 30, 2006 and 2005**





Total
      operating expenses for the third quarter of 2006 increased by $1,012,001 or
      27%,
      from $3,718,286 in 2005 to $4,730,287 in 2006. The Company entered 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 complete a second Phase I
      trial
      prior to March 2007 for its NanoEmulsion drug delivery system. During the third
      quarter of 2006, the Company incurred higher professional fees of $816,110
      primarily in connection with legal fees related to the proxy contest including
      the coverage of Lloyd Miller’s legal costs, higher costs of $508,266 for the
      clinical trial activity for cannabinor and NanoEmulsion and higher investor
      relation costs of $253,307 related to the acquisition and proxy preparation
      which were partially offset by reduced compensation costs of approximately
      $400,000 from a reduction in workforce as compared with the third quarter of
      2005.





Research
      efforts in 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. Cannabinor
      was in Phase II at the end of the second quarter. During the third quarter
      of
      2006, the gross cost of development and review was approximately $1.1 million.
      Total costs since the cannabinor project entered Phase II development in 2006
      through September 30, 2006 were $1.7 million.





Gross
      expenses for other research and development projects in early stages of
      development for the third quarter of 2006 and 2005 were $860,591 and $1,453,807,
      respectively. Research & development (R&D) gross expenses increased
      by $158,255 or 7% from $2,180,137 to $2,338,392 in 2006, related to higher
      clinical study activities over 2005. Costs associated with clinical activities
      have increased since late in the second quarter. The
      Company recorded research and development grant receivables from the Office
      of
      the Chief Scientist of Israel’s Ministry of Industry and Trade of $415,203 and
      $284,185 during the third quarter of 2006 and 2005, respectively, which reduced
      research and development expenses. Total research and development expenses,
      net
      of grants, increased by $27,237 or 1%, from $1,895,952 in 2005 to $1,923,189
      in
      2006.





General
      and administrative expenses for the third quarter of 2006 increased by $995,571,
      or 57%, from $1,734,493 in 2005 to $2,730,064. The increase reflects $827,119
      of
      one time acquisition and proxy related expenses, including the reimbursement
      of
      Lloyd Miller’s legal costs, and $168,452 for other general and administrative
      costs, or a 10% increase from $1,734,493 in 2005. The $168,452 contains a
      $209,501 increase in business development activities offset by a decrease in
      insurance costs of $63,184 and a decrease in salary costs of $78,534. The salary
      decrease is a net result of reduction in force, reduced amortization costs
      related to the 50% share of the vested (on December 31, 2005) Retention Awards,
      and the implementation of the equity based compensation related to the 2006
      implementation of SFAS 123(R).





Depreciation
      and amortization expenses decreased by $10,807, or 12%, from $87,841 in 2005
      to
      $77,034 in 2006. The decrease is due to fixed assets which have become fully
      depreciated.





25




Other
      income (expense), net, increased by $63,124 from $425,610 in 2005 to $488,734
      in
      2006. The majority of the increase is from increased interest income from higher
      interest rates. Interest income increased by $66,640, or 16%, to $482,907 in
      2006 from $416,267 in 2005 as a result of higher interest rates. The gain
      related to the valuation of warrants decreased by $4,511 from $11,562 in 2005
      to
      $7,051 in 2006. During the quarter, the Company recorded, in other income,
      royalties of $2,190 compared with $2,219 in 2005 per the licensing agreement
      with Herbamed Ltd, a company controlled by Dr. Haim Aviv, the Company’s
      CEO.





**Nine
      months ended September 30, 2006 and 2005**





Total
      operating expenses for the first three quarters of 2006 increased by $1,008,045
      from $11,776,490 in 2005 to $12,784,535 in 2006. The Company entered 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 complete a second Phase I trial in the fourth quarter of 2006 for
      its
      NanoEmulsion drug delivery system. During the first three quarters of 2006,
      the
      Company incurred higher professional fees of $727,214 primarily related to
      legal
      fees related to the proxy contest including the coverage of Lloyd Miller’s legal
      costs, a net increase in salaries of $88,053 which includes costs for severance
      for a number of executives and the 2006 implementation of the equity based
      compensation of SFAS 123(R) which were offset by reduced compensation costs
      of
      approximately $860,000 from a reduction in workforce as compared with the first
      three quarters of 2005.





Research
      efforts in the first three quarters 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. Cannabinor
      is
      in Phase II at the end of the second quarter. During the first three quarters
      of
      2006, the gross cost of development and review was approximately $1.7 million.
      Total costs since the cannabinor project entered Phase II development in 2006
      through September 30, 2006 were $1.7 million,





Gross
      expenses for other research and development projects in early stages of
      development for the first three quarters of 2006 and 2005 were $2,391,907 and
      $4,521,387, respectively. Research & development (R&D) gross expenses
      decreased by $637,893 or 9% from $7,225,373 in 2005 to $6,587,480 in 2006,
      related to a decrease in clinical activities. Costs associated with clinical
      activities have started to be incurred late in the second quarter into the
      third
      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 $1,083,464 and $1,015,640 during the first three quarters of 2006
      and
      2005, respectively, which reduced research and development expenses. Total
      research and development expenses, net of grants, decreased by $705,717, or
      11%,
      from $6,209,733 in 2005 to $5,504,016 in 2006.





General
      and administrative expenses for the nine months ended September 30, 2006
      increased by $1,773,368 or 57%, from $5,265,239 in 2005 to $7,038,607. The
      $1,773,368 increase reflects the following: a $1,388,830 charge for one time
      acquisition and proxy related expenses, including the reimbursement of Lloyd
      Miller’s legal costs; an $808,981 charge for executive severance cost; and a
      $424,443 reduction in other general and administrative costs, or 8% decrease
      from $5,265,239 in 2005. The $424,443 decrease includes $580,443 from reduced
      litigation costs from the class action suits and a decrease in compensation
      of
      $76,532. The compensation decrease is a net result of reduction in force,
      reduced amortization costs related to the 50% share of the vested (on December
      31, 2005) Retention Awards, and the implementation of the equity based
      compensation related to the 2006 implementation of SFAS 123(R).





Depreciation
      and amortization expenses decreased by $59,606, or 20%, from $301,518 in 2005
      to
      $241,912 in 2006. The decrease is due to fixed assets which have become fully
      depreciated.




26





Other
      income (expense), net, decreased by $10,380,983 from income of $11,822,903
      in
      2005 to income of $1,441,920 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 $165,591 to $0 in 2006
      from
      $165,591 in 2005 related to the retirement of the September 2003 Convertible
      Debentures during the first quarter of 2005. Interest income increased by
      $363,594, or 35%, from $1,043,283 in 2005 to $1,407,237 in 2006 as a result
      of
      higher interest rates. The gain related to the valuation of warrants decreased
      by $225,467 from $254,246 in 2005 to $28,779 in 2006. During the first three
      quarters, the Company recorded, in other income, royalties of $3,838 compared
      with $22,710 in the first three quarters 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.




27





**Liquidity
      and Capital Resources**





The
      Company incurred cumulative operating losses since 2002 and had an accumulated
      deficit of $157.2 million at September 30, 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
      September 30, 2006, and on December 31, 2005:





**September
                30, 2006**
            
            **December
                31, 2005**Working
                capital
            
            $
            33,179,651
            
            $
            44,763,056Cash
                and cash equivalents
            
            $
            9,122,377
            
            $
            10,289,127Short
                term investments
            
            $
            26,209,172
            
            $
            35,748,343Total
                cash, cash equivalents and short term investments
            
            $
            35,331,549
            
            $
            46,037,470





*Current
      working capital position*





As
      of
      September 30, 2006, the Company had working capital of $33.1 million consisting
      of current assets of $36.4 million and current liabilities of $3.3 million.
      This
      represents a decrease of $11.7 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 $11.7 million was
      principally associated with the funding of R&D and G&A activities and
      merger and proxy costs associated with the Vela acquisition.





*Current
      and future liquidity position*





Management
      believes that the current cash, cash equivalents and short term investments,
      totaling $35.3 million as of September 30, 2006, will be sufficient to support
      the Company’s continuing operations beyond September 30, 2007. The
      Company routinely pursues various funding options, including additional equity
      offerings, equity-like
      financing, 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 $35.5 million as of September
      30, 2006, will be sufficient to support the Company’s continuing operations for
      the combined company of Pharmos and Vela beyond September 30, 2007.





*Cash*





At
      September 30, 2006, cash and cash equivalents totaled $9.1 million. At December
      31, 2005 cash and cash equivalents totaled $10.3 million. This net decrease
      in
      cash of $1.2 million was due to the net conversion of $9.5 million of short
      term
      investments into cash, $9.3 million for normal operating requirements, $.1
      million for capital expenditures, and $.9 million for merger related expenses.
      The cash, cash equivalents short term investments will be used to fund its
      Research & Development activities.





28




*Operating
      activities*





Net
      cash
      used in operating activities through the first three quarters of 2006 was $9.0
      million compared to net cash used of $9.9 million through the first three
      quarters of 2005. The decrease in cash used of $0.9 million is primarily due
      to
      lower R&D spending related to the clinical trials and the timing of the of
      grants offset by cash outflows for severance payments of $1.2
      million.





*Investing
      activities*





During
      the first three quarters of 2006, the Company invested cash of approximately
      $.9
      million in merger related costs, $.5 million in advances to Vela and a net
      investment in short term investments of $9.5 million.





During
      the first three quarters of 2005, restricted cash was reduced by approximately
      $4.8 million as a result of the final repayment of the September 2003
      Convertible Debentures. Also, during this time, the Company received $10.7
      million related to investing activities for a non-recurring milestone payment
      from Bausch & Lomb related to the FDA approval of ZyletTM. Lastly, the
      Company invested cash of approximately $13.6 million in short term securities
      during the first three quarters of 2005.





Capital
      expenditures for property, plant and equipment for the nine months ended
      September 30, 2006 and 2005 totaled approximately $146,000 and $127,000,
      respectively for normal replacements and improvements.





*Financing
      activities*





There
      were no financing activities in the first three quarters of 2006. In the first
      three quarters 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 ZyletTM 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 ZyletTM 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 ZyletTM. 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 ZyletTM 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 ZyletTM, 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 ZyletTM 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 ZyletTM.




29





*Commitment
      and Contingencies*





As
      of
      September 30, 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
            
            $
            853,393
            
            $
            336,867
            
            $
            457,834
            
            $
            58,692
            
            $
            -
            
            $
            -Other
                long-term liabilities reflected on our balance sheet*
            
            
            1,257,910
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,257,910Other
                Commitments**
            
            
            150,000
            
            
            150,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            2,261,303
            
            $
            486,867
            
            $
            457,834
            
            $
            58,692
            
            $
            -
            
            $
            1,257,910





*
            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
                $928,488.


**
            Represents
                cash portion of the September 2004 Retention Award Agreement given
                to the
                CEO. The Company has accrued $110,294 through September 30,
                2006.





*New
      accounting pronouncements*





New
      pronouncements issued by the FASB and not effective until after September 30,
      2006 are not expected to have a significant effect on the company’s financial
      position or results of operations, with the possible exception of the following,
      which are currently being evaluated by management:





In
      July
      2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
      No. 48, “ *Accounting
      for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
      109* ”
(“FIN
      48”), which clarifies the accounting for uncertainty in tax positions. This
      Interpretation requires an entity to recognize the impact of a tax position
      in
      its financial statements if that position is more likely than not to be
      sustained on audit based on the technical merits of the position. The provisions
      of FIN 48 are effective as of the beginning of fiscal year 2007, with the
      cumulative effect of the change in accounting principle recorded as an
      adjustment to opening retained earnings. Early application of FIN 48 is
      encouraged.  The Company is evaluating the timing of its adoption of FIN 48
      and the potential effects of implementing this Interpretation on its financial
      condition and results of operations





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS
      157"). SFAS 157 establishes a single authoritative definition of fair value,
      sets out a framework for measuring fair value, and requires additional
      disclosures about fair-value measurements. SFAS 157 applies only to fair value
      measurements that are already required or permitted by other accounting
      standards (except for measurements of share-based payments) and is expected
      to
      increase the consistency of those measurements. Accordingly, SFAS 157 does
      not
      require any new fair value measurements. However, for some entities, the
      application of SFAS 157 will change current practice. SFAS 157 is effective
      for
      fiscal years beginning after November 15, 2007, and interim periods within
      those
      fiscal years. The Company does not expect the adoption of SFAS 157 to have
      a
      material impact on our consolidated financial statements.





In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin 108, "Considering the Effects of Prior Year Misstatements When
      Quantifying Misstatements in Current Year Financial Statements" ("SAB 108").
      SAB
      108 clarifies the staff's views regarding the process of quantifying financial
      statement misstatements. SAB 108 allows registrants to adjust prior year
      financial statements for immaterial errors in the carrying amount of assets
      and
      liabilities as of the beginning of this fiscal year, with an offsetting
      adjustment being made to the opening balance of retained earnings. SAB 108
      is
      effective for fiscal years ending on or after November 15, 2006 with earlier
      adoption encouraged. The Company does not expect that the adoption of SAB 108
      to
      have a material impact on our consolidated financial statements.





30




**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 September 30,
      2006. Based on this evaluation, Pharmos’ Chief Executive Officer and Chief
      Financial Officer concluded that as of September 30, 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.




31





**Part
      II**


**Other
      Information**


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





Class
      Action Suits




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
      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
      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. 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. An agreement was reached
      to settle both of the derivative cases and a stipulation and agreement of
      settlement was filed with the federal court on October 4, 2006. The settlement
      is subject to court approval. Any direct financial impact of the proposed
      settlement is expected to be borne by the Company’s insurer. There is no
      assurance that the settlement will be approved by the court.





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.





Proxy
      Contest


In
      April
      2006, Lloyd I. Miller, III, a shareholder who then beneficially owned
      approximately 10.3% of our common stock, indicated his opposition to the
      transaction with Vela because he believed that the transaction would be unduly
      dilutive to Pharmos’ shareholders and would increase Pharmos’ requirements for
      cash in its operations. In May 2006, Mr. Miller commenced a proxy contest to
      solicit proxies in opposition to our proposal to issue shares of our common
      stock in connection with the Merger and to elect his own slate of directors.
      After extensive discussions and negotiations with Mr. Miller and with Vela
      during July and August, the Company we agreed with Vela to restructure some
      of
      the terms of the Merger, and on August 31, 2006, the Company signed an amendment
      to the Merger Agreement to reflect the revised terms. As amended, the number
      of
      shares of Pharmos common stock to be issued to Vela shareholders at closing
      was
      reduced from 11.5 million shares to 6.5 million shares and the cash payable
      by
      Pharmos at closing was increased from $5 million to $6 million. The amended
      Merger Agreement also includes additional performance-based milestone payments
      related to the development of dextofisopam aggregating up to an additional
      $8,000,000 in cash and the issuance of up to an additional 13,500,000
      shares of Pharmos common stock. Pharmos also agreed to reimburse Mr. Miller
      up
      to $680,000 for legal and related expenses incurred by him in connection with
      the proxy contest and the lawsuit against a former executive of Pharmos. In
      connection with the settlement agreement with Mr. Miller, the Company agreed
      to
      dismiss the lawsuit. The actual reimbursement to Mr. Miller was approximately
      $490,000 which was expensed in the third quarter of 2006.





Other


On
      June
      20, 2006, the Company filed a lawsuit against Dr. Raymond E. McKee, a former
      officer of the Company, in the United States District Court for the District
      of
      Connecticut. The lawsuit alleged that Dr. McKee wrongfully disclosed
      confidential information about the Company in breach of his fiduciary duty
      while
      an officer of the Company and asserted other related claims concerning Dr.
      McKee’s conduct while an officer of the Company and thereafter. The complaint
      sought damages and injunctive relief. In connection with the settlement
      agreement with Mr. Miller, the Company dismissed the lawsuit in September
      2006.




32




**Item
                1A**
            **Risk
                Factors**





There
      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**
              **NONE****Item
                  3**
              **Defaults
                  upon Senior Securities**
              **NONE****Item
                  4**
              **Submission
                  of Matters to Vote of Security Holders**
              **NONE****Item
                  5**
              **Other
                  Information**
              **NONE****Item
                  6**
              **Exhibits**




Number
            
            Exhibit2.1
            
            Amendment
                to Agreement and Plan of Merger by and among Pharmos Corporation,
                Vela
                Acquisition Corporation and Vela Pharmaceuticals Inc. dated August
                31,
                2006 (incorporated by reference to Exhibit 2.1 of the registrant’s Current
                Report on Form 8-K filed September 5, 2006).2.2
            
            Amendment
                No.2 to Agreement and Plan of Merger by and among Pharmos Corporation,
                Vela Acquisition Corporation, Vela Acquisition No.2 Corporation and
                Vela
                Pharmaceuticals Inc. dated September 29, 2006 (incorporated by reference
                to Exhibit 2.1 of the registrant’s Current Report on Form 8-K filed
                October 5, 2006).10.1
            
            Settlement
                Agreement between the Company and Lloyd I. Miller, III dated August
                31,
                2006 (incorporated by reference to Exhibit 10.1 of the registrant’s
                Current Report on Form 8-K filed September 5, 2006).10.2
            
            Voting
                Agreement and Waiver by and among the Company, Lloyd I. Miller, III,
                Trust
                A-4 - Lloyd I. Miller, Milfam II L.P. and Milfam LLC dated August
                31, 2006
                (incorporated by reference to Exhibit 10.2 of the registrant’s Current
                Report on Form 8-K filed September 5, 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.




33





**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
                CORPORATION****Dated:
                November 10, 2006**by:
            /s/
                S. Colin NeillS,
                Colin NeillSenior
                Vice President and Chief Financial Officer(Principal
                Accounting and Financial Officer)






34