**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

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

**For thequarterly period ended September 30, 2006**

**OR**

**o****                                ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from             to             **

**CommissionFile Number: 000-30289**

**PRAECIS PHARMACEUTICALSINCORPORATED**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                     |   | **04-3200305**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**830 Winter Street, Waltham, MA02451-1420**

(Address ofprincipal executive offices and zip code)

**(781) 795-4100**

(Registrant’stelephone number, including area code)

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.    Yes x  No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.  (Checkone):
| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|---------------------------|---------------------|-------------------------|

 

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

Yes o  No x

As of October 31, 2006, there were 10,708,417 shares ofthe registrant’s common stock, $.01 par value, outstanding.

All share and per share amounts, including allcommon stock equivalents (stock options and the exercise prices thereof),reported in this Quarterly Report on Form 10-Q have been have adjusted for allperiods presented to reflect a 1-for-5 reverse split of the registrant’s commonstock effected on November 1, 2005.

 

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**PRAECIS PHARMACEUTICALSINCORPORATED**FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2006INDEX
| **PART I.**        | ** ** | **FINANCIAL INFORMATION**                                                                                        |   |   |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------|--------|--------|
| ** **         | ** ** | ** **                                                                                                       |   |   |
| Item  1.           |       | Financial Statements  (Unaudited)                                                                                |   |   |
|               |       |                                                                                                             |   |   |
|               |       | Condensed  Consolidated Balance Sheets –  December 31, 2005 and September 30, 2006                          |   |   |
|               |       |                                                                                                             |   |   |
|               |       | Condensed  Consolidated Statements of Operations –  three and nine months ended September 30, 2005 and 2006 |   |   |
|               |       |                                                                                                             |   |   |
|               |       | Condensed  Consolidated Statements of Cash Flows –  nine months ended September 30, 2005 and 2006           |   |   |
|               |       |                                                                                                             |   |   |
|               |       | Notes to  Condensed Consolidated Financial Statements                                                            |   |   |
|               |       |                                                                                                             |   |   |
| Item 2.            |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                      |   |   |
|               |       |                                                                                                             |   |   |
| Item 3.            |       | Quantitative  and Qualitative Disclosures About Market Risk                                                      |   |   |
|               |       |                                                                                                             |   |   |
| Item 4.            |       | Controls and  Procedures                                                                                         |   |   |
|               |       |                                                                                                             |   |   |
| **PART II.**       | ** ** | **OTHER INFORMATION**                                                                                            |   |   |
| ** **         | ** ** | ** **                                                                                                       |   |   |
| Item 1.            |       | Legal Proceedings                                                                                                |   |   |
|               |       |                                                                                                             |   |   |
| Item  1A.          |       | Risk Factors                                                                                                     |   |   |
|               |       |                                                                                                             |   |   |
| Item  6.           |       | Exhibits                                                                                                         |   |   |
|               |       |                                                                                                             |   |   |
| **SIGNATURE**      |       |                                                                                                             |
| ** **         |       |                                                                                                             |
| **EXHIBIT  INDEX** | * *   | * *                                                                                                         |

 

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**PART I.  FINANCIAL INFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS.**

**PRAECISPHARMACEUTICALS INCORPORATEDCondensed Consolidated Balance Sheets(In thousands, except share data)**

**(Unaudited)**
| ** **                                                                                                                                                                     | ** ** | **December 31,  2005** | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **Assets**                                                                                                                                                                     |       |                        |       |                         |       |
| Current assets:                                                                                                                                                                |       |                        |       |                         |       |
| Cash and cash  equivalents                                                                                                                                                     |       | $                           | 57,088     |                         | $          | 40,370 |   |
| Marketable  securities                                                                                                                                                         |       | 5,492                       |       | —                       |       |
| Accounts  receivable                                                                                                                                                           |       | 184                         |       | 70                           |       |
| Inventory                                                                                                                                                                      |       | 154                         |       | —                       |       |
| Prepaid expenses  and other current assets                                                                                                                                     |       | 742                         |       | 943                          |       |
| Total current  assets                                                                                                                                                          |       | 63,660                      |       | 41,383                       |       |
| Property and equipment,  net                                                                                                                                                   |       | 3,559                       |       | 1,595                        |       |
| Inventory                                                                                                                                                                      |       | 1,532                       |       | —                       |       |
| Restricted cash                                                                                                                                                                |       | 793                         |       | 793                          |       |
| Total assets                                                                                                                                                                   |       | $                           | 69,544     |                         | $          | 43,771 |   |
| ** **                                                                                                                                                                     |       |                        |       |                         |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                 |       |                        |       |                         |       |
| Current liabilities:                                                                                                                                                           |       |                        |       |                         |       |
| Accounts payable                                                                                                                                                               |       | $                           | 780        |                         | $          | 627 |   |
| Accrued expenses                                                                                                                                                               |       | 3,373                       |       | 2,740                        |       |
| Accrued restructuring                                                                                                                                                          |       | 3,608                       |       | 4,217                        |       |
| Deferred gain on  sale-leaseback of building                                                                                                                                   |       | 1,818                       |       | 1,818                        |       |
| Total current  liabilities                                                                                                                                                     |       | 9,579                       |       | 9,402                        |       |
|                                                                                                                                                                           |       |                        |       |                         |       |
| Long-term accrued  restructuring, less current portion                                                                                                                         |       | 1,834                       |       | 3,152                        |       |
| Long-term deferred gain  on sale-leaseback of building, less current portion                                                                                                   |       | 6,968                       |       | 5,605                        |       |
|                                                                                                                                                                           |       |                        |       |                         |       |
| Commitments and  contingencies                                                                                                                                                 |       |                        |       |                         |       |
|                                                                                                                                                                           |       |                        |       |                         |       |
| Stockholders’ equity:                                                                                                                                                     |       |                        |       |                         |       |
| Common Stock,  $0.01 par value; 200,000,000 shares authorized; 10,494,174 shares issued and  outstanding in 2005; 10,749,289 shares issued and 10,708,417 outstanding in  2006 |       | 105                         |       | 107                          |       |
| Treasury Stock,  at cost; 40,872 shares in 2006                                                                                                                                |       | —                      |       | (123                         | )          |
| Additional paid-in  capital                                                                                                                                                    |       | 356,234                     |       | 359,592                      |       |
| Accumulated  other comprehensive loss                                                                                                                                          |       | (90                         | )          | —                       |       |
| Accumulated  deficit                                                                                                                                                           |       | (305,086                    | )          | (333,964                     | )          |
| Total stockholders’  equity                                                                                                                                               |       | 51,163                      |       | 25,612                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                               |       | $                           | 69,544     |                         | $          | 43,771 |   |

 

*See accompanying notes.*

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**PRAECIS PHARMACEUTICALS INCORPORATEDCondensed Consolidated Statements of Operations**

**(In thousands, except per share data)**

**(Unaudited)**
| ** **                                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Revenues:**                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Product sales                                                           |       | $                                                    | 282        |                                                | $          | — |   | $ | 1,437 |   | $ | 209 |   |
| Licensing and other revenues                                            |       | 1,806                                                |       | —                                              |       | 1,924 |   | 35 |   |
| Total revenues                                                          |       | 2,088                                                |       | —                                              |       | 3,361 |   | 244 |   |
| **Costs  and expenses:**                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of goods sold                                                      |       | 97                                                   |       | 45                                                  |       | 3,889 |   | 5,615 |   |
| Research and development                                                |       | 5,333                                                |       | 5,610                                               |       | 18,892 |   | 18,157 |   |
| Sales and marketing                                                     |       | 203                                                  |       | —                                              |       | 5,988 |   | — |   |
| General and administrative                                              |       | 1,489                                                |       | 1,560                                               |       | 5,456 |   | 5,433 |   |
| Restructuring and asset impairment                                      |       | —                                               |       | 110                                                 |       | 28,680 |   | 1,688 |   |
| Total costs and expenses                                                |       | 7,122                                                |       | 7,325                                               |       | 62,905 |   | 30,893 |   |
|                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Operating loss                                                          |       | (5,034                                               | )          | (7,325                                              | )          | (59,544 | ) | (30,649 | ) |
|                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                         |       | 378                                                  |       | 572                                                 |       | 1,145 |   | 1,766 |   |
| Interest expense                                                        |       | (512                                                 | )          | —                                              |       | (1,484 | ) | — |   |
| Gain on sale of  property and equipment                                 |       | —                                               |       | —                                              |       | — |   | 5 |   |
| Net loss                                                                |       | $                                                    | (5,168     | )                                                   | $          | (6,753 | ) | $ | (59,883 | ) | $ | (28,878 | ) |
|                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and  diluted net loss per common share                            |       | $                                                    | (0.49      | )                                                   | $          | (0.63 | ) | $ | (5.71 | ) | $ | (2.73 | ) |
|                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average number  of basic and diluted common shares outstanding |       | 10,494                                               |       | 10,687                                              |       | 10,488 |   | 10,594 |   |

 

*See accompanying notes.*

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**PRAECIS PHARMACEUTICALS INCORPORATEDCondensed Consolidated Statements of Cash Flows(In thousands)**

**(Unaudited)**
| ** **                                                                    | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| **Operating  activities:**                                                    |       |                                                |       |   |   |
| Net loss                                                                      |       | $                                                   | (59,883    | ) | $ | (28,878 | ) |
| Adjustments to  reconcile net loss to cash used in operating activities:      |       |                                                |       |   |   |
| Non-cash restructuring and asset impairment                                   |       | 23,169                                              |       | 7,109 |   |
| Amortization of deferred gain on sale-leaseback of  building                  |       | —                                              |       | (1,363 | ) |
| Gain on sale of property and equipment                                        |       | —                                              |       | (5 | ) |
| Depreciation                                                                  |       | 2,165                                               |       | 872 |   |
| Stock-based compensation                                                      |       | —                                              |       | 2,627 |   |
| Changes in operating assets and liabilities:                                  |       |                                                |       |   |   |
| Accounts receivable                                                           |       | 770                                                 |       | 114 |   |
| Inventory                                                                     |       | (793                                                | )          | — |   |
| Prepaid expenses, other current assets and other  assets                      |       | 21                                                  |       | (201 | ) |
| Accounts payable                                                              |       | (857                                                | )          | (153 | ) |
| Accrued expenses                                                              |       | (2,921                                              | )          | (633 | ) |
| Accrued restructuring                                                         |       | 6,372                                               |       | (1,618 | ) |
| Deferred revenue                                                              |       | (1,889                                              | )          | — |   |
| Net cash used in  operating activities                                        |       | (33,846                                             | )          | (22,129 | ) |
|                                                                          |       |                                                |       |   |   |
| **Investing  activities:**                                                    |       |                                                |       |   |   |
| Purchase of  available-for-sale securities                                    |       | (13,094                                             | )          | — |   |
| Sales and  maturities of available-for-sale securities                        |       | 78,853                                              |       | 5,582 |   |
| Proceeds from  disposition of property and equipment                          |       | 15                                                  |       | 5 |   |
| Purchase of  property and equipment                                           |       | (1,184                                              | )          | (786 | ) |
| Net cash  provided by investing activities                                    |       | 64,590                                              |       | 4,801 |   |
|                                                                          |       |                                                |       |   |   |
| **Financing  activities:**                                                    |       |                                                |       |   |   |
| Repayments of  long-term debt                                                 |       | (396                                                | )          | — |   |
| Proceeds from  the issuance of Common Stock under employee compensation plans |       | 95                                                  |       | 110 |   |
| Proceeds from  the sale of Common Stock in connection with pilot study        |       | —                                              |       | 500 |   |
| Net cash (used  in) provided by financing activities                          |       | (301                                                | )          | 610 |   |
|                                                                          |       |                                                |       |   |   |
| Increase  (decrease) in cash and cash equivalents                             |       | 30,443                                              |       | (16,718 | ) |
| Cash and cash  equivalents at beginning of period                             |       | 11,178                                              |       | 57,088 |   |
|                                                                          |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                   |       | $                                                   | 41,621     |   | $ | 40,370 |   |

 

##### *See accompanying notes.*

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**PRAECISPHARMACEUTICALS INCORPORATEDNotes to Condensed Consolidated Financial Statements(Unaudited)**

# **1.             Basis of Presentation**

Theaccompanying condensed consolidated financial statements have been prepared byPRAECIS PHARMACEUTICALS INCORPORATED (the “Company”) in accordance withaccounting principles generally accepted in the United States and pursuant tothe rules and regulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States have beencondensed or omitted pursuant to such rules and regulations.  It is suggested that the financial statementsbe read in conjunction with the audited financial statements and theaccompanying notes included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2005.

Theinformation furnished reflects all adjustments which, in the opinion ofmanagement, are considered necessary for a fair presentation of results for theinterim periods.  Such adjustmentsconsist only of normal recurring items. It should also be noted that results for the interim periods are notnecessarily indicative of the results expected for the full year or any futureperiod.

# **2.             Summary of Significant AccountingPrinciples**

## ***Use of Estimates***

The preparation of financial statements in accordancewith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Such estimates relate to the useful lives of fixed assets, the netrealizable value of inventory, accrued restructuring expenses, other accruedexpenses, other reserves, and assumptions used in valuing stock-basedcompensation awards.  Actual results could differ from thoseestimates and such differences may be material to the Company’s condensedconsolidated financial statements.

## ***Principles of Consolidation***

Theaccompanying condensed consolidated financial statements include the Company’saccounts and the accounts of its wholly owned subsidiaries, 830 Winter StreetLLC and PRAECIS Europe Limited. In August 2006, the Company dissolved 830Winter Street LLC as it was formed solely to engage in real estate activityrelated to the acquisition and ownership of the Company’s corporate headquarters and research facility,which was sold in October 2005.  Allsignificant intercompany account balances and transactions between thecompanies have been eliminated.

## ***Inventory***

Inventoryis stated at the lower of cost or market with cost determined under thefirst-in, first-out method. The Company writes down any obsolete, excess orotherwise unmarketable inventory to its estimated net realizable value, asnecessary.  Inventory as ofDecember 31, 2005 consisted of materials used to produce Plenaxis®.

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Thecomponents of inventory are as follows (in thousands): 

|                       | ** ** | **December 31,  2005** | ** ** |
|-----------------------|------------|-----------------------------|------------|
| Work-in-process       | ** ** | $                           | 1,532      |   |
| Finished goods        | ** ** | 154                         |       |
| Total inventory       | ** ** | 1,686                       |       |
| Less current  portion | ** ** | (154                        | )          |
| Long-term inventory   | ** ** | $                           | 1,532      |   |

 

Rawmaterials, work-in-process and finished goods inventories consist of materials,labor and manufacturing overhead.  TheCompany classifies any inventory that is estimated to be sold in the nexttwelve months as current inventory, with the remaining amount classified aslong-term inventory.

In connection with the Company’s strategicrestructuring announced in May 2005, the Company voluntarily discontinuedpromotional activities related to Plenaxis® and the sale of Plenaxis® for new patients in the United States.  As a result, the Company wrote downapproximately $3.5 million of inventory during the three months ended June 30,2005 that it estimated to be in excess of its expected requirements.  This amount was classified in cost of goodssold in the consolidated statement of operations for that period.  The remaining inventory balance,approximately $1.7 million at December 31, 2005, consisted of materials thatwere expected to be used in connection with the commercialization of Plenaxis® by a third party in Europe andother territories following a license or sale transaction relating to theproduct.  In September 2005, the Companyreceived marketing authorization for Plenaxis® in Germany. In June 2006, the Company announced that it would cease its activeefforts to license or sell its Plenaxis® assets. As a result, the Company recorded a non-cash impairment charge ofapproximately $1.7 million during the three months ended June 30, 2006 to writedown the remaining inventory balance to zero. This amount was classified incost of goods sold in the condensed consolidated statement of operations forthat period.

## ***Impairment or Disposal of Long-Lived Assets***

Statement of Financial Accounting Standards (“SFAS”) No.144, *Accounting for the Impairment or Disposal ofLong-Lived Assets* (“SFAS No.144”), requires that if the sum of the undiscounted future cash flows expectedto result from a company’s asset, net of interest charges, is less than the reportedvalue of the asset, an asset impairment may be recognized in the financialstatements if the reported value of the asset exceeds the fair value determinedby either a quoted market price, if any, or a value determined by utilizing adiscounted cash flow technique.  TheCompany evaluates its property, plant and equipment for impairment wheneverindicators of impairment exist.  Theamount of the impairment to be recognized is calculated by subtracting the fairvalue of the asset from the reported value of the asset.

## ***Stock-Based Compensation***

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 123R, *Share-Based Payment—An Amendment of FASB StatementsNo. 123 and 95* (“SFAS No. 123R”), which requires all companies tomeasure compensation cost for all share-based payments, including employeestock options, at fair value. Generally, the approach in SFAS No. 123R issimilar to the approach described in SFAS No. 123, *Accountingfor Stock-Based Compensation* (“SFAS No.123”). However, SFAS No. 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalue over the requisite service period. Pro forma disclosure is no longer an alternative.   In March 2005, the SEC issued StaffAccounting Bulletin (“SAB”) No. 107 (“SABNo. 107”), which expressed the views of the SEC regarding the interactionbetween SFAS No. 123R and certain rules and regulations of the SEC. SAB No. 107provides guidance related to the valuation of share-based payment arrangementsfor public companies, including assumptions such as expected volatility andexpected term.

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EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisions ofSFAS No. 123R, using the modified prospective transition method.  Under this transition method, compensationcost recognized in the statement of operations during 2006 includes: (a)compensation cost for all share-based payments granted prior to, but not yetvested as of, January 1, 2006, based on the grant-date fair value estimated inaccordance with the original provisions of SFAS No. 123; and (b) compensationcost for all share-based payments granted, modified or settled subsequent toJanuary 1, 2006, based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123R.  Inaccordance with the modified prospective transition method, results for priorperiods have not been restated.

Forthe three months ended September 30, 2006, the Company recorded stock-basedcompensation expense of approximately $0.8 million for stock options grantedunder the Company’s Fourth Amended and Restated 1995 Stock Plan (the “Plan”)and approximately $10,000 related to the Company’s Second Amended and RestatedEmployee Stock Purchase Plan, as amended (the “ESPP”), of which $0.6 millionwas included in research and development expenses and $0.2 million was includedin general and administrative expenses. For the nine months ended September 30, 2006, the Company recordedstock-based compensation expense of approximately $2.6 million for stockoptions granted under the Plan and approximately $26,000 related to the ESPP,of which $1.9 million was included in research and development expenses and$0.7 million was included in general and administrative expenses.  The stock-based compensation expense for thenine months ended September 30, 2006 includes approximately $78,000 recorded inconnection with the acceleration of vesting of the unvested portion of twooutstanding option grants to purchase an aggregate of 33,998 shares of CommonStock at a weighted average exercise price of $5.80 per share.  No amounts relating to stock-basedcompensation have been capitalized.

TheCompany currently has the following stock-based employee compensation planswhich are subject to the provisions of SFAS No. 123R:

*Stock Option Plan* - The Planallows for the granting of incentive and nonqualified options, restricted stockawards and awards of, or awards to purchase, shares of Common Stock.Historically, incentive options granted to employees under the Plan generallyvested over a five-year period, with 20% vesting on the first anniversary ofthe date of grant and the remainder vesting in equal monthly installmentsthereafter. During 2005 and thereafter, the Company began granting options toemployees which generally vest over a four-year period, with 25% vesting on thefirst anniversary of the date of grant and the remainder vesting in equalmonthly installments thereafter. Nonqualified options issued to non-employeedirectors and consultants under the Plan generally vest during their period ofservice with the Company. Options granted under the Plan have a maximum term often years from the date of grant.  InMarch 2006, the Company’s Board of Directors approved the Plan, subject tostockholder approval, which was obtained in May 2006.  The Plan amends and restates the Company’sThird Amended and Restated 1995 Stock Plan to increase by 500,000 the number ofshares of Common Stock authorized for issuance under the Plan, permit the grantof restricted stock awards and include certain performance goals for purposesof Section 162(m) of the Internal Revenue Code of 1986, as amended.  At September 30, 2006, a total of 3,675,000shares of Common Stock were authorized for issuance under the Plan, 1,534,369of which were reserved for issuance upon the exercise of outstanding stockoptions and 1,042,114 of which remained available for issuance of new awardsunder the Plan.

*Employee Stock Purchase Plan* -Under the ESPP, eligible employees may purchase shares of Common Stock at aprice per share equal to 85% of the lower of the fair market value per share ofCommon Stock at the beginning or the end of each six-month period during theterm of the ESPP. Participation is limited to the lesser of 10% of the employee’scompensation or $25,000 in any calendar year. In May 2005, the Company’s Boardof Directors approved an amendment and restatement of the employee stockpurchase plan to extend its term through June 25, 2007 and provide forwithdrawal by employees during a six-month exercise period.  In March 2006, the Company’s Board ofDirectors approved an amendment, subject to stockholder approval, which wasobtained in May 2006, to increase by 80,000 shares the number of shares ofCommon Stock reserved for issuance under the ESPP.  At September 30, 2006, a total of 82,645shares of Common Stock had been issued under the ESPP and 77,355 sharesremained available for issuance.

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The Company uses the Black-Scholes option pricingmodel to calculate the fair value on the grant date of stock-based compensationfor both stock options granted under the Plan and options to purchase sharesgranted under the ESPP.  The fair value ofstock options granted under the Plan during the three and nine months endedSeptember 30, 2005 and 2006 was calculated using the following estimatedweighted-average assumptions:

|                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **  2005  **                     | ** ** | **  2006  **                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Expected term  (years)   |       | 5.0                                                  |       | 4.5                                                 |       | 6.2 |   | 4.5 |   |
| Volatility               |       | 86.2                                                 | %          | 67.5                                                | %          | 86.5 | % | 67.1 | % |
| Risk-free  interest rate |       | 4.1                                                  | %          | 4.9                                                 | %          | 3.8 | % | 4.9 | % |

 

Expected term: The expected term of options granted represents the period of time forwhich the options are expected to be outstanding and is derived from theCompany’s historical stock option exercise experience and option expirationdata.  To estimate the expected term, theCompany excluded options granted to employees whose employment was terminatedin connection with the Company’s strategic restructuring announced in May 2005,which included a reduction of the Company’s then 182-person headcount byapproximately 60%.  The Company believesthat this adjusted historical data is currently the best estimate of theexpected term of a new option.  Inaddition, for purposes of estimating the expected term, the Company hasaggregated all individual option awards into one group as the Company does notexpect substantial differences in exercise behavior among its employees.

Expected volatility: The expected volatility is a measure of the amount by which the Company’sstock price is expected to fluctuate during the expected term of optionsgranted. The Company determines the expected volatility based solely upon thehistorical volatility of the Common Stock over a period commensurate with theoption’s expected term.  The Company doesnot believe that the future volatility of its Common Stock over an option’sexpected term is likely to differ significantly from the past.

Risk-free interest rate:  The risk-free interest rate is the impliedyield available on U.S. Treasury zero-coupon issues with a remaining term equalto the option’s expected term on the grant date.

Expected dividend yield:  The Company has never declared or paid anycash dividends on any of its capital stock and does not expect to do so in theforeseeable future.  Accordingly, theCompany uses an expected dividend yield of zero to calculate the grant-datefair value of a stock option.

Theassumptions used to calculate the grant-date fair value for options to purchaseshares granted under the ESPP for the three and nine months ended September 30,2006 include the following: an expected term of six months, representing thecurrent exercise period for purchases under the ESPP; an expected annualvolatility of 85.4% and 76.9% for the three and nine months ended September 30,2006, respectively; an annualized risk-free interest rate of 5.3% and 5.0% forthe three and nine months ended September 30, 2006, respectively; and a zeroexpected dividend yield.  Theweighted-average per share fair value of options to purchase shares grantedunder the ESPP during the three and nine months ended September 30, 2006 was$1.13 and $1.20, respectively.

TheCompany recognizes compensation expense on a straight-line basis over therequisite service period based upon options that are ultimately expected tovest, and accordingly, such compensation expense has been adjusted by an amountof estimated forfeitures.  Forfeituresrepresent only the unvested portion of a surrendered option.  SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates. Prior to the adoption of SFASNo. 123R, the Company accounted for forfeitures upon occurrence as permittedunder SFAS No. 123.  Based on an analysisof historical data, excluding the impact of options granted to employees whoseemployment was terminated in connection with the Company’s strategicrestructuring announced in May 2005, the Company has calculated a 6.0% annualforfeiture rate, which it believes is a reasonable assumption to estimateforfeitures. However, the estimation of forfeitures requires significantjudgment, and to the extent actual results or updated estimates differ from theCompany’s current estimates, such amounts will be recorded as a cumulativeadjustment in the period estimates are revised.

9

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Theweighted average per share fair value of stock options granted under the Planwas $1.91 and $1.34 during the three months ended September 30, 2005 and 2006,respectively, and $2.83 and $1.90 during the nine months ended September 30,2005 and 2006, respectively.

Priorto January 1, 2006, the Company applied the pro forma disclosure requirementsunder SFAS No. 123 and accounted for its stock-based employee compensationplans using the intrinsic value method under the recognition and measurementprovisions of Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*and related interpretations.  Accordingly, no stock-based employeecompensation cost was recognized in the statement of operations for the threeand nine months ended September 30, 2005, as all stock options granted underthe Plan had an exercise price equal to the fair market value of the underlyingCommon Stock on the date of grant as determined in accordance with the Plan.

The following table illustrates the effect on net lossand net loss per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to options granted under the Plan for the three andnine months ended September 30, 2005. Since stock-based compensation expense for the three and nine monthsended September 30, 2006 was recorded under the provisions of SFAS No. 123R,there is no disclosure of pro forma net loss and net loss per share for theseperiods.  For purposes of the pro formadisclosure for the three and nine months ended September 30, 2005 set forth inthe table below, the value of the options is estimated using a Black-Scholesoption pricing model and amortized on a straight-line basis to expense over theoptions’ vesting periods.
| ** **                                                                                                                                                                                     | ** ** | **Three Months Ended  September 30, 2005**     | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **(in thousands, except per share data)** | ** ** |
|  Net loss, as reported                                                                                                                                                                    |       | $                                                                  | (5,168     | )                                                             | $          | (59,883 | ) |
| Deduct:  Stock-based employee compensation cost that would have been included in  the determination of net loss as reported if the fair value method had been  applied to all awards |       | (1,212                                                             | )          | (4,292                                                        | )          |
| Pro forma net  loss                                                                                                                                                                            |       | $                                                                  | (6,380     | )                                                             | $          | (64,175 | ) |
| Basic and  diluted net loss per common share, as reported                                                                                                                                      |       | $                                                                  | (0.49      | )                                                             | $          | (5.71 | ) |
| Basic and diluted net  loss per common share, pro forma (1)                                                                                                                                    |       | $                                                                  | (0.61      | )                                                             | $          | (6.12 | ) |

 

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(1)       The amounts for the three and nine months ended September 30, 2005 wereoriginally reported as $(0.66) and $(6.40), respectively, and have beenadjusted due to an error in the calculations.

Informationregarding option activity for the three months ended September 30, 2006 underthe Plan is summarized below (in thousands, except price per share data):

|                                            | ** ** | **Options Outstanding** | ** ** | **Weighted-  Average  Exercise  Price Per  Share** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|---------------------------------------------------------|------------|
| Options  outstanding at June 30, 2006      |       | 1,677                        |       | $                                                       | 26.18      |   |
| Granted                                    |       | 215                          |       | 2.31                                                    |       |
| Exercised                                  |       | (117                         | )          | 1.33                                                    |       |
| Forfeited                                  |       | (16                          | )          | 9.56                                                    |       |
| Expired                                    |       | (224                         | )          | 38.86                                                   |       |
| Options outstanding at  September 30, 2006 |       | 1,535                        |       | $                                                       | 23.05      |   |

 

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Informationregarding option activity for the nine months ended September 30, 2006 underthe Plan is summarized below (in thousands, except price per share data):

|                                                            | ** ** | **Options  Outstanding** | ** ** | **Weighted-  Average  Exercise  Price Per Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
| Options  outstanding at December 31, 2005                  |       | 1,682                    |       | $                                                           | 26.62      |                                                              |       |                            |       |   |
| Granted                                                    |       | 297                      |       | 3.28                                                        |       |                                                              |       |                            |       |
| Exercised                                                  |       | (127                     | )          | 1.33                                                        |       |                                                              |       |                            |       |
| Forfeited                                                  |       | (66                      | )          | 10.87                                                       |       |                                                              |       |                            |       |
| Expired                                                    |       | (251                     | )          | 37.77                                                       |       |                                                              |       |                            |       |
| Options  outstanding at September 30, 2006                 |       | 1,535                    |       | $                                                           | 23.05      |                                                              | 6.9        |                            | $          | — |   |
|                                                       |       |                     |       |                                                        |       |                                                              |       |                            |       |
| Options  exercisable at September 30, 2006                 |       | 911                      |       | $                                                           | 31.29      |                                                              | 5.7        |                            | $          | — |   |
|                                                       |       |                     |       |                                                        |       |                                                              |       |                            |       |
| At September 30, 2006,  options vested or expected to vest |       | 1,460                    |       | $                                                           | 23.94      |                                                              | 6.9        |                            | $          | — |   |

 

Theaggregate intrinsic value in the table above represents the total pre-taxintrinsic value (the difference between the closing price of the Common Stockon September 30, 2006 of $2.05 and the exercise price of each in-the-moneyoption) that would have been received by the option holders had all optionholders exercised their vested and unvested options on September 30, 2006.  Total intrinsic value of stock optionsexercised under the Plan for the three and nine months ended September 30, 2006was $0.2 million.  In July 2006, anemployee exercised an option to purchase 92,500 shares of Common Stock at $1.33per share and paid the exercise price by tendering to the Company 40,872 sharesof Common Stock previously acquired by the employee more than six months priorto such exercise, as provided for in the Plan and approved by the Company’sCompensation Committee.  The fair marketvalue of the 40,872 shares of Common Stock on the date of exercise was equal tothe option exercise price.

Asof September 30, 2006, there was $4.5 million of total unrecognizedcompensation cost related to unvested share-based awards.  That cost is expected to be recognized over aperiod of 4.0 years with a weighted-average period of 1.1 years.

## ***Revenue Recognition***

TheCompany follows the provisions of SAB No. 104, *RevenueRecognition*.  The Companyrecognizes revenues from product sales in the period when the product isdelivered, provided there is persuasive evidence that an arrangement exists,the price is fixed or determinable and collection of the related receivable isreasonably assured.  Revenues arerecorded net of applicable allowances as provision is made for estimated salesreturns, rebates, distributor fees and other applicable discounts andallowances.  Shipping and otherdistribution costs are charged to cost of product sales. Product revenues arerelated solely to Plenaxis® for all periodspresented in this report.  In connectionwith the Company’s strategic restructuring announced in May 2005, the Companyvoluntarily discontinued promotional activities related to Plenaxis® and the sale of Plenaxis® fornew patients in the United States.  InJune 2006, the Company announced that it would voluntarily discontinue thelimited sale and distribution of Plenaxis® to allpatients.  As of August 31, 2006, theCompany ceased all commercial distribution of the product in the United States.

TheCompany has historically provided****substantiallyall of its distributors with payment terms of up to 120 days on purchases ofPlenaxis®.  Through September 30, 2006, payments havegenerally been made in a timely manner.

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The Company analyzes its multiple element arrangementsto determine whether the elements can be separated and accounted forindividually as separate units of accounting in accordance with EITF No. 00-21,*Revenue Arrangements with Multiple Deliverables*.  Nonrefundable upfront licensing fees andcertain guaranteed, time-based payments that require continuing involvement inthe form of development, manufacturing or other commercialization efforts bythe Company are recognized as licensing revenue ratably over the period duringwhich the Company is obligated to perform those services.  Milestone payments are recognized aslicensing revenue or product sales when the performance obligations, as definedin the contract, are achieved. Performance milestones typically consist of significant milestones inthe development and/or commercialization of a product such as obtainingapproval from regulatory agencies or the achievement of targeted sales levels.Reimbursements of development costs are recognized as licensing revenue as therelated costs are incurred.

Whenthe period over which a fee or payment will be recognized as revenue cannot bespecifically identified from the contract, management estimates the deferralperiod based upon other critical factors contained within the contract,including but not limited to patent life or contract term.   The Company continually reviews theseestimates which could result in a change in the deferral period and mightimpact the timing and the amount of revenue recognized.

## ***Net Loss Per Share***

Basicnet loss per share is based on the weighted average number of shares of CommonStock outstanding.  For all periodspresented, diluted net loss per share of Common Stock is the same as basic netloss per share of Common Stock as the inclusion of Common Stock equivalents,including the effect of stock options, would be antidilutive due to the Company’snet loss position for all periods presented. Diluted net loss per share of Common Stock excluded 1,747,277 and1,534,369 Common Stock options for the periods ended September 30, 2005 and2006, respectively, as their impact would have been antidilutive.

## ***Comprehensive Loss***

SFAS No. 130, *Reporting ComprehensiveIncome*, establishes standards for the reporting and display ofcomprehensive income or loss and its components in the condensed consolidatedfinancial statements.  The Company’saccumulated other comprehensive loss is comprised of net unrealized gains orlosses on available-for-sale securities. For the three and nine months ended September 30, 2005 and 2006,comprehensive loss was as follows (in thousands):
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Net loss                                    |       | $                                                    | (5,168     | )                                                   | $          | (6,753 | ) | $ | (59,883 | ) | $ | (28,878 | ) |
| Changes in  comprehensive loss:             |       |                                                 |       |                                                |       |   |   |   |   |
| Net unrealized  holding gain on investments |       | 25                                                   |       | —                                              |       | 55 |   | 90 |   |
| Total comprehensive loss                    |       | $                                                    | (5,143     | )                                                   | $          | (6,753 | ) | $ | (59,828 | ) | $ | (28,788 | ) |

 

## ***Recent Accounting Pronouncements***

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurement* (“SFAS No. 157”), which defines fair value, establishesa framework for measuring fair value and expands disclosures on fair valuemeasurements.  SFAS No. 157 appliesto other accounting pronouncements that require or permit fair valuemeasurements and is effective for fiscal years beginning after November 15,2007.  The Company is evaluating SFAS No.157 and has not yet determined the effect, if any, the adoption of thisstatement will have on the Company’s results of operations or financialposition.

InSeptember 2006, the SEC issued SAB No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*(“SAB No 108”). Traditionally, there have been two common approaches used to accumulateand quantify the effects of financial statement misstatements:  (1) the roll-over approach which quantifies amisstatement based on the amount of error, including the reversing effect

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of prior year misstatements, originating in thecurrent year income statement and (2) the iron-curtain approach whichquantifies a misstatement based on the effects of correcting a misstatementexisting in the current period-end balance sheet, irrespective of when themisstatement occurred.  SAB No. 108states that registrants should use both approaches when quantifying andevaluating the materiality of a misstatement on current year financialstatements.  SAB No. 108 is effective forfiscal years ending after November 15, 2006. The Company is evaluating SAB No. 108 and has not yet determined theeffect, if any, this guidance will have on the Company’s results of operationsor financial position.

# **3.             Restructuringand Asset Impairment**

OnMay 19, 2005, the Company’s Board of Directors approved a strategicrestructuring to focus the Company’s resources on its most promising assets andprograms and significantly reduce its cost structure.  The strategic restructuring includedvoluntarily discontinuing promotional activities related to Plenaxis® and the sale of Plenaxis® fornew patients in the United States; voluntarily suspending the ongoing clinicaldevelopment of ApanTM, the Company’s drug candidate for Alzheimer’s disease; andimplementing a reduction of the Company’s 182-person headcount by approximately60%.

Duringthe year ended December 31, 2005, the Company recorded approximately $28.7million of restructuring and asset impairment expenses under SFAS No. 146, *Accounting for Costs Associated with Exit or Disposal Activities*(“SFAS No. 146”)*. *Includedin these restructuring and asset impairment expenses were cash charges ofapproximately $2.6 million for employee severance, benefits and related costs,approximately $0.2 million associated with the termination of various contractsand approximately $0.2 million of other associated costs.  The Company also recorded a non-cashimpairment charge in cost of goods sold of approximately $3.5 million relatedto inventory due to the discontinuation of promotional activities relating toPlenaxis® and the sale of Plenaxis® fornew patients in the United States.  AtDecember 31, 2005, the Company’s condensed consolidated balance sheet includedapproximately $1.9 million of Plenaxis®-relatedequipment and approximately $1.7 million of Plenaxis®-related inventory.

Inconnection with the restructuring, the Company also determined that itscommitments under certain manufacturing and supply agreements with thirdparties exceeded the Company’s estimated future Plenaxis® requirements by approximately $7.2million.  During the year ended December31, 2005, the Company recorded a charge of approximately $6.0 million whichrepresented the net present value of such excess future commitments at thattime.  Under SFAS No. 146, the remaining$1.2 million of these excess commitments was required to be expensed over the remainingrespective terms of the applicable manufacturing and supply agreements, whichranged from two to five years.

Inaddition, in connection with the restructuring, the Company performed anassessment and determined that its corporate headquarters and research facility(the “Facility”) was impaired.  As aresult, a non-cash impairment charge of approximately $19.7 million related tothe Facility was recorded as part of restructuring and asset impairmentexpenses under SFAS No. 144 during the year ended December 31, 2005. TheCompany obtained an independent appraisal that was based upon a fee simpleexpected present value technique in combination with an evaluation ofcomparable assets in the geographic area in order to estimate the fair value ofits Facility.

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The following table sets forth the components of theCompany’s restructuring and asset impairment expenses for the year endedDecember 31, 2005 (in thousands):
| ** **                                       | ** ** | **Original  Charges** | ** ** | **Non-Cash  Write-off** | ** ** | **Amounts  Paid  Through  December  31, 2005** | ** ** | **Amounts  Accrued as of  December 31,  2005** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Employee severance,  benefits and related costs  |       | $                     | 2,555      |                    | $          | —                                              |       | $                                                             | 2,437      |   | $ | 118 |   |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Contract  termination costs                      |       | 168                   |       | —                  |       | 168                                                 |       | —                                                        |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Other costs                                      |       | 247                   |       | —                  |       | 197                                                 |       | 50                                                            |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Impairment on  building                          |       | 19,676                |       | 19,676                  |       | —                                              |       | —                                                        |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Manufacturing  commitments restructuring expense |       | 6,034                 |       | —                  |       | 760                                                 |       | 5,274                                                         |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Total restructuring and asset impairment         |       | 28,680                |       | 19,676                  |       | 3,562                                               |       | 5,442                                                         |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Impairment on  inventory                         |       | 3,493                 | *          | 3,493                   | *          | —                                              |       | —                                                        |       |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Total                                            |       | $                     | 32,173     |                    | $          | 23,169                                              |       | $                                                             | 3,562      |   | 5,442 |   |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Less current  portion                            |       |                  |       |                    |       |                                                |       | (3,608                                                        | )          |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |
| Long-term  restructuring accrual                 |       |                  |       |                    |       |                                                |       | $                                                             | 1,873      |   |
|                                             |       |                  |       |                    |       |                                                |       |                                                          |       |

 

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*****Amount was recorded in cost ofgoods sold.

OnJune 19, 2006, the Company’s Board of Directors determined to cease the Company’spreviously announced process of actively seeking to dispose of the Company’sPlenaxis® assets through a license or sale transaction.The Company voluntarily discontinued the limited sale and distribution of theproduct in the United States as of August 31, 2006 and will not pursue furtherthe commercialization of Plenaxis® outside the United States. The Company is alsodiscontinuing any remaining Plenaxis®-relatedactivities, except as necessary to support the wind-down of productdistribution in the United States. During this wind-down, the Company iscontinuing to evaluate potential opportunities for its Plenaxis® assets to the extent such opportunities arise.

Dueto the cessation of its previously announced process of actively seeking tolicense or sell its Plenaxis® assets, theCompany recorded charges of approximately $7.5 million during the three monthsended June 30, 2006.  Of this amount,non-cash charges of approximately $1.9 million and $1.7 million were incurredwith respect to Plenaxis®-relatedequipment and inventory, respectively, to write down these assets to their netrealizable or salvage value.  AtSeptember 30, 2006, the estimated net realizable value of Plenaxis®-related inventory was zero and theestimated salvage value of Plenaxis®-relatedequipment was $45,000.  During the threemonths ended June 30, 2006, the Company also recorded a charge of approximately$3.8 million related to commitments under certain Plenaxis® manufacturing and supply agreements, which theCompany concluded will provide no future economic benefit to the Company, andother associated costs of approximately $0.1 million.  The $3.8 million charge represents the netpresent value of approximately $4.9 million of the aggregate future cashcommitments under these agreements. The Company expects to expense the balanceof $1.1 million over the remaining respective terms of the applicablemanufacturing and supply agreements, which range from one to four years. TheCompany currently has an aggregate of approximately $9.2 million in cashobligations under third-party Plenaxis® manufacturingand supply agreements, which become payable in varying annual amounts through2010.

Duringthe nine months ended September 30, 2006, the Company also recorded additionalrestructuring expenses of approximately $0.3 million related to theamortization of the net present value of excess future Plenaxis® manufacturingcommitments.  In addition, in January2006, the Company amended a Plenaxis® manufacturingand supply agreement to provide for the suspension of certain manufacturingactivities in exchange for a reduced payment by the Company of $1.5 million ofa $2.1 million excess future commitment. Accordingly,

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during the nine months ended September 30, 2006, theCompany reduced the excess accrued restructuring liability by $0.6 millionthrough a reduction to restructuring expense. Cash disbursements of approximately $1.6 million were made during thenine months ended September 30, 2006 related to restructuring charges.

The following table sets forth the activity andcomponents of the Company’s restructuring and asset impairment expenses for thenine months ended September 30, 2006 (in thousands):
| ** **                                           | ** ** | **Amounts  Accrued as of** | ** ** | **Activity During the Nine Months Ended September 30, 2006** | ** ** | **Amounts  Accrued as of** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **December 31,  2005**          | ** ** | **Additional  Charges**                                                                              | ** ** | **Reversal of  Charges**        | ** ** | **Non-Cash  Write-off** | ** ** | **Amounts  Paid** | ** ** | **September  30, 2006** | ** ** |
| Employee  severance, benefits and related costs |       | $                                    | 118        |                                                                                                 | $          | —                               |       | $ | — |   | $ | — |   | $ | 118 |   | $ | — |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Other costs                                          |       | 50                                   |       | 90                                                                                                   |       | —                               |       | 50 |   | — |   | 90 |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Impairment on  fixed assets                          |       | —                               |       | 1,878                                                                                                |       | —                               |       | 1,878 |   | — |   | — |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Manufacturing  commitments restructuring expense     |       | 5,274                                |       | 320                                                                                                  |       | (600                                 | )          | — |   | 1,500 |   | 3,494 |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Total restructuring and asset impairment             |       | 5,442                                |       | 2,288                                                                                                |       | (600                                 | )          | 1,928 |   | 1,618 |   | 3,584 |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Manufacturing  commitments                           |       | —                               |       | 3,785                                                                                                | *          | —                               |       | — |   | — |   | 3,785 | * |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Impairment on  inventory                             |       | —                               |       | 1,686                                                                                                | *          | —                               |       | 1,686 | * | — |   | — |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Total                                                |       | $                                    | 5,442      |                                                                                                 | $          | 7,759                                |       | $ | (600 | ) | $ | 3,614 |   | $ | 1,618 |   | 7,369 |   |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Less current  portion                                |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   | (4,217 | ) |
|                                                 |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   |   |   |
| Long-term restructuring  accrual                     |       |                                 |       |                                                                                                 |       |                                 |       |   |   |   |   | $ | 3,152 |   |

 

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*****Amounts were recorded in cost of goods sold.

# **4.             Litigation**

InDecember 2004 and January 2005, the Company, Chairman and (now former) ChiefExecutive Officer Malcolm Gefter, President and (now former) Chief OperatingOfficer Kevin F. McLaughlin, Chief Financial Officer and Treasurer Edward C.English, and former President and Chief Operating Officer William K. Heiden, werenamed as defendants in three purported class action securities lawsuits filedin the United States District Court for the District of Massachusetts.  On February 7, 2005, a motion was filed toconsolidate the three actions and to appoint lead plaintiffs and leadcounsel.  On February 18, 2005, theCompany and the individual defendants filed a brief response to that motion,reserving their rights to challenge the adequacy and typicality, among otherthings, of the proposed lead plaintiffs in connection with class certificationproceedings, if any.  On April 13, 2005,the Court entered an Order granting the plaintiffs’ motion to consolidate thethree actions (as well as each case that relates to the same subject matterthat may be subsequently filed in or transferred to the United States DistrictCourt for the District of Massachusetts), appoint lead plaintiffs and approvesuch plaintiffs’ selection of co-lead counsel.

On August 1, 2005, lead plaintiffs filed aconsolidated amended complaint.  Leadplaintiffs generally allege securities fraud during the period fromNovember 25, 2003 through December 6, 2004. The consolidated amended complaint purports to assert claims underSections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5promulgated thereunder, and alleges that the Company and the individually nameddefendants made materially false and misleading public statements concerningthe Company’s business and financial results, particularly relating tostatements regarding the commercialization of Plenaxis®, thereby allegedly causingplaintiffs to purchase the Company’s securities at artificially inflatedprices.  At this time, plaintiffs havenot specified the

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amount of damages they are seeking in theactions.  On September 12, 2005, the Company and the individual defendants filed a Motion to Dismiss the consolidatedamended complaint in its entirety.  OnOctober 24, 2005, lead plaintiffs filed an Opposition to the Company’s Motionto Dismiss and the defendants filed a reply on November 14, 2005.  On January 17, 2006, the Court heard oralargument on the Motion to Dismiss and took the matter under advisement.

TheCompany has not recorded an estimated liability associated with the legalproceedings described above.  Due to theuncertainties related to both the likelihood and the amount of any potentialloss, the Company is unable to make a reasonable estimate of the liability thatcould result from an unfavorable outcome. Management believes that the allegations against the Company are withoutmerit, and the Company intends to vigorously defend against the plaintiffs’claims.  However, if the Company is notsuccessful in defending these actions, its business and financial conditioncould be adversely affected.

**5.**             **Stock Purchase Agreement**

On April 7, 2006,the Company entered into a pilot study and option agreement with SmithKlineBeecham Corporation (“SBC”) and Glaxo Group Limited (“GGL”), relating to theCompany’s DirectSelectTM drug discovery technology (the “Pilot Study Agreement”).  In connection with the execution of the PilotStudy Agreement, the Company concurrently entered into a stock purchaseagreement (the “Stock Purchase Agreement”) with SBC and GGL (SBC and GGLtogether, the “Investor”).  Under theStock Purchase Agreement, on April 28, 2006 the Investor purchased 102,538unregistered shares of Common Stock at $4.88 per share, for an aggregatepurchase price of $500,000.  Under the terms of theStock Purchase Agreement, the per share price was determined based upon theaverage of the daily closing prices per share of the Common Stock on The NASDAQGlobal Market, as reported in the Wall Street Journal, over the trading daysduring the period beginning on, and including, March 11, 2006, and ending on,and including, April 25, 2006.

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**ITEM 2.     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS.**

*The followingdiscussion of our financial condition and results of operations should be readtogether with the condensed consolidated financial statements and accompanyingnotes to those statements included elsewhere in this Form 10-Q.  This Form 10-Q contains forward-lookingstatements within the meaning of Section 21E of the Securities Exchange Act of1934, as amended, that involve risks and uncertainties.  All statements other than statements ofhistorical information set forth herein are forward-looking and may containinformation about financial results, expected or anticipated events, economicconditions, trends and known uncertainties. Actual results and events could differ materially from those discussedin these forward-looking statements as a result of a number of factors, whichinclude those discussed in this section and elsewhere in this report under PartII, Item 1A – Risk Factors, and the risks discussed in our other filings withthe Securities and Exchange Commission. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis, judgment,belief or expectation only as of the date hereof.  PRAECIS undertakes no obligation to publiclyreissue or modify these forward-looking statements to reflect events orcircumstances that arise after the date hereof.*

### **Overview**

We are a biopharmaceutical company focused onutilizing our proprietary technologies to discover, in a rapid and efficientmanner, and develop, novel, orally-available compounds with the potential toaddress unmet medical needs or improve existing therapies.  We are seeking to collaborate with pharmaceuticaland biotechnology companies on the discovery and development of these compoundsacross a broad range of therapeutic areas. To that end, we entered into two pilot agreements relating to ourDirectSelectTM drug discovery technology during the first half of 2006. We alsointend to select for internal development promising compounds that we discoverand will partner these compounds at various stages of development in an effortto optimize their value to the Company. We have a novel methionine aminopeptidase type 2, or MetAP-2, inhibitor,PPI-2458, in clinical development for cancer indications, including non-Hodgkin’slymphoma and solid tumors.  Preclinicaldata also supports the use of PPI-2458 in inflammatory and autoimmune disordersand we are evaluating the potential initiation of clinical studies of PPI-2458in rheumatoid arthritis.  We currently donot intend to independently market the products that may ultimately result fromour discovery and development efforts. The key elements of our strategicoperating plan include:

·                  AdvancingPPI-2458 through a phase 1 trial in cancer patients and continuing preclinicalevaluation of the compound in inflammatory and autoimmune disorders, includingrheumatoid arthritis, with a goal of partnering this program in one or moreindications as clinical development advances;

·                  Entering intopharmaceutical partnerships for drug discovery and development utilizing, orother transactions with respect to, our DirectSelectTM technology that willprovide cash and/or cost reduction benefits to us, and, through DirectSelectTM,potentially expanding our own proprietary development pipeline; and

·                  Selecting one ormore lead candidates from sphingosine-1-phosphate receptor-1 (S1P-1) agonistcompounds we have previously identified and entering into a collaborativearrangement for the development and commercialization of such compound(s) onterms that include upfront, as well as milestone and other downstream, cashpayments.

As previously announced, we are actively exploringstrategic options which may be available to the Company.  We have engaged an investment banking firm toadvise and assist us in this process.  Nodecision has been made as to whether we will engage in a strategic transaction,and there can be no assurance as to whether or when this process will result ina successful transaction.  We do notcurrently intend to disclose developments or anticipated timing regarding thestatus or outcome of this process unless and until our board of directors hasapproved a specific transaction.

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In June 2006, we reported that we were ceasing ourpreviously announced process of actively seeking to license or sell ourPlenaxis® assets. We voluntarily discontinued the limited sale and distribution of theproduct in the United States as of August 31, 2006 and will not pursue furtherthe commercialization of Plenaxis® outside the United States.  We are also discontinuing any remainingPlenaxis®-related activities, except as necessary to support the wind-down ofproduct distribution in the United States. During this wind-down, we are continuing to evaluate potentialopportunities for our Plenaxis® assets to the extent such opportunitiesarise.  Due to the cessation of ourprocess of actively seeking to license or sell our Plenaxis® assets, werecorded charges of approximately $7.5 million during the three months endedJune 30, 2006.

#### *PPI-2458*

PPI-2458 is a novel, proprietary oral compoundtargeted at the inhibition of the enzyme MetAP-2.  We believe that, due to its antiproliferativeand antiangiogenic activity, PPI-2458 has the potential to address broadtherapeutic areas.** **In late 2004, we opened a phase 1clinical trial of PPI-2458 in non-Hodgkin’s lymphoma patients.  During the first quarter of 2005, we expandedthe enrollment criteria of this trial to include patients with solid tumors. Thestudy is a multi-center, open-label, dose-escalation study designed todetermine the maximum tolerated dose of PPI-2458 in patients. PPI-2458 isadministered to subjects orally every other day for two 28 day cycles.  Subjects are allowed to continue treatment,in the absence of unacceptable toxicity, until evidence of disease progression.The primary endpoint of the study is safety, with disease response beingevaluated as a secondary endpoint. Additional secondary endpoints includepharmacokinetic and pharmacodynamic data. On November 9, 2006, we presentedinterim data from this clinical trial at the 18th EORTC-NCI-AACR Symposium. Interim resultspresented include data for 32 subjects that have been treated across 4 dosecohorts ranging from 2 mg to 8 mg.  Datato date suggests that PPI-2458 is well tolerated at doses up to 8 mg. Themaximum tolerated dose has not been determined and treatment is currentlyongoing in a fifth cohort of subjects receiving a 12 mg dose. Results reportedfor this trial also include investigation of pharmacokinetics, pharmacodynamicsand tumor assessments.  Thepharmacodynamic endpoint is assessed using PRAECIS’ proprietary MetAP-2 assay.Results reported show that MetAP-2 in white blood cells is substantiallyinhibited by PPI-2458 in patients across each cohort.  In addition, 7 subjects across the first 4cohorts have been reported by the clinical investigators to have stable diseaseat the end of the first 2 cycles of treatment.

We are currently planning our phase 2 clinicaldevelopment protocols in oncology.  Inaddition, based on preclinical data we have generated, we believe PPI-2458could be a potential treatment with disease modifying activity for rheumatoidarthritis and other inflammatory and autoimmune disorders, and we are currentlyevaluating the potential initiation of clinical studies for PPI-2458 inrheumatoid arthritis.  In light of the anticipateddevelopment costs associated with the PPI-2458 clinical program, we anticipateseeking a partner for this program in one or more indications as clinicaldevelopment advances.

#### *DirectSelect**TM*

We believe our novel drug discovery technology,DirectSelectTM, can be an important tool for the future of drug discovery anddevelopment.  We believe thatDirectSelectTM, which enables the generation and practical use of ultra-largelibraries for the discovery of orally active compounds for drug development,will allow us to more rapidly and directly identify orally available compoundswith high affinity and specificity than has routinely been possible usingtraditional drug discovery methods. During 2006, we have continued to expand our library collection togreater than 6.5 billion compounds and we are focusing on the creation of noveldrug-like molecules that are patentable. We continue to incorporate new chemistries and scaffolds into theselibraries.  We are applying DirectSelectTMto a number of therapeutic targets.  Inconnection with these efforts, we have identified inhibitors to eight targetsincluding three proteases, four kinases and one additional proprietary target. Duringthe course of these studies, we have demonstrated that DirectSelectTM librariescan generate molecules with nanomolar potency, high selectively and lead-likeproperties directly from the primary screen in a period of months. Furthermore, we have demonstrated that DirectSelectTM succeeds in identifyingmolecules for targets where high throughput screening has failed; moreover,DirectSelectTM has been utilized to identify highly specific allostericinhibitors and inhibitors of protein:protein interactions.

Our strategic operating plan includes entering intopharmaceutical partnerships for drug discovery and development utilizing, orother transactions with respect to, our DirectSelectTM technology that willprovide cash and/or cost reduction benefits to us.  In March 2006, we entered into a technologytransfer and option agreement with Gilead Sciences, Inc.  Under the agreement, we are utilizingDirectSelectTM to identify lead drug candidates for an antiviral target suppliedby Gilead.  We will collaborate withGilead to identify lead molecules that have defined activities against theantiviral target.  Each company isfunding its own efforts during the course of the research collaboration.  We will own any lead molecules identifiedduring the course of the research collaboration.  Gilead has an exclusive option to enter intoa license agreement for any lead molecules so identified.

In addition, in April 2006, we entered into a two yearpilot study and option agreement with SmithKline Beecham Corporation and GlaxoGroup Limited, which we refer to together as GSK, through GSK’s Center ofExcellence for External Drug Discovery, or CEEDD.  The goal of this pilot study is to applyDirectSelectTM to identify small molecule lead drug candidates against a diverseset of four targets selected by GSK. Under the terms of the agreement, following our identification of leadcompounds meeting pre-established success criteria against at least one of thespecified targets, GSK will have the exclusive option to enter into a broaderstrategic alliance for further discovery and development of such leadcompounds.  The pilot agreementcontemplates that any broader strategic alliance could cover one or more of thetargets included in the pilot study, as well as additional targets as may beagreed upon by the parties.  During thepilot study, we will be entitled to receive a $500,000 milestone

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payment with respect toeach of the first two targets for which lead compounds are identified meetingthe pre-established success criteria.

In connection with the execution of the pilot studyagreement, we concurrently entered into a stock purchase agreement with GSK,pursuant to which we sold, on April 28, 2006, 102,538 unregistered shares ofour common stock at $4.88 per share, for an aggregate purchase price of $500,000.

We are continuing to initiate and advance researchcollaboration discussions with other major pharmaceutical companies withrespect to DirectSelectTM and, we may also, through DirectSelectTM, expand ourown proprietary development pipeline.

#### *S1P-1 Agonist*

In parallel with thedevelopment of our DirectSelectTM technology, we have also been conducting ahighly focused discovery research effort to identify small molecules thatinteract with S1P-1. S1P-1 is a G-protein coupled receptor that is implicatedin immunomodulation, making it an attractive therapeutic target for treatingautoimmune disorders such as multiple sclerosis and for preventing rejection insolid organ transplants. Utilizing conventional medicinal chemistry leadoptimization techniques, we have identified a number of selective S1P-1 agonistcompounds. We are currently evaluating several preclinical candidates with agoal of identifying one or more lead compounds to advance into clinical testing.  Our goal is to enter into a collaborativearrangement for the development and commercialization of such lead compound(s)on terms that include upfront, as well as milestone and other downstream, cashpayments.

#### *2005Strategic Restructuring*

During 2005, we fundamentally altered our strategicoperating plan to focus our efforts on early stage research and developmentactivities.  On May 19, 2005, our boardof directors approved a strategic restructuring to focus the Company’sresources on our most promising assets and programs and significantly reduceour cost structure.  The strategicrestructuring included voluntarily discontinuing promotional activities relatedto Plenaxis® and the sale of Plenaxis® fornew patients in the United States; voluntarily suspending the ongoing clinicaldevelopment of ApanTM, our drug candidate for Alzheimer’s disease; andimplementing a reduction of our 182-person headcount by approximately 60% toapproximately 75 full-time employees.  Wevoluntarily discontinued the limited sale and distribution of Plenaxis® in the United States as of August 31,2006.  As of September 30, 2006, we had75 full-time employees, 60 of whom were research and development personnel and15 of whom were general and administrative personnel.  This compares to 72 full-time employees as ofSeptember 30, 2005.

During 2005, we recorded approximately $28.7 millionof restructuring and asset impairment expenses under Statement of FinancialAccounting Standards No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*, or SFAS No. 146.  Included in these restructuring and assetimpairment expenses were cash charges of approximately $2.6 million foremployee severance, benefits and related costs, approximately $0.2 millionassociated with the termination of various contracts and approximately $0.2million of other associated costs.  Wealso recorded a non-cash impairment charge of approximately $3.5 millionrelated to inventory due to the discontinuation of promotional activitiesrelating to Plenaxis® in the United States and the sale of Plenaxis® for new patients.  In addition, a non-cash impairment charge ofapproximately $19.7 million was recorded under Statement of FinancialAccounting Standards No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*, or SFAS No. 144,relating to the impairment of our corporate headquarters and research facility.

We also determined that our commitments under certainmanufacturing and supply agreements with third parties exceeded our estimated futurePlenaxis® requirements by approximately $7.2million.  Accordingly, during 2005, werecorded a charge of approximately $6.0 million which represented the netpresent value of these excess commitments at that time.  Under SFAS No. 146, the remaining $1.2million of these excess commitments was required to be expensed over theremaining respective terms of the applicable manufacturing and supplyagreements, which ranged from two to five years.  We recorded restructuring expenses of $0.3million related to the amortization of the net present value for these excesscommitments during the nine months ended September 30, 2006.  In addition, in January 2006, we amended aPlenaxis® manufacturingand supply agreement to provide for the suspension of certain manufacturingactivities in exchange for a reduced payment of $1.5 million of a $2.1 millionexcess future commitment.

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In October 2005, we sold our corporate headquartersand research facility for $51.25 million. We realized proceeds, net of fees and expenses, of approximately $50.4million from this sale, and used approximately $31.6 million of the proceeds toretire the outstanding debt obligation related to the facility.  In connection with the sale of the facility,we executed a lease for approximately 65,000 square feet of office andlaboratory space in this facility.  As aresult of the sale and partial leaseback of the facility, we realized a totalgain of approximately $10.5 million, of which we recognized approximately $1.4million as a gain during 2005.  Theremaining amount of approximately $9.1 million will be recorded as a reductionof rent expense over the initial term of the lease.  During the nine months ended September 30,2006, we recorded a reduction of approximately $1.4 million to rent expenserelated to this deferred gain.

#### *Plenaxis*®* Assets*

As noted above, on June 19, 2006, our board ofdirectors determined to cease our previously announced process of activelyseeking to dispose of our Plenaxis® assets through a license or sale transaction.We voluntarily discontinued the limited sale and distribution of the product inthe United States as of August 31, 2006 and will not pursue further thecommercialization of Plenaxis® outside the United States. We are alsodiscontinuing any remaining Plenaxis®-relatedactivities, except as necessary to support the wind-down of productdistribution in the United States. During this wind-down, we are continuing toevaluate potential opportunities for our Plenaxis® assets to the extent such opportunities arise.

Due to the cessation of our previously announcedprocess of actively seeking to license or sell our Plenaxis® assets, we recorded charges of approximately$7.5 million during the three months ended June 30, 2006.  Of this amount, non-cash charges of approximately$1.9 million and $1.7 million were incurred with respect to Plenaxis®-related equipment andinventory, respectively, to write down these assets to their net realizable orsalvage value.  At September 30, 2006,the estimated net realizable value of Plenaxis®-related inventory was zero and theestimated salvage value of Plenaxis®-relatedequipment was $45,000.

During the three months ended June 30, 2006, we alsorecorded a charge of approximately $3.8 million related to commitments undercertain Plenaxis® manufacturing and supply agreements, which weconcluded will provide no future economic benefit to us, and other associatedcosts of approximately $0.1 million.  The$3.8 million charge represents the net present value of approximately $4.9million of the aggregate future cash commitments under these agreements. Weexpect to expense the balance of $1.1 million over the remaining respectiveterms of the applicable manufacturing and supply agreements, which range fromone to four years. We currently have an aggregate of approximately $9.2 millionin cash obligations under third-party Plenaxis® manufacturing and supply agreements,which become payable in varying annual amounts through 2010.

#### *AccumulatedDeficit*

Most of our expenditures to date have been for drugdevelopment, the development of our drug discovery technologies,commercialization activities related to Plenaxis® andfor general and administrative expenses. Our accumulated deficit as of September 30, 2006 was approximately$334.0 million.  We have incurred netoperating losses since fiscal 2000 and expect to continue to incur such lossesfor at least the next several years.

# **Critical Accounting Policies**

While our significant accounting policies are morefully described in Note 2 to our condensed consolidated financialstatements appearing elsewhere in this report, we believe the followingaccounting policies to be critical:

*Use of Estimates.*  We prepare our financial statements inaccordance with accounting principles generally accepted in the United States.These principles require that we make estimates and use assumptions that affectthe reporting of our assets and our liabilities as well as the disclosures thatwe make regarding assets and liabilities and revenues and expenses that are contingentupon uncertain factors as of the reporting date.  Such estimates relate to the useful lives offixed assets, the net realizable value of inventory, accrued restructuringexpenses, other accrued expenses, other reserves, and assumptions used invaluing stock-based compensation awards. Actual payments, and

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thus our actual results,could differ from our estimates and suchdifferences may be material to our condensed consolidated financial statements.

*Restructuring and Asset Impairment Expenses.*  On May 19, 2005, our board of directorsapproved a strategic restructuring to focus the Company’s resources on our mostpromising assets and programs and significantly reduce our cost structure.  The strategic restructuring includedvoluntarily discontinuing promotional activities related to Plenaxis® and the sale of Plenaxis® fornew patients in the United States; voluntarily suspending the ongoing clinicaldevelopment of ApanTM; and implementing a reduction of our 182-person headcountby approximately 60%. The restructuring charges were accounted for inaccordance with SFAS No. 146.  Indetermining the manufacturing commitments restructuring expense and inventoryimpairment, various assumptions were made with respect to future Plenaxis® sales. These assumptions will be reviewedperiodically and should these estimates change, adjustments to the net presentvalue of remaining commitments may be necessary in future periods.

On June 19, 2006, our board of directors determined tocease our previously announced process of actively seeking to dispose of ourPlenaxis® assets through a license or sale transaction.We voluntarily discontinued the limited sale and distribution of the product inthe United States as of August 31, 2006 and will not pursue further thecommercialization of Plenaxis® outside the United States. We are alsodiscontinuing any remaining Plenaxis®-relatedactivities, except as necessary to support the wind-down of productdistribution in the United States. During this wind-down, we are continuing toevaluate potential opportunities for our Plenaxis® assets to the extent such opportunities arise.Please refer to the discussion of *Impairment or Disposal ofLong-Lived Assets*appearing directly below, as well as Note 3 –Restructuring and Asset Impairment, included in our condensed consolidatedfinancial statements appearing elsewhere in this report, for additionalinformation regarding our strategic restructuring and the cessation of ourprocess of actively seeking to dispose of our Plenaxis® assets.

*Impairment or Disposal of Long-Lived Assets*.  SFAS No. 144 requires that if the sum of theundiscounted future cash flows expected to result from a company’s asset, netof interest charges, is less than the reported value of the asset, an assetimpairment may be recognized in the financial statements if the reported valueof the asset exceeds the fair value determined by either a quoted market price,if any, or a value determined by utilizing a discounted cash flowtechnique.  We evaluate our property,plant and equipment for impairment whenever indicators of impairment exist.  The amount of the impairment to be recognizedis calculated by subtracting the fair value of the asset from the reportedvalue of the asset.

We believe that the application of SFAS No. 144 andthe method used to determine the impairment of our property, plant andequipment involve critical accounting estimates because they are highlysusceptible to change from period to period and because they require managementto make assumptions about future cash flows, including residual values.  In addition, we believe that had alternativeassumptions been used, the impact on the assets reported on our balance sheet,as well as our net loss, may have been material.

*Stock-based Compensation. *Effective January 1, 2006,we adopted the fair value recognition provisions of Statement of FinancialAccounting Standards No. 123R, *Share-Based Payment – AnAmendment of FASB Statements No. 123 and 95,*or SFAS No. 123R.  SFAS No. 123R requires companies to measurecompensation cost for all share-based awards at fair value on the date of grantand recognize it as expense ratably over the requisite service period of theaward.  We use the Black-Scholes optionpricing model to calculate the fair value of share-based awards on the grantdate.  This option pricing model requiresthe input of highly subjective assumptions, including the term during which theawards are expected to be outstanding and the price volatility of theunderlying stock.  In addition, SFAS No.123R requires forfeitures, which represent only the unvested portion of asurrendered award, to be estimated at the time of the grant and revised, ifnecessary, in subsequent periods.  Pleaserefer to Note 2 – Summary of Significant Accounting Principles – Stock-BasedCompensation, included in the condensed consolidated financial statementsappearing elsewhere in this report, for additional information regarding ouradoption of SFAS No. 123R.

Management has discussed the development, selectionand disclosure of these critical accounting policies with the audit committeeof our board of directors.

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# **Results of Operations**

# **Three Months Ended September 30, 2006 Compared ToThree Months Ended September 30, 2005**

During the three months ended September 30, 2006,there were no revenues compared to revenues of approximately $2.1 million forthe corresponding period in 2005. Licensing and other revenues for the three months ended September 30,2005 included approximately $1.8 million representing the remaining deferredrevenue under a license, supply and distribution agreement which was terminatedin September 2005.  Revenues fromPlenaxis® sales for thethree months ended September 30, 2005 were approximately $0.3 million.  Thedecrease in revenues from Plenaxis® saleswas due to the voluntary discontinuation of promotional activities related toPlenaxis® and the sale of Plenaxis® fornew patients in the United States in May 2005 and ultimately the cessation ofall commercial distribution of the product as of August 31, 2006.  Due to our discontinuation of commercialdistribution, we will no longer have any revenues from Plenaxis® sales. Other sources of revenues during 2006 and thereafter may includepotential payments under our current or future partnerships relating to ourDirectSelectTM drug discovery technology, or future partnerships relating toPPI-2458, an S1P-1 agonist compound(s) or our other research programs ortechnologies, in each case if consummated. The amount and timing of these other potential sources of revenues willdepend on the success of our DirectSelectTM technology, our PPI-2458 clinicaldevelopment program and our S1P-1 research and development program, and ourability to enter into partnerships with respect to these and other programswhich provide cash to us.  We cannotassure investors as to if or when we will receive any such revenues.

Cost of goods sold for the three months endedSeptember 30, 2006 was approximately $45,000 compared to approximately $97,000for the corresponding period in 2005.  Weexpect cost of goods sold to be consistent with current levels for the remainderof 2006.

We currently have several ongoing research anddevelopment programs.  Using industryestimates, typical drug development programs may last for ten or more years andmay cost hundreds of millions of dollars to complete. As our programs progress,we assess the possibility of entering into partnerships or other arrangementsto offset a portion or all of our research and development costs. The ultimatesuccess of our research and development programs and the impact of theseprograms on our operations and financial results cannot be accurately predictedand will depend, in large part, upon the outcome and timing of many variablesoutside of our control.

Members of our research and development team typicallywork on a number of projects concurrently. In addition, a substantial amount ofour fixed costs such as facility and equipment depreciation, utilities andmaintenance are shared by our various programs. Accordingly, we have notspecifically identified, and do not plan to specifically identify, all costsrelated to each of our research and development programs.  During the three months ended September 30,2006 and 2005, the majority of our research and development expenses consistedof salaries, benefits, clinical trial costs, manufacturing costs and labsupplies related to the development of our DirectSelectTM technology, as well asour clinical development programs and other research programs.  In addition, research and developmentexpenses for the three months ended September 30, 2006 include stock-basedcompensation expense due to our adoption of SFAS No. 123R effective January 1,2006.

Researchand development expenses for the three months ended September 30, 2006increased 5% to approximately $5.6 million, from approximately $5.3 million forthe corresponding period in 2005.  Totalpersonnel-related research and development expenses for the three months endedSeptember 30, 2006 increased approximately $0.8 million due to our adoption ofSFAS No. 123R effective January 1, 2006. Stock-based compensation expense forthe three months ended September 30, 2006 was approximately $0.6 million.  The increase in personnel-related researchand development expenses was offset by reduced spending in our clinical andpreclinical development programs.  Due toour strategic restructuring, spending on the Plenaxis® and ApanTM programs during the three monthsended September 30, 2006 decreased by approximately $0.1 million and $0.5million, respectively, and spending on the PPI-2458 program increased byapproximately $0.4 million, in each case as compared to the correspondingperiod in 2005.  Other decreases inresearch and development expenses of approximately $0.4 million during thethree months ended September 30, 2006 include lower depreciation and equipmentmaintenance expense of approximately $0.3 million, which was due primarily tothe sale of our corporate headquarters and research facility in October2005.  Although we are unable to predictthe precise level of spending on individual research and development orclinical programs due to the uncertain nature of these activities, we expectour research and

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development expenses toincrease slightly during 2006 and thereafter, consisting principally ofexpenses related to DirectSelectTM as we seek to enter into pharmaceuticalpartnerships for drug discovery and development utilizing, or othertransactions with respect to, this technology, the continuing clinicaldevelopment of PPI-2458, and our other research and development programs,including our S1P-1 program.

There were no sales and marketing expenses for thethree months ended September 30, 2006, compared to sales and marketing expensesof approximately $0.2 million for the corresponding period in 2005.  The decrease resulted from the voluntarydiscontinuation of promotional activities related to Plenaxis® in the United States.  Beginning in 2004 through May 2005, wepromoted Plenaxis® in the United States through our own marketingand sales team.  In the future, we intendto partner products that may ultimately result from our discovery anddevelopment efforts at the appropriate time in an effort to maximize the valueof the product to the Company. Accordingly, we currently do not intend to independently market futureproducts and do not expect to incur significant sales and marketing expensesduring 2006 or thereafter.

General and administrative expenses were approximately$1.6 million for the three months ended September 30, 2006 compared toapproximately $1.5 million for the corresponding period in 2005.  Total personnel-related general and administrativeexpenses increased $0.4 million compared to the corresponding period in 2005due primarily to our adoption of SFAS No. 123R effective January 1, 2006.Stock-based compensation expense was approximately $0.2 million for the threemonths ended September 30, 2006.Theincrease in total personnel-related general and administrative expenses for thethree months ended September 30, 2006 was partially offset by reduced spendingof approximately $0.2 million for professional services and lower occupancycosts of approximately $0.1 million compared to the corresponding period in2005 due to the sale of our corporate headquarters and research facility inOctober 2005.  We expect that general and administrative expenses will remainconsistent with current levels for the remainder of 2006.

As described in more detail in Note 4 – Litigation,included in our condensed consolidated financial statements appearing elsewherein this report, in December 2004 and January 2005, the Company and certain ofits current and former executive officers were named as defendants in threepurported class action securities lawsuits filed in the United States DistrictCourt for the District of Massachusetts. The complaints were consolidated into one action in April 2005.  Management believes that the allegationsagainst the Company are without merit, and the Company intends to vigorouslydefend against the plaintiffs’ claims. As this litigation is in an early stage, management is unable to predictits outcome or its ultimate effect, if any, on our financial condition.  However, we expect that the costs andexpenses related to this litigation may be significant.  Our current director and officer liabilityinsurance policies (which, subject to the terms and conditions thereof, alsoprovide “entity coverage” for the Company for this litigation) provide that theCompany is responsible for the first $2.5 million of such costs andexpenses.  Also, a judgment in orsettlement of these actions could exceed our insurance coverage.  Accordingly, if we are not successful indefending these actions, our business and financial condition could beadversely affected.

Restructuring and asset impairment expenses for thethree months ended September 30, 2006 were $0.1 million.  There were no restructuring and assetimpairment expenses accrued during the three months ended September 30,2005.  Please refer to the discussionunder “Overview – 2005 Strategic Restructuring” and “Critical AccountingPolicies” in this Item 2, as well as Note 3 – Restructuring and AssetImpairment, included in our condensed consolidated financial statementsappearing elsewhere in this report, for additional information regarding theseexpenses.

Interest income for the three months ended September30, 2006 was approximately $0.6 million compared to net interest expense ofapproximately $0.1 million for the corresponding period in 2005. This changewas due primarily to the retirement of theoutstanding debt related to our corporate headquarters and research facility,which we sold in October 2005.

The provision for income taxes for the three monthsended September 30, 2006 and 2005 was zero. We anticipate that we will continue to be in a net operating losscarryforward position for the next several years.  Therefore, no tax benefit from our operatinglosses was recognized.

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For the three months endedSeptember 30, 2006, net loss was approximately $6.8 million, or $0.63 pershare, compared to a net loss of approximately $5.2 million, or $0.49 pershare, for the three months ended September 30, 2005.

# **Nine Months Ended September 30, 2006 Compared ToNine Months Ended September 30, 2005**

Revenues for the nine months ended September 30, 2006were approximately $0.2 million compared to approximately $3.4 million for thecorresponding period in 2005.  Licensingand other revenues for the nine months ended September 30, 2006 and 2005 wereapproximately $35,000 and $1.9 million, respectively.  Due to the termination of a license, supplyand distribution agreement in September 2005, we recognized approximately $1.8million in license and other revenues for the nine months ended September 30,2005, representing the remaining deferred revenue related to thisagreement.  Revenues from Plenaxis® sales for the nine months ended September 30,2006 decreased to $0.2 million compared to approximately $1.4 million for thecorresponding period in 2005.  The decrease in revenues from Plenaxis® saleswas due to the voluntary discontinuation of promotional activities related toPlenaxis® and the sale of Plenaxis® fornew patients in the United States in May 2005 and ultimately the cessation ofall commercial distribution of the product as of August 31, 2006.  Due to this discontinuation of commercialdistribution, we will no longer have any revenues from Plenaxis® sales.

Cost of goods sold for the nine months ended September30, 2006 was approximately $5.6 million compared to approximately $3.9 millionfor the corresponding period in 2005. During the nine months ended September 30, 2006, we recorded a charge of$3.8 million related to excess Plenaxis®-related manufacturing and supplycommitments and a non-cash impairment charge of approximately $1.7 millionrelated to inventory due to the cessation of our previously announced processto actively seek to license or sell our Plenaxis® assets, which charges were recorded in cost ofgoods sold.  During the nine months endedSeptember 30, 2005, we recorded a non-cash impairment charge of approximately$3.5 million related to inventory due to the discontinuation of promotionalactivities relating to Plenaxis® in the United States.

Research and development expenses for the nine monthsended September 30, 2006 decreased to approximately $18.2 million, fromapproximately $18.9 million for the corresponding period in 2005. Totalpersonnel-related research and development expenses for the nine months endedSeptember 30, 2006 increased approximately $1.1 million due to our adoption ofSFAS No. 123R effective January 1, 2006. Stock-based compensation expense ofapproximately $1.9 million for the nine months ended September 30, 2006 morethan offset lower personnel-related expenses resulting from our strategicrestructuring announced in May 2005.  Thedecrease in research and development expenses for the nine months ended September30, 2006 reflects reduced spending in our clinical and preclinical developmentprograms.  Due to our strategicrestructuring, spending on the Plenaxis® andApanTM programs during the nine months ended September 30, 2006 decreased,compared to the corresponding period in 2005, by approximately $0.8 million oneach program and spending on the PPI-2458 program increased by approximately$0.9 million.  The remaining decrease inresearch and development expenses during the nine months ended September 30,2006 reflects lower depreciation and equipment maintenance expense ofapproximately $1.5 million, which was due primarily to the sale of ourcorporate headquarters and research facility in October 2005, and lowerallocation of both corporate personnel and related expenses of approximately$0.3 million, offset by a net increase in third-party laboratory services andsupply expenses of approximately $0.7 million.

There were no sales and marketing expenses for thenine months ended September 30, 2006, compared to sales and marketing expensesof approximately $6.0 million for the corresponding period in 2005.  The decrease resulted from the voluntarydiscontinuation of promotional activities related to Plenaxis® in the United States.

General and administrative expenses were approximately$5.4 million for the nine months ended September 30, 2006 compared toapproximately $5.5 million for the corresponding period in 2005.  Total personnel-related general andadministrative expenses for the nine months ended September 30, 2006 increased$0.8 million compared to the corresponding period in 2005 due primarily to ouradoption of SFAS No. 123R, effective January 1, 2006, and increased recruitingcosts. Stock-based compensation expense was approximately $0.7 million for thenine months ended September 30, 2006.Theincrease in total personnel-related general and administrative expenses for thenine months ended September 30, 2006 was offset by reduced spending ofapproximately $0.2 million for professional services, lower depreciation andequipment maintenance expense of approximately $0.2 million and lower

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occupancy costs ofapproximately $0.4 million due to the sale of our corporate headquarters andresearch facility in October 2005.

Restructuring and asset impairment expenses for thenine months ended September 30, 2006 and 2005 were $1.7 million and $28.7million, respectively.  Please refer tothe discussion under “Overview – 2005 Strategic Restructuring” and “CriticalAccounting Policies” in this Item 2, as well as Note 3 – Restructuring andAsset Impairment, included in our condensed consolidated financial statementsappearing elsewhere in this report, for additional information regarding theseexpenses.

Interest income for the nine months ended September30, 2006 was approximately $1.8 million compared to net interest expense ofapproximately $0.3 million for the corresponding period in 2005. This changewas due primarily to the retirement of theoutstanding debt related to our corporate headquarters and research facility,which we sold in October 2005.

The provision for income taxes for the nine monthsended September 30, 2006 and 2005 was zero. We anticipate that we will continue to be in a net operating losscarryforward position for the next several years.  Therefore, no tax benefit from our operatinglosses was recognized.

For the nine months endedSeptember 30, 2006, net loss was approximately $28.9 million, or $2.73 pershare, compared to a net loss of approximately $59.9 million, or $5.71 pershare, for the nine months ended September 30, 2005.

# **Liquidity and Capital Resources**

To date, our operations and capital requirements havebeen financed primarily with the proceeds of public and private sales of commonstock and preferred stock, payments received under research and developmentpartnerships and collaborative agreements, investment income, revenues fromproduct sales and proceeds from the October 2005 sale of our corporateheadquarters and research facility.  Wehave no committed sources of capital and do not know whether additionalfinancing will be available when needed, or, if available, that the terms willbe favorable to us.

At September 30, 2006, we had cash and cashequivalents of approximately $40.4 million and working capital of approximately$32.0 million, compared to cash, cash equivalents and marketable securities ofapproximately $62.6 million and working capital of approximately $54.1 millionat December 31, 2005.

In May 2005, our board of directors approved astrategic restructuring to focus the Company’s resources on our most promisingassets and programs and significantly reduce our cost structure.  The strategic restructuring includedvoluntarily discontinuing promotional activities related to Plenaxis® and the sale of Plenaxis® fornew patients in the United States; voluntarily suspending the ongoing clinicaldevelopment of ApanTM; and implementing a headcount reduction of approximately60%.

We expect to continue to have net operating losses forthe next several years as a result of continued expenditures related to:DirectSelectTM, as we seek to enter into pharmaceutical partnerships for drugdiscovery and development utilizing, or other transactions with respect to,this technology; the continuing clinical development of PPI-2458; and otherresearch and development programs, including our S1P-1 program.  The key elements of our current strategicoperating plan include:  advancingPPI-2458 through a phase 1 trial in cancer patients, continuing preclinicalevaluation of the compound in inflammatory and autoimmune disorders, includingrheumatoid arthritis, and partnering this program in one or more indications asclinical development advances; entering into pharmaceutical partnerships fordrug discovery and development utilizing, or other transactions with respectto, our DirectSelectTM technology that would provide cash and/or cost reductionbenefits to us; and selecting one or more lead candidates from previouslyidentified S1P-1 agonist compounds and entering into a collaborativearrangement for the development and commercialization of such compound(s) onterms that include upfront, as well as milestone and other downstream, cashpayments.  Given the uncertainty oftiming related to the key elements of our strategic operating plan, we are notproviding earnings or cash guidance for quarterly or annual periods.

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We believe that our existing cash and investments ofapproximately $40.4 million at September 30, 2006 will be sufficient to meetour working capital and capital expenditure needs, at current levels, throughapproximately the end of 2007.  If we areable to successfully and in a timely manner carry out key elements of ourstrategic operating plan described in the immediately preceding paragraph, wemay have available resources to allow us to meet our operating needs beyond theend of 2007.  However, we cannot assureinvestors that we will be able to successfully and in a timely manner carry outkey elements of our current strategic operating plan.  If we are unable to successfully and in atimely manner carry out key elements of our current strategic operating plan,we will have to obtain additional funding in 2007 or significantly modify thatplan, including by curtailing, eliminating or disposing of certain elements ofour operations.  We have no committedsources of capital and do not know whether additional financing will beavailable when needed, or, if available, that the terms will be acceptable tous.  If we are required to raise money inthe future and we experience difficulties or are unable to do so, it couldbecome necessary for us to cease operations or seek protection under state orfederal insolvency or bankruptcy laws.

As previously disclosed, we are actively exploringstrategic options which may be available to the Company.  We have engaged an investment banking firm toadvise and assist us in this process.  Nodecision has been made as to whether we will engage in a strategic transaction,and there can be no assurance as to whether or when this process will result ina successful transaction.

For the nine months ended September 30, 2006, net cashof approximately $22.1 million was used in operating activities, compared toapproximately $33.8 million used in operating activities during the nine monthsended September 30, 2005. During the nine months ended September 30, 2006, ouruse of cash in operations was due principally to our net loss of approximately$28.9 million and the impact of non-cash charges such as restructuring andasset impairment charges of approximately $7.1 million, depreciation ofapproximately $0.9 million and stock-based compensation of approximately $2.6million, offset by non-cash gains of approximately $1.4 million related to theamortization of the deferred gain on the sale of our facility.  Our use of cash in operations for the ninemonths ended September 30, 2006 also includes a reduction of approximately $0.8million in accounts payable and accrued expenses.  In addition, we made cash payments ofapproximately $1.6 million associated with accrued restructuring charges duringthe nine months ended September 30, 2006. During the nine months ended September 30, 2005, our use of cash inoperations was due principally to our net loss of approximately $59.9 millionand the reduction in accounts payable and accrued expenses of approximately$3.8 million, offset by non-cash asset impairment expenses of approximately$23.2 million, an increase in accrued restructuring costs of approximately $6.4million, and depreciation of approximately $2.2 million.

Our cash utilization will continue for 2006 andthereafter as we continue to develop and advance our research and developmentinitiatives.  The actual amount ofoverall expenditures will depend on numerous factors, including the timing of expenses,the timing and terms of collaboration agreements or other strategic actions ortransactions, if any, the timing and progress of our research and developmentefforts, and the timing of potential costs and expenses associated with the defense of thepending purported class action securities lawsuit.

Net cash provided by investing activities ofapproximately $4.8 million for the nine months ended September 30, 2006consisted primarily of maturities of marketable securities of approximately$5.6 million offset by purchases of property and equipment of approximately$0.8 million.  This compares to net cash provided by investing activitiesof approximately $64.6 million for the corresponding period in 2005, which wasrelated primarily to net sales and maturities of marketable securities ofapproximately $65.8 million.

Our financing activities for the nine months endedSeptember 30, 2006 consisted of approximately $0.5 million in proceeds from theissuance of common stock in connection with a pilot study relating to theCompany’s DirectSelectTM drug discovery technology in the second quarter of 2006and approximately $0.1 million in proceeds from the issuance of common stockunder employee compensation plans.  Ourfinancing activities for the nine months ended September 30, 2005 consisted of$0.4 million in debt principal repayments offset by approximately $0.1 millionin proceeds from the issuance of common stock under employee compensationplans.

At December 31, 2005, we hadprovided a valuation allowance of approximately $133.5 million for our deferredtax assets. The valuation allowance represents the value of the deferred taxassets.  Due to anticipated operatinglosses in the future, we believe that it is more likely than not that we willnot realize the net deferred tax assets in the future and we have provided anappropriate valuation allowance.

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# **Recent Accounting Pronouncements**

In September 2006, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards No. 157, *Fair Value Measurement*, or SFAS No. 157, which defines fairvalue, establishes a framework for measuring fair value and expands disclosureson fair value measurements.  SFASNo. 157 applies to other accounting pronouncements that require or permitfair value measurements and is effective for fiscal years beginning afterNovember 15, 2007.  We are evaluatingSFAS 157 and have not yet determined the effect, if any, the adoption of thisstatement will have on our results of operations or financial position.

In September 2006, the Securitiesand Exchange Commission issued Staff Accounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*, or SAB No. 108.  Traditionally, there have been two commonapproaches used to accumulate and quantify the effects of financial statementmisstatements:  (1) the roll-overapproach which quantifies a misstatement based on the amount of error,including the reversing effect of prior year misstatements, originating in the currentyear income statement and (2) the iron-curtain approach which quantifies amisstatement based on the effects of correcting a misstatement existing in thecurrent period-end balance sheet, irrespective of when the misstatementoccurred.  SAB No. 108 states thatregistrants should use both approaches when quantifying and evaluating themateriality of a misstatement on current year financial statements.  SAB No. 108 is effective for fiscal yearsending after November 15, 2006.  We areevaluating SAB No. 108 and have not yet determined the effect, if any, thisguidance will have on our results of operations or financial position.

# **ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

The primary objective of our investment activities isto preserve principal while at the same time maximizing the income we receivefrom our investments without significantly increasing risk.  We have not entered into any instruments fortrading purposes.  Some of the securitiesthat we invest in may have market risk. This means that an increase in prevailinginterest rates may cause the principal amount of the investment to decrease. Tominimize this risk in the future, we maintain our portfolio of cash equivalentsand short-term investments in a variety of securities, including commercialpaper, money market funds and government and non-government debt securities. Asof September 30, 2006, we did not own any marketable securities.  As of December 31, 2005, we ownedapproximately $5.5 million of marketable securities with a weighted-averagematurity of approximately four months. An immediate hypothetical 100 basis point increase in interest rateswould have resulted in an approximate $5,000 decrease in the fair value of ourmarketable securities as of December 31, 2005. Due to the conservative nature of our investments and relatively shortduration, interest rate risk is mitigated.

# **ITEM 4.****     CONTROLSAND PROCEDURES.**

*(a)*       Disclosure Controls and Procedures.

The Company’s management, with the participation ofour chief executive officer and chief financial officer, has evaluated theeffectiveness of the Company’s disclosure controls and procedures (as definedin Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of September 30, 2006.  Based on such evaluation, our chief executiveofficer and chief financial officer have concluded that, as of September 30,2006, the Company’s disclosure controls and procedures were effective inensuring that information required to be disclosed by the Company in the reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in applicable rulesand forms of the Securities and Exchange Commission, and is accumulated andcommunicated to the Company’s management, including the Company’s chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

*(b)*       Changes inInternal Control Over Financial Reporting.

There have not been any changes in the Company’sinternal control over financial reporting (as such term is defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) during the three months endedSeptember 30, 2006 that have materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

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**PART II.  OTHER INFORMATION**

# **ITEM 1.  LEGALPROCEEDINGS.**

As previously disclosed, in December 2004 and January2005, the Company, Chairman and (now former) Chief Executive Officer MalcolmGefter, President and (now former) Chief Operating Officer Kevin F. McLaughlin,Chief Financial Officer and Treasurer Edward C. English, and former Presidentand Chief Operating Officer William K. Heiden, were named as defendants inthree purported class action securities lawsuits filed in the United StatesDistrict Court for the District of Massachusetts.  In April 2005, these actions wereconsolidated, and the Court appointed lead plaintiffs and approved suchplaintiffs’ selection of co-lead counsel. The consolidated actions are captioned IN RE PRAECIS PHARMACEUTICALS,INC. SECURITIES LITIGATION, Civil Action No. 04-12581-GAO.  InAugust 2005, lead plaintiffs filed a consolidated amended complaint.  The lead plaintiffs generally allegesecurities fraud during the period from November 25, 2003 through December 6,2004.  In September 2005, the Company and the individual defendants moved to dismiss the consolidated amendedcomplaint in its entirety.  In January2006, the Court heard oral argument on this motion and took the matter underadvisement.

There have been no material developmentswith respect to this litigation since the filing of our Quarterly Report onForm 10-Q for the three months ended June 30, 2006, which was filed with theSecurities and Exchange Commission on August 4, 2006.

# **ITEM 1A.               RISKFACTORS.**

*The risks and uncertaintiesdescribed below are not the only ones we face. Additional risks and uncertainties not presently known to us or that arecurrently deemed immaterial may also impair our business, financial conditionand results of operations.  If any ofthese risks actually occur, our business, financial condition and results ofoperations could be materially adversely affected.*

# **The outcome of our exploration of strategicoptions is uncertain and this process entails numerous risks and uncertainties.**

As previously disclosed, we are actively exploringstrategic options which may be available to the Company.  We have engaged an investment banking firm toadvise and assist us in this process.  Nodecision has been made as to whether we will engage in a strategic transactionas a result of our exploration of available alternatives, and there can be noassurance that any transaction will occur or, if a transaction does occur, theterms or timing thereof or the impact thereof on our operating results or stockprice.  The process of exploringstrategic options entails numerous risks and uncertainties, including thefollowing:

·                  the process is time-consuming and maydisrupt our operations and divert management’s attention;

·                  perceiveduncertainties as to our future direction may result in the loss of, or ourinability to attract, key employees or business partners;

·                  the process will increaseexpenditures for professional advisors to assist in reviewing and evaluatingpossible strategic alternatives which may be presented and advising our boardof directors and management with respect thereto; and

·                  we may not beable to identify in the near term a strategic transaction that our board ofdirectors determines is the best means reasonably available to achieve andenhance shareholder value, as compared to other alternatives available to theCompany.

If  we do notidentify and conclude in a timely manner a strategic transaction, orsuccessfully and in a timely manner carry out the key elements of our strategicoperating plan such that our capital resources are enhanced, we will need toconsider other alternatives for the Company. Such alternatives would likely include significantly modifying ourcurrent strategic operating plan, including by curtailing, eliminating ordisposing of certain elements of our operations.

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# **If we engage in a strategic transaction, we willincur a variety of costs and may never realize the anticipated benefits of sucha transaction.**

We have announced that we are actively exploringstrategic options which may be available to the Company.  If we identify and proceed with a businesscombination transaction, the process of integrating our business with anotherbusiness may result in unforeseen operating difficulties and expenditures andmay absorb significant management attention that would otherwise be availablefor the ongoing development of our business, which could diminish the value ofany interest that our stockholders may have in a combined or continuing companyresulting from such a transaction.  In additionto the risks associated with our business as it is currently constituted,reasons for the failure of any business combination transaction could includerisks associated with the other party’s business, including all the risksassociated with a development-stage biotechnology or biopharmaceuticalcompany.  Moreover, we may fail torealize the anticipated benefits of any transaction of this sort.  To the extent we issue stock in atransaction, the ownership interest of our stockholders will be diluted andsuch dilution could be substantial. Transactions of this kind could also cause us to incur debt, expose usto future liabilities and result in expenses related to goodwill and otherintangible assets.

# **If we lose our key personnel or are unable to attractand retain additional skilled personnel, we may be unable to enter intopharmaceutical partnerships for drug discovery and development utilizing, orother transactions with respect to, our drug discovery technology or mayexperience delays in our product research and development programs, and ourongoing process of exploring strategic options could be adversely affected.**

We depend substantially on the principal members ofour management and scientific staff, including but not limited to Kevin F.McLaughlin, our President and Chief Executive Officer, and Richard W. Wagner,Ph.D., our Executive Vice President, Discovery Research.  We do not have employment agreements with anyof our executive officers.  Any officeror employee can terminate his or her relationship with us at any time and workfor one of our competitors. The loss of these key individuals could result incompetitive harm because we could spend a significant amount of time andresources to replace them and could be unable, without their involvement andexpertise, to enter into pharmaceutical partnerships for drug discovery anddevelopment utilizing, or other transactions with respect to, our drugdiscovery technology or may experience delays in our product research anddevelopment programs.

Retaining our current employees and recruiting andretaining qualified personnel to perform future research and development workalso will be critical to our success. Competition for skilled personnel isintense and the turnover rate can be high. We compete with numerous companiesand academic and other research institutions for experienced scientists. Thiscompetition may limit our ability to recruit and retain qualified personnel onacceptable terms.  Moreover, due to ourstrategic restructuring in May 2005, our announcement in June 2006 of ourexploration of strategic options for the Company and our limited resourcescompared to many of our competitors, we may face additional challengesretaining our current employees, including, possibly, key members of ourmanagement and scientific staff, and recruiting qualified personnel in thefuture.  The failure of any key employeeto perform in his or her current position, or our inability to attract andretain qualified personnel, as needed, could result in our being unable tosuccessfully and in a timely manner carry out the key elements of our currentstrategic operating plan.  Such a failureor inability could also hinder or delay, or adversely affect the outcome of,our ongoing process of exploring strategic options. Depending on the outcome ofthis process, we may also incur significant costs relating to retention orseverance of employees.

# **We have a history of losses and we may not beprofitable in the future.**

We cannot assure investors that we will be profitablein the future or, if we attain profitability, that it will be sustainable.  In May 2005, our board of directors approveda strategic restructuring to focus the Company’s resources on our mostpromising assets and programs and significantly reduce our cost structure.

Todate, we have derived substantially all of our revenues from payments undercorporate collaboration and license agreements, and from product sales.  Our marketing and selling efforts with regardto Plenaxis® in the United States were not commerciallysuccessful and, as of August 31, 2006, we voluntarily discontinued the limitedsale and distribution of the product in the United States.  We have also ceased our previouslyannounced process to actively seek to license or sell our Plenaxis® assets.  We may be unable to successfully discover, develop ormarket any other

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products in the future.  In addition, we may be unable to successfully and in atimely manner carry out the key elements of our current strategic operatingplan which could require us to significantly modify that plan as describedbelow in the next succeeding risk factor. As of September 30, 2006, we had an accumulated deficit of approximately$334.0 million.  We expect that we willcontinue to incur significant operating losses for at least the next severalyears, and we may not be profitable in the future.

# **If we are unable to successfully and in a timelymanner carry out key elements of our current strategic operating plan, we willhave to obtain additional funding in 2007 or significantly modify our currentstrategic operating plan.**

If we are unable to successfully carry out keyelements of our current strategic operating plan described in Item 2 of thisreport in the first paragraph under “Overview,” we believe that our existingcash and investments of approximately $40.4 million at September 30, 2006 willbe sufficient to meet our working capital and capital expenditure needs, atcurrent levels, through approximately the end of 2007.  If we are able to successfully carry out keyelements of our current strategic operating plan, we may have availableresources to allow us to meet our operating needs beyond the end of 2007,although we cannot provide any assurances as to if or for how long we would beable to do so.  If we are unable tosuccessfully and in a timely manner carry out key elements of our currentstrategic operating plan, we will have to obtain additional funding in 2007 orsignificantly modify our current strategic operating plan, including bycurtailing, eliminating or disposing of certain elements of ouroperations.  We have no committed sourcesof capital and do not know whether additional financing will be available whenneeded, or, if available, that the terms will be acceptable to us.

Todate, our operations and capital requirements have been financed primarily withthe proceeds of public and private sales of common stock and preferred stock,payments under research and development partnerships and collaborativeagreements, investment income, revenues from product sales and the net proceedsfrom the sale of our facility.  However,there can be no assurance that we will be able to sell any securities, enterinto additional partnerships and collaborative agreements or borrow funds inthe future on favorable terms, or at all. If we raise additional funds by issuing equity securities, furtherdilution to existing stockholders will result, which could be substantial.  In addition, as a condition to investing inus, future investors may demand, and may be granted, rights superior to thoseof existing stockholders.  We may also berequired to take other actions, which may lessen the value of our common stockor dilute our common stockholders, including borrowing money on terms that arenot favorable to us.  If we are requiredto raise money in the future and we experience difficulties or are unable to doso, it could become necessary for us to cease operations or seek protectionunder state or federal insolvency or bankruptcy laws.

# **We may not be able to enter into pharmaceuticalpartnerships or other transactions with respect to our DirectSelectTM drugdiscovery technology and/or discover compounds that will provide cash and/orcost reduction benefits to us.**

A key element of our current strategic operating planis entering into pharmaceutical partnerships for drug discovery and developmentutilizing, or other transactions with respect to, our DirectSelectTM technologythat will provide cash and/or cost reduction benefits to us.  If we are unable to obtain and maintainadequate patent protection for our DirectSelectTM technology, another partycould offer drug discovery capabilities that directly compete with ourcapabilities or could attempt to block our ability to practice ourtechnology.  For example, there arepublished U.S. patent applications that disclose variations of certain aspectsof our DirectSelectTM technology. Furthermore, we cannot assure investors that this technology will allowus to offer significant advantages over traditional drug discovery methods orcompeting technologies.  For example, thefeasibility of creating and screening ultra-large advanced combinatorialchemistry libraries resulting in successful leads is still in the developmentstage.  Moreover, we may not be able toidentify novel compounds from the libraries that we create that can address abroad spectrum of targets or that can be rapidly taken into clinicaldevelopment and that ultimately lead to marketable products.  If we are not successful in identifyingproduct candidate(s) using this technology and in realizing cash or costreduction benefits through partnerships or other actions or transactions withrespect to this technology or such product candidate(s), we would likely needto significantly modify our current strategic operating plan to reduce overallcosts and expenses.

Giventhat forming partnerships with respect to our DirectSelectTM technology is a keyelement of our current strategic operating plan, we are also dependent upon theextent to which pharmaceutical and biotechnology companies

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continue to collaborate with outside companies toobtain drug discovery expertise.  Ourrevenue will depend, in part, on research and development expenditures bypharmaceutical and biotechnology companies, particularly companies outsourcingresearch and development projects and adding new and improved technologies toaccelerate their drug discovery and development initiatives.  Our capabilities include aspects of the drugdiscovery process that pharmaceutical companies have traditionally performedinternally.  Although there is a historyamong pharmaceutical and biotechnology companies of outsourcing drug researchand development functions, this practice may not continue.  Our ability to convince one or more of thesecompanies to use and pay for our drug discovery technology and capabilitiesrather than develop them internally will depend on many factors, including ourability to:

·                  rapidlyidentify using our DirectSelectTM technology high-quality drug candidates underour current pilot study agreements, potentially leading to broadercollaborations with the counter-parties to these agreements or with otherparties, and in connection with our internal drug discovery programs;

·                  identify and retain scientists anddiscover and utilize technology that are of the highest caliber; and

·                  achieve intendedresults in a timely fashion, with acceptable quality and cost.

We also face and will continue to face intensecompetition from other companies for such collaborative arrangements, andtechnological and other developments by our competitors may make it moredifficult for us to establish such relationships.  In addition, perceived uncertainties as toour future direction following our announcement in June 2006 regarding ourexploration of strategic options may make it more difficult for us to attractcollaborators.  If we are unable tocontinue to attract collaborators, we may never generate revenues from ourDirectSelectTM technology and would be forced to significantly modify ourcurrent strategic operating plan to reduce overall costs and expenses.

# **We may be unable to enter into and maintaincorporate collaborations necessary to support the continued clinicaldevelopment and potential commercialization of PPI-2458, or the development andcommercialization of other potential products in the future.**

We have announced our intention to partner ourPPI-2458 program in one or more indications as development advances.  In addition, our goal is to enter into acollaborative arrangement for the development and commercialization of S1P-1 agonistcompound(s) on terms that include upfront, as well as milestone and otherdownstream, cash payments.  We do notcurrently intend to independently market the products that may ultimatelyresult from our discovery and development efforts. We cannot assure investorsthat we will be able to enter into and maintain partnerships and corporatecollaborations in a timely manner and on favorable terms, if at all.  Moreover, perceived uncertainties as to ourfuture direction following our announcement in June 2006 regarding ourexploration of strategic options may make it more difficult for us to attractcollaborators.  Even if we are able toenter into such arrangements, we cannot assure our investors that our futurecollaborators will meet their obligations to us under our collaborationagreements.  If a partner terminates itsagreement with us or fails to perform its obligations, it may delay thediscovery and development of product candidates.  As a result, we could have to devoteunforeseen additional resources to drug discovery and development or be forcedto significantly modify our current strategic operating plan.

 

# **We are subject to extensive government regulationthat increases our costs and could prevent us from developing, and ultimatelycommercializing, potential products.**

The development and sale of pharmaceutical products,including PPI-2458, or other product candidates we may discover and seek todevelop, is subject to extensive regulation by governmental authorities.  Obtaining regulatory approval typically iscostly and takes many years; maintaining regulatory approval also requiressubstantial resources.  Regulatoryauthorities, most importantly, the FDA, have substantial discretion to place onclinical hold or terminate clinical trials, delay, withhold or withdrawregistration and marketing approval in the United States, and effectivelymandate product recalls. Failure to comply with regulatory requirements mayresult in criminal prosecution, civil penalties, recall or seizure of products,total or partial suspension of production or injunction. Outside the UnitedStates, we can market a product only if we receive marketing authorization fromthe appropriate regulatory authorities. This foreign regulatory approvalprocess includes all of the risks associated with the FDA approval process, andmay include additional risks.

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To gain regulatory approval from the FDA and foreignregulatory authorities for the commercial sale of any product, we mustdemonstrate in clinical trials, and satisfy the FDA and foreign regulatoryauthorities as to, the safety and efficacy of the product.  If we develop a product to treat a long-term,recurrent or terminal disease, such as cancer, we must gather data over anextended period of time. There are many risks associated with our clinicaltrials. For example, we may discover that the product we are testing is noteffective, despite positive results in preclinical studies.  While our compound, PPI-2458, has been shownto inhibit its target enzyme, MetAP-2, in preclinical and early clinicaltesting, we do not know if this will ultimately result in an effectivetreatment for cancer or any other disease. We also may be unable to achieve the same level of success in latertrials as we did in earlier ones. Additionally, data we obtain from preclinicaland clinical activities are susceptible to varying interpretations that couldimpede regulatory approval.  Furthermore,patients may experience adverse events while participating in a clinical trialthat are unrelated to our product, but that nevertheless may affect thestatistical analysis of the safety and efficacy of PPI-2458, potentially slowthe rate of subject accrual in this trial or otherwise adversely affect theclinical trial.  If we obtain regulatoryapproval for a product, the approval will be limited to those diseases forwhich our clinical trials demonstrate the product is safe and effective.

In addition, many factors could delay or result intermination of our ongoing or future clinical trials. For example, results fromongoing preclinical studies or analyses could raise concerns over the safety orefficacy of a product candidate.  InMarch 2004, the FDA placed our phase 1 clinical trial of PPI-2458 on clinicalhold due to non-clinical study findings with PPI-2458.  Although we subsequently received clearancefrom the FDA to resume clinical testing of PPI-2458 in June 2004, we cannotassure investors that the FDA will not place this or other clinical trials onhold in the future or that we will be able to resolve any such clinical hold ina timely manner, or at all.  A clinicaltrial may also experience slow patient enrollment.  A study could also be delayed due to lack ofsufficient drug supply.  Patients mayexperience adverse medical events or side effects, and there may be a real orperceived lack of effectiveness of, or of safety issues associated with, thedrug we are testing.  Future governmentalaction or existing or changes in FDA or foreign regulatory authority policiesor precedents, may also result in delays or rejection of an application formarketing approval.  The FDA, andcomparable foreign regulatory authorities, have considerable discretion indetermining whether to grant marketing approval for a drug, and may delay ordeny approval even in circumstances where the applicant’s clinical trials haveproceeded in compliance with established procedures and regulations and havemet the established end-points of the trials. Challenges to regulatorydeterminations are generally time-consuming and costly, and rarely, if ever,succeed.  We can give no assurance thatwe will obtain marketing approval for PPI-2458 or any other potential productcandidate.

Any regulatory approval may be conditioned uponsignificant labeling requirements and, as in the case of the FDA approval ofPlenaxis®,marketing restrictions and post-marketing study commitments.  Such labeling and marketing restrictionscould materially adversely affect the marketability and/or value of theproduct.

Even if regulatory approval is obtained for a product,the product and the manufacturing facilities for the product will be subject tocontinual review and periodic inspection by regulatory authorities.  Later discovery of previously unknownproblems with a product, manufacturer or facility may result in restrictions onthe product, the manufacturer or us, including withdrawal of the product fromthe market. The FDA and comparable foreign regulatory authorities stringentlyapply regulatory standards.  Ourmanufacturing facilities will also be subject to FDA or foreign regulatoryinspections for adherence to good manufacturing practices prior to marketingclearance and periodically during the manufacturing process.  Failure to comply can, among other things,result in fines, denial or withdrawal of regulatory approvals, product recallsor seizures, operating restrictions, injunctions and criminal prosecution.  If there are any modifications to a product,further regulatory approval will be required.

In addition, manufacturing, sales, promotion, andother activities following product approval are subject to regulation bynumerous regulatory authorities in addition to the FDA and comparableregulatory authorities outside the United States, including potentially theFederal Trade Commission, the Department of Justice and individual U.S.Attorney offices within the Department of Justice, CMS, other divisions of theDepartment of Health and Human Services, state and local governments andcomparable governmental authorities outside the United States.  Sales, marketing and scientific/educationalprograms must comply with the anti-kickback provisions of the Social SecurityAct, the False Claims Act, and similar state laws.  Pricing and rebate programs must comply withpricing and reimbursement rules, including the Medicaid rebate requirements ofthe Omnibus Budget Reconciliation Act of 1990 and the Veteran’s Health CareAct.  If products are made available toauthorized users of the Federal Supply Schedule of the General ServicesAdministration, additional laws and requirements apply.  All of our activities are

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potentially subject tofederal and state consumer protection and unfair competition laws andcomparable foreign laws.

Dependingon the circumstances, failure to meet these applicable legal and regulatoryrequirements can result in criminal prosecution, fines or other penalties,injunctions, recall or seizure of products, total or partial suspension ofproduction, denial or withdrawal of pre-marketing product approvals, private “quitam” actions brought by individual whistleblowers in the name of thegovernment, or refusal to allow us to enter into supply contracts, includinggovernment contracts.

# **Because we depend on third parties to conductlaboratory testing and human clinical studies and assist us with regulatorycompliance, we may encounter delays in our drug discovery and developmentefforts.**

We currently have contracts with a limited number ofresearch organizations to design and conduct our laboratory testing,preclinical evaluations and human clinical studies.  If we cannot contract for data analysis andtesting activities on acceptable terms, or at all, we may not complete our drugdiscovery and development efforts in a timely manner.  To the extent we rely on third parties forthese activities, we may lose some control over these activities.  For example, third parties may not completedata analysis and testing activities on schedule or when we request them to doso.  In addition, these third parties mayconduct these contracted tasks in a manner inconsistent with regulatoryrequirements or otherwise in a manner that yields misleading or unreliabledata.  This, or other failures of thesethird parties to carry out their duties, could result in significant additionalcosts and expenses and could delay or prevent our ability to effectivelyperform our responsibilities under existing or future third-party agreements orutilize our DirectSelectTM technology for internal programs, or further developPPI-2458, or other future product candidates, including S1P-1 agonist compound(s).

# **If we fail to develop and maintain ourrelationships with third-party manufacturers, or if these manufacturers fail toperform adequately, we may be unable to develop and commercialize PPI-2458 orany other future product candidate.**

Our ability to conduct large clinical trials for, orto commercialize, PPI-2458 or any future product candidate, including S1P-1 agonistcompound(s), will depend in part on our ability to manufacture, or arrange forthird-party manufacture of, PPI-2458 or any such future product on a largescale, at a competitive cost and in accordance with regulatoryrequirements.  We must establish andmaintain a commercial scale formulation and manufacturing process for each ofour potential products for which we seek marketing approval.  We or third-party manufacturers may encounterdifficulties with these processes at any time that could result in delays inclinical trials, regulatory submissions or in the commercialization ofpotential products.

We have no direct experience in large-scale productmanufacturing, nor do we have the resources or facilities to manufacture ourown products for use in humans. We currently rely on contract manufacturers forthe manufacture of PPI-2458, and expect to rely on contract manufacturers forthe foreseeable future for the manufacture of any other compounds forlater-stage preclinical, clinical and commercial purposes. Third-partymanufacturers may not be able to meet our needs as to timing, quantity orquality of materials. If we are unable to contract for a sufficient supply ofneeded materials on acceptable terms, or if we encounter delays or difficultiesin our relationships with manufacturers, our clinical trials may be delayed,thereby preventing or delaying the submission of product candidates for, or thegranting of, regulatory approval and the commercialization of our potentialproducts.  Any such delays may lower ourfuture revenues and delay or prevent our attaining or maintainingprofitability.

In addition, we and the third-party manufacturers thatwe use must continually adhere to current good manufacturing practicerequirements enforced by the FDA through its facilities quality programs.  Foreign regulatory authorities may alsoinspect our third-party manufacturers as a condition of obtaining andmaintaining the requisite approvals.  Incomplying with these requirements, we and any of our third-party manufacturerswill be obligated to expend time, money and effort in production,record-keeping and quality control to assure that our potential products meetapplicable specifications and other requirements.  If we or any of our third-party manufacturersfail to comply with these requirements, we may be subject to regulatorysanctions, manufacturing delays, or the facilities could be shut down.

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Any ofthese factors could prevent, or cause delays in, obtaining regulatory approvalsfor PPI-2458 or any other potential product, and the manufacturing, marketingor selling of PPI-2458 or any such other product, and could also result insignificantly higher operating expenses.

# **We may have substantial exposure to productliability claims and may not have adequate insurance to cover those claims.**

The administration of drugs to humans, whether inclinical trials or commercially, can result in product liability claims whetheror not the drugs are actually at fault for causing an injury.  Plenaxis®, PPI-2458, ApanTM or future productcandidates may cause, or may appear to have caused, adverse side effects(including death) or potentially dangerous drug interactions that we may notlearn about or understand fully until the drug has been administered topatients for some time.

Productliability claims can be expensive to defend and may result in large judgmentsor settlements against us, which could have a negative effect on our financialperformance. The costs of product liability insurance have increaseddramatically in recent years, and the availability of coverage hasdecreased.  Although we carry insurancethat we regard as reasonably adequate to protect us from potential claims,there can be no assurance that we will be able to maintain our current productliability insurance at a reasonable cost, or at all.  Our former collaboration agreements included,and some of the agreements regarding the termination of certain of thosecollaborations also include, an indemnification for liabilities associated withthe development and commercialization of Plenaxis®.  If a thirdparty, including a former collaborator, successfully sues us for any injury, orfor indemnification for losses, there is no guarantee that the amount of theclaim would not exceed the limit of our insurance coverage.  Even if a product liability claim is notsuccessful, the adverse publicity and time and expense of defending such aclaim may interfere with our business.

# **Many of our competitors have substantially greaterresources than we do and may be able to discover and develop product candidatesor technologies that make our potential products and technologies obsolete ornon-competitive.**

A biopharmaceutical company such as ours faces intensecompetition.  We face competition fromcompanies that are pursuing the same or similar technologies for drugdiscovery.  We also face significantcompetition from organizations that are pursuing drugs that would compete withthe product candidates we are now developing or may pursue in the future.  We may not be able to compete successfullyagainst these organizations, which include many large and well-financed andexperienced pharmaceutical and biotechnology companies, as well as academicinstitutions and government-based agencies. These entities may have greater financial resources and more experiencethan we do in developing and improving drug discovery technologies andidentifying and completing collaborations with respect thereto with interestedparties, and in discovering and developing drugs, obtaining regulatoryapprovals, manufacturing and marketing. In addition, academic, government and industry-based research isintense, resulting in considerable competition in obtaining qualified researchpersonnel, submitting patent filings for protection of intellectual propertyrights and establishing strategic corporate alliances.

Our investigational compound, PPI-2458, and any otherpotential products in research or development, including any S1P-1 agonistcompound(s) we may identify and seek to develop and commercialize through apartner, will face competition from other products.  Many companies are developing or marketproducts for the treatment of cancer, inflammation and autoimmunedisorders.  We are currently enrollingpatients with non-Hodgkin’s lymphoma and solid tumors in our phase 1 trial forPPI-2458.  We are competing with manyother companies that are conducting clinical trials in these indications.  We may not be able to accrue patients to ourtrial at the same pace as our competitors. Even if we are able to successfully complete our clinical trials ofPPI-2458 and gain regulatory approval to market the product, we will facecompetition from a broad range of therapeutics available for the treatment ofcancer.

We also expect to encounter competition from othercompanies with drug discovery technologies similar to our technologies.  For example, we are aware of competitors orpotential competitors that may be able to offer technologies that would competewith our DirectSelectTM technology andthere may also be other competitors of which we are not aware.  Moreover, if we are unable to obtain adequate patent protection for our DirectSelectTMtechnology, another company could offer drug discovery capabilities that directlycompete with our capabilities or

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couldattempt to block our ability to practice our technology.  Given that forming partnerships with respectto our DirectSelectTM technology is a key element of our current strategicoperating plan, we are also dependent upon the extent to which pharmaceuticaland biotechnology companies continue to collaborate with outside companies toobtain drug discovery expertise and our ability to establish and maintainpartnerships with such companies.  Wealso face and will continue to face intense competition from other companiesfor such collaborative arrangements, and technological and other developmentsby our competitors may make it more difficult for us to establish suchrelationships.

Thesuccess or continued success of our competitors in any of these efforts mayadversely affect our ability to further enhance and refine and partner onfavorable terms our DirectSelectTM technology, to develop, partner on favorableterms and commercialize PPI-2458 or other future product candidates, and toultimately attain and maintain profitability.

# **If we are unable to obtain and enforce validpatents, we could lose any competitive advantage we may have.**

Our success will depend in part on our ability toobtain patents and maintain adequate protection of our technologies andpotential products.  If we do notadequately protect our intellectual property, competitors may be able to useour technologies and erode any competitive advantage we may have. If we areunable to obtain adequate patent protection for our DirectSelectTM technology,another party could offer drug discovery capabilities that directly competewith our capabilities or could attempt to block our ability to practice ourtechnology.  For example, there arepublished U.S. patent applications that disclose variations of certain aspectsof our DirectSelectTM technology.  Someforeign countries lack rules and methods for defending intellectual propertyrights and do not protect proprietary rights to the same extent as the UnitedStates. Many companies have had difficulty protecting their proprietary rightsin certain foreign countries.

Patentpositions are sometimes uncertain and usually involve complex legal and factualquestions. We can protect our proprietary rights from unauthorized use by thirdparties only to the extent that our proprietary technologies are covered byvalid and enforceable patents or are effectively maintained as tradesecrets.  We currently own or haveexclusively licensed 36 issued United States patents and 118 granted foreignpatents.  We have applied, and willcontinue to apply, for patents covering both our technologies and products aswe deem appropriate. Others may challenge our patent applications or our patentapplications may not result in issued patents. Moreover, any issued patents onour own inventions, or those licensed from third parties, may not provide uswith adequate protection, or others may challenge the validity of, or seek tonarrow or circumvent, these patents. Third-party patents may impair or block our ability to conduct ourbusiness.  Additionally, third partiesmay independently develop products similar to our products, duplicate ourunpatented products, or design around any patented products we develop.

# **If we are unable to protect our trade secrets andproprietary information, we could lose any competitive advantage we may have.**

In addition to patents, we rely on a combination oftrade secrets, confidentiality, nondisclosure and other contractual provisions,and security measures to protect our confidential and proprietary information.These measures may not adequately protect our trade secrets or otherproprietary information.  If thesemeasures do not adequately protect our rights, third parties could use ourtechnology, and we could lose any competitive advantage we may have. Inaddition, others may independently develop similar proprietary information ortechniques, which could impair any competitive advantage we may have.

# **If our technologies, processes or productsconflict with the patents or other intellectual property rights of competitors,universities or others, we could have to engage in costly litigation and beunable to commercialize those products.**

Our technologies, processes, product or productcandidates may give rise to claims that they infringe patents or otherintellectual property rights of third parties. A third party could force us to pay damages, stop our use of thesetechnologies or processes, or stop our manufacturing or marketing of theaffected products by bringing a legal action against us for infringement. Inaddition, we could be required to obtain a license to continue to use thetechnologies or processes or to manufacture or market the affected products,and we may not be able to do so on acceptable terms or at all. We believe thatsignificant litigation will continue in our industry regarding patent and

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other intellectualproperty rights. If we become involved in litigation, it could consume asubstantial portion of our resources. Even if legal actions were meritless,defending a lawsuit could take significant time, be expensive and divertmanagement’s attention from other business concerns.

# **We are a defendant in purported class actionsecurities lawsuits regarding the adequacy of our public disclosure which couldhave a material adverse affect on our financial condition.**

As described in more detail in Note 4 – Litigation,included in our condensed consolidated financial statements appearing elsewherein this report, in December 2004 and January 2005, the Company, Chairman and(now former) Chief Executive Officer Malcolm Gefter, President and (now former)Chief Operating Officer Kevin F. McLaughlin, Chief Financial Officer andTreasurer Edward C. English, and former President and Chief Operating OfficerWilliam K. Heiden, were named as defendants in three purported class actionsecurities lawsuits filed in the United States District Court for the Districtof Massachusetts.  The complaints wereconsolidated into one action in April 2005. In August 2005, lead plaintiffs filed a consolidated amendedcomplaint.  The lead plaintiffs generallyallege securities fraud during the period from November 25, 2003 throughDecember 6, 2004.

Managementbelieves that the allegations against the Company are without merit, and the Companyintends to vigorously defend against the plaintiffs’ claims.  As this litigation is in an early stage,management is unable to predict its outcome or its ultimate effect, if any, onthe Company’s financial condition. However, we expect that the costs and expenses related to thislitigation may be significant.  Ourcurrent director and officer liability insurance policies (which, subject tothe terms and conditions thereof, also provide “entity coverage” for theCompany for this litigation) provide that the Company is responsible for thefirst $2.5 million of such costs and expenses. Also, a judgment in or settlement of these actions could exceed ourinsurance coverage.  Accordingly, if weare not successful in defending these actions, our business and financialcondition could be adversely affected. In addition, whether or not we are successful, the defense of theseactions may divert the attention of our management and other resources thatwould otherwise be engaged in running our business.

# **We use hazardous chemicals and radioactive andbiological materials in our business and any claims relating to the handling,storage or disposal of these materials could be time consuming and costly.**

Our research and development processes involve thecontrolled use of hazardous materials, including chemicals and radioactive andbiological materials, which may pose health risks. In addition, the healthrisks associated with accidental exposure to Plenaxis® include temporary impotence or infertility andharmful effects on pregnant women. Our operations also produce hazardous wasteproducts. We cannot completely eliminate the risk of accidental contaminationor discharge from hazardous materials and any resultant injury. Federal, stateand local laws and regulations govern the use, manufacture, storage, handlingand disposal of hazardous materials. Compliance with health and safety andenvironmental laws and regulations is necessary and expensive. Current orfuture health and safety and environmental regulations may impair our research,development or production efforts. We may be required to pay fines, penaltiesor damages in the event of noncompliance or the exposure of individuals tohazardous materials.

Fromtime to time, third-parties have also worked with hazardous materials inconnection with our agreements with them. We have agreed to indemnify ourpresent and former collaborators in some circumstances against damages andother liabilities arising out of development activities or products produced inconnection with these collaborations.

# **Changes in the securities laws and regulationshave increased, and are likely to continue to increase, our costs.**

The Sarbanes-Oxley Act of 2002, which became law inJuly 2002, has required changes in some of our corporate governance,securities disclosure and compliance practices. In response to the requirementsof that Act, the Securities and Exchange Commission and the NASDAQ Stock Markethave promulgated rules and listing standards covering a variety of subjects.Compliance with these rules and listing standards has increased our legalcosts, and significantly increased our financial and accounting costs, and weexpect these increased costs to continue. These developments may make it moredifficult and more expensive for us to obtain director and officer liabilityinsurance. Likewise, these developments may make it more difficult for us toattract and retain qualified members of our board of directors, particularlyindependent directors, or qualified executive officers.

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# **The market price of our common stock mayexperience extreme price and volume fluctuations.**

The market price of our common stock may fluctuatesubstantially due to a variety of factors, including, but not limited to:

·                  our announcementof a strategic transaction, the terms of such a transaction and itsimplications for our existing stockholders, or other announcement regarding theoutcome of our ongoing exploration of strategic options;

·                  our ability toenter into partnerships for our DirectSelectTM drug discovery technology, ourproduct candidate, PPI-2458, or our S1P-1 research and development program, andthe timing and terms of such partnerships;

·                  the success rateof our discovery efforts, particularly utilizing our DirectSelectTM drugdiscovery technology for both external and internal programs, and progress orsetbacks in our clinical trials;

·                  ourability to identify and complete, and our announcement of, a disposition of ourPlenaxis® assets;

·                  developments ordisputes concerning patents or proprietary rights, including claims ofinfringement, interference or litigation against us, our licensors or potentiallicensees;

·                   failure ordelay by third-party manufacturers in performing their supply obligations ordisputes or litigation regarding those obligations;

·                  announcementsof technological innovations or new products by us or our competitors;

·                  adverseoutcomes with respect to the pending purported shareholder class action againstus;

·                  announcementsconcerning our competitors, or the biotechnology or pharmaceutical industry ingeneral;

·                  changesin government regulation of the pharmaceutical or medical industry;

·                  actualor anticipated fluctuations in our operating results;

·                  changesin financial estimates or recommendations by securities analysts;

·                  salesof large blocks of our common stock;

·                  changesin accounting principles; and

·                  the loss of any of ourkey scientific or management personnel.

In addition, the stock market has experienced extremeprice and volume fluctuations. The market prices of the securities ofbiotechnology companies, particularly companies like ours with limited productrevenues and without earnings, have been highly volatile, and may continue tobe highly volatile in the future. This volatility has often been unrelated tothe operating performance of particular companies. In the past, securitiesclass action litigation has often been brought against companies thatexperience volatility in the market price of their securities.  We are currently a defendant in a purported classaction lawsuit.  Whether or notmeritorious, this or other litigation brought against us could result insubstantial costs and a diversion of management’s attention and resources.

# **We expect that our quarterly results of operationswill fluctuate, and this fluctuation could cause our stock price to decline.**

Our quarterly operating results have fluctuated in thepast and are likely to do so in the future. These fluctuations could cause ourstock price to decline.  Some of thefactors that could cause our operating results to fluctuate include:

·                  the timing ofpartnerships relating to our DirectSelectTM drug discovery technology, ourPPI-2458 program and our S1P-1 research and development program, resulting inrevenues; and

·                  the timing and level ofexpenses related to our other research and clinical development programs.

Due to the possibility of fluctuations in our revenuesand expenses, we believe that quarter-to-quarter comparisons of our operatingresults are not a good indication of our future performance.

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# **If we or our independent registered publicaccounting firm are unable to affirm the effectiveness of our internal controlover financial reporting in future years, the market value of our common stockcould be adversely affected.**

As directed by Section 404 of the Sarbanes-OxleyAct of 2002, the Securities and Exchange Commission adopted rules requiringmany public companies, including the Company, to include in their annualreports on Form 10-K a report of management, based on its assessment of thecompany’s internal control over financial reporting, as to the effectiveness ofsuch internal control as of the end of the most recent fiscal year.  In addition, under these rules, theindependent registered public accounting firm auditing the company’s financialstatements must audit and report on management’s assessment and on theeffectiveness of the company’s internal control over financial reporting as ofsuch fiscal year end.  Our managementreported, based on its assessment, that as of December 31, 2004 our internalcontrol over financial reporting was effective, and our independent registeredpublic accounting firm provided us with an unqualified report as to management’sassessment and the effectiveness of our internal control over financialreporting as of December 31, 2004.  Thesereports were included in our Annual Report on Form 10-K for the year endedDecember 31, 2004.  Since we are nolonger an “accelerated filer” under rules recently promulgated by theSecurities and Exchange Commission, we were not required to include in ourAnnual Report on Form 10-K for the year ended December 31, 2005, and will notbe required to include in our Annual Report on Form 10-K for the year endedDecember 31, 2006, such a report of management based on its assessment, or areport by our independent registered public accounting firm on management’sassessment and the effectiveness, of our internal control over financialreporting as of December 31, 2005. However, under the current transition rules, as proposed to be amended,we will be required to include such a report of management in our Annual Reportfor the year ended December 31, 2007, and both such a report of management and sucha report of our independent registered public accounting firm for the yearended December 31, 2008 and for subsequent years, and we cannot assureinvestors that management or our independent registered public accounting firmwill be able to provide such reports, or that such reports will be unqualified.  In this event, investors could loseconfidence in the reliability of our financial statements, which could resultin a decrease in the market value of our common stock.

# **Anti-takeover provisions in our charter andby-laws, our rights agreement and certain provisions of Delaware law may makean acquisition of us more difficult, even if an acquisition would be beneficialto our stockholders.**

Provisions in our certificate of incorporation andby-laws may delay or prevent an acquisition of us or a change in ourmanagement. Also, because we are incorporated in Delaware, we are governed bythe provisions of Section 203 of the Delaware General Corporation Law, whichmay prohibit or delay large stockholders, in particular those owning 15% ormore of our outstanding voting stock, from merging or combining with us. Inaddition, the rights issued under our rights agreement may be a substantialdeterrent to a person acquiring 10% or more of our common stock without theapproval of our board of directors. These provisions in our charter andby-laws, rights agreement and under Delaware law could reduce the price thatinvestors might be willing to pay for shares of our common stock in the futureand result in the market price being lower than it would be without theseprovisions.

# **ITEM 6.****     EXHIBITS.**

| Exhibit  Number | ** ** | **Exhibit**                                                                                                                                                                |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Amended and Restated Certificate of Incorporation  (1)                                                                                                                     |
| 3.2             |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (effecting reverse stock split)(4)                                                      |
| 3.3             |       | Third Amended and Restated By-Laws(3)                                                                                                                                      |
| 4.1             |       | Specimen certificate representing shares of common  stock (post-reverse stock split)(4)                                                                                    |
| 4.2             |       | Rights Agreement between the Registrant and American  Stock Transfer & Trust Company, as Rights Agent(2)                                                               |
| 4.3             |       | Form of Certificate of Designations of Series A  Junior Participating Preferred Stock (attached as Exhibit A to the Rights  Agreement identified as Exhibit 4.2 hereto)(2) |
| 4.4             |       | Form of Rights Certificate (attached as Exhibit B to  the Rights Agreement identified as Exhibit 4.2 hereto)(2)                                                            |

 

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| Exhibit  Number | ** ** | **Exhibit**                                                                                                                                         |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1            |       | Certification of Chief Executive Officer                                                                                                            |
| 31.2            |       | Certification of Chief Financial Officer                                                                                                            |
| 32.1            |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
| 32.2            |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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(1)                                  Incorporatedby reference to Quarterly Report on Form 10-Q for the quarter ended March 31,2000 filed with the Securities and Exchange Commission on June 7, 2000.

(2)                                  Incorporatedby reference to Registration Statement on Form 8-A filed with the Securitiesand Exchange Commission on January 26, 2001.

(3)                                  Incorporatedby reference to Annual Report on Form 10-K for the year ended December 31, 2002filed with the Securities and Exchange Commission on March 19, 2003.

(4)                                  Incorporated by reference to Quarterly Report onForm 10-Q for the quarter ended September 30, 2005 filed with theSecurities and Exchange Commission on November 4, 2005.

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**SIGNATURE**

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the Registranthas duly caused this report to be signed on its behalf by the undersignedhereunto duly authorized.
|                         | PRAECIS PHARMACEUTICALS INCORPORATED |
|-------------------------|--------------------------------------|
|                    |                                 |   |
| Date: November  9, 2006 | By                                   | /s/ Edward C. English |
|                    |                                 |  Edward C. English |
|                    |                                 |  Chief Financial Officer, Vice President, |
|                    |                                 |  Treasurer and Assistant Secretary |
| * *                | * *                             | *(Duly Authorized Officer and  Principal Financial  and Accounting Officer)* |

 

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# **EXHIBITINDEX**

| Exhibit  Number | ** ** | **Exhibit**                                                                                                                                                                 |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Amended and Restated Certificate of Incorporation  (1)                                                                                                                      |
| 3.2             |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (effecting reverse stock split) (4)                                                      |
| 3.3             |       | Third Amended and Restated By-Laws (3)                                                                                                                                      |
| 4.1             |       | Specimen certificate representing shares of common  stock (post-reverse stock split) (4)                                                                                    |
| 4.2             |       | Rights Agreement between the Registrant and American  Stock Transfer & Trust Company, as Rights Agent (2)                                                               |
| 4.3             |       | Form of Certificate of Designations of Series A  Junior Participating Preferred Stock (attached as Exhibit A to the Rights  Agreement identified as Exhibit 4.2 hereto) (2) |
| 4.4             |       | Form of Rights Certificate (attached as Exhibit B to  the Rights Agreement identified as Exhibit 4.2 hereto) (2)                                                            |
| 31.1            |       | Certification of Chief Executive Officer                                                                                                                                    |
| 31.2            |       | Certification of Chief Financial Officer                                                                                                                                    |
| 32.1            |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                         |
| 32.2            |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                         |

 

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(1)          Incorporated byreference to Quarterly Report on Form 10-Q for the quarter ended March 31, 2000filed with the Securities and Exchange Commission on June 7, 2000.

(2)          Incorporated byreference to Registration Statement on Form 8-A filed with the Securities andExchange Commission on January 26, 2001.

(3)          Incorporated byreference to Annual Report on Form 10-K for the year ended December 31, 2002filed with the Securities and Exchange Commission on March 19, 2003.

(4)          Incorporated by reference to Quarterly Report on Form 10-Q for thequarter ended September 30, 2005 filed with the Securities and ExchangeCommission on November 4, 2005.

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