Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 
| **x**      | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                   |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                |
| ** ** | **For  the quarterly period ended March 31, 2010.**                                                                                                                                  |
| ** ** | ** **                                                                                                                                                                                |
| **or**     |
| ** ** | ** **                                                                                                                                                                                |
| **o**      | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                  |
| ** ** | ** **                                                                                                                                                                                |
| ** ** | **For  the Transition Period  From              to            .** |

 

**Commission file number 001-33782**

 

----

 

**ARYxTHERAPEUTICS, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                  | ** ** | **77-0456039**                      |
|---------------------------------------------------------------|------------|-------------------------------------|
| (State or Other Jurisdiction ofIncorporation or Organization) |       | (I.R.S. EmployerIdentification No.) |

 

**6300 Dumbarton Circle, Fremont,California 94555**

(Address ofPrincipal Executive Offices including zip code)

 

**(510) 585-2200**

(Registrant’sTelephone Number, Including Area Code)

 

----

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x  No o

 

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

 

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

 

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).    Yes  o    No  x

 

As of April 30,2010, the registrant had 33,461,975 shares of common stock outstanding.

 

 

 

----

Table of Contents

 

**ARYx THERAPEUTICS, INC.**

 

**FORM 10-Q FOR THE QUARTER ENDED MARCH 31,2010**

 

**INDEX**

** **
| ** **                                                                                                | ** **                                                                                  | **Page**   |
|-----------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|------------|
| **PART I —  FINANCIAL INFORMATION**                                                             |
| ** **                                                                                                | ** **                                                                                  | ** ** |
| Item 1.                                                                                                   | Condensed Consolidated  Financial Statements (Unaudited)                                    |       |
| Condensed Consolidated  Balance Sheets as of March 31, 2010 and December 31, 2009               | 2                                                                                           |
| Condensed  Consolidated Statements of Operations for the three months ended March 31,  2010 and 2009 | 3                                                                                           |
| Condensed Consolidated  Statements of Cash Flow for the three months ended March 31, 2010 and  2009  | 4                                                                                           |
| Notes to Condensed Consolidated Financial Statements                                                      | 5                                                                                           |
| Item 2.                                                                                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 12         |
| Item 3.                                                                                                   | Quantitative  and Qualitative Disclosures About Market Risk                                 | 21         |
| Item 4T.                                                                                                  | Controls and  Procedures                                                                    | 21         |
|                                                                                                      |                                                                                        |       |
| **PART II  — OTHER INFORMATION**                                                                |
| Item 1.                                                                                                   | Legal Proceedings                                                                           | 22         |
| Item 1A.                                                                                                  | Risk Factors                                                                                | 22         |
| Item 2.                                                                                                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 43         |
| Item 3.                                                                                                   | Defaults  Upon Senior Securities                                                            | 44         |
| Item 4.                                                                                                   | (Removed and  Reserved)                                                                     | 44         |
| Item 5.                                                                                                   | Other Information                                                                           | 45         |
| Item 6.                                                                                                   | Exhibits                                                                                    | 45         |
|                                                                                                      |                                                                                        |       |
| SIGNATURE                                                                                                 | 46                                                                                          |

 

1

----

Table of Contents

 

**PART I— FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSED FINANCIAL STATEMENTS**

 

**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands)**

 
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2010**           | ** ** | **2009**              | ** ** |
| ** **                                       | ** ** | **(unaudited)**    | ** ** | **(Note 1)**          | ** ** |
| **ASSETS**                                       |       |               |       |                  |       |
| Current  assets:                                 |       |               |       |                  |       |
| Cash  and cash equivalents                       |       | $                  | 6,297      |                  | $          | 7,409 |   |
| Marketable  securities                           |       | —             |       | 353                   |       |
| Restricted  cash - current                       |       | 150                |       | 150                   |       |
| Prepaid  research and development expenses       |       | 201                |       | 220                   |       |
| Other  prepaid, receivable, and current assets   |       | 621                |       | 675                   |       |
| Total  current assets                            |       | 7,269              |       | 8,807                 |       |
| Restricted  cash                                 |       | 1,003              |       | 1,003                 |       |
| Property  and equipment, net                     |       | 2,006              |       | 2,258                 |       |
| Other  assets                                    |       | 297                |       | 338                   |       |
| **Total assets**                                 |       | $                  | 10,575     |                  | $          | 12,406 |   |
|                                             |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |               |       |                  |       |
| Current  liabilities:                            |       |               |       |                  |       |
| Accounts  payable                                |       | $                  | 197        |                  | $          | 685 |   |
| Accrued  compensation                            |       | 245                |       | 893                   |       |
| Accrued  research and development expenses       |       | 224                |       | 70                    |       |
| Current  portion of notes payable                |       | 4,102              |       | 4,850                 |       |
| Current  portion of interest payable             |       | 1,329              |       | 1,257                 |       |
| Other  accrued liabilities                       |       | 1,148              |       | 926                   |       |
| Total  current liabilities                       |       | 7,245              |       | 8,681                 |       |
| Deferred  lease credit                           |       | 954                |       | 1,053                 |       |
| Notes  payable                                   |       | 4,436              |       | 5,283                 |       |
| Interest  payable                                |       | 344                |       | 305                   |       |
| Commitments  and contingencies                   |       |               |       |                  |       |
| Stockholders’  equity (deficit):            |       |               |       |                  |       |
| Common  stock                                    |       | 34                 |       | 28                    |       |
| Additional  paid-in capital                      |       | 191,061            |       | 184,165               |       |
| Accumulated  deficit                             |       | (193,499           | )          | (187,109              | )          |
| Total  stockholders’ equity (deficit)       |       | (2,404             | )          | (2,916                | )          |
| Total  liabilities and stockholders’ equity |       | $                  | 10,575     |                  | $          | 12,406 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

2

----

Table of Contents

 

**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(In thousands, except per shareamounts)**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                    | ** ** | **March 31,**             | ** ** | **March 31,** | ** ** |
| ** **                                                                    | ** ** | **2010**                       | ** ** | **2009** | ** ** |
| ** **                                                                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Revenue                                                                       |       | $                              | —     |   | $ | — |   |
|                                                                          |       |                           |       |   |   |
| Costs  and expenses:                                                          |       |                           |       |   |   |
| Research  and development                                                     |       | 2,242                          |       | 6,789 |   |
| Selling,  general and administrative                                          |       | 3,777                          |       | 2,603 |   |
| Total  costs and expenses                                                     |       | 6,019                          |       | 9,392 |   |
| Loss  from operations                                                         |       | (6,019                         | )          | (9,392 | ) |
|                                                                          |       |                           |       |   |   |
| Interest  and other income, net                                               |       | 63                             |       | 54 |   |
| Interest  expense                                                             |       | (434                           | )          | (500 | ) |
| Net  loss                                                                     |       | (6,390                         | )          | (9,838 | ) |
|                                                                          |       |                           |       |   |   |
| Basic  and diluted net loss per share                                         |       | $                              | (0.22      | ) | $ | (0.36 | ) |
| Weighted  average shares used to compute basic and diluted net loss per share |       | 29,349                         |       | 27,345 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

3

----

Table of Contents

 

**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOW**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **For the three months ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**             | ** ** | **March 31,** | ** ** |
| ** **                                                                   | ** ** | **2010**                       | ** ** | **2009** | ** ** |
| **Cash flows from operating activities:**                                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net  loss                                                                    |       | $                              | (6,390     | ) | $ | (9,838 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                           |       |   |   |
| Depreciation  and amortization                                               |       | 251                            |       | 293 |   |
| Amortization  of warrants                                                    |       | 55                             |       | 55 |   |
| Gain  or loss on marketable securities                                       |       | (17                            | )          | 11 |   |
| Stock-based  compensation                                                    |       | (118                           | )          | 528 |   |
| Stock-based  severance                                                       |       | 595                            |       | — |   |
| Change  in assets and liabilities:                                           |       |                           |       |   |   |
| Prepaid  research and development expenses                                   |       | 19                             |       | (136 | ) |
| Other  prepaid, receivables, and current assets                              |       | 41                             |       | 68 |   |
| Accounts  payable and other accrued liabilities                              |       | (365                           | )          | (1,462 | ) |
| Accrued  compensation                                                        |       | (648                           | )          | 91 |   |
| Accrued  research and development expenses                                   |       | 154                            |       | (1,295 | ) |
| Net  cash used in operating activities                                       |       | (6,423                         | )          | (11,685 | ) |
|                                                                         |       |                           |       |   |   |
| **Cash flows from investing activities:**                                    |       |                           |       |   |   |
| Purchases  of marketable securities                                          |       | —                         |       | (4,665 | ) |
| Proceeds  from sales of marketable securities                                |       | 370                            |       | — |   |
| Proceeds  from maturities of marketable securities                           |       | —                         |       | 3,000 |   |
| Purchases  of fixed assets                                                   |       | —                         |       | (77 | ) |
| Net  cash (used in) provided by investing activities                         |       | 370                            |       | (1,742 | ) |
|                                                                         |       |                           |       |   |   |
| **Cash flows from financing activities:**                                    |       |                           |       |   |   |
| Proceeds  from exercise of stock options and issuance of common stock        |       | 1                              |       | 34 |   |
| Issuance  of equity, net of issuance cost                                    |       | 6,424                          |       | (92 | ) |
| Principal  payments on notes payable                                         |       | (1,484                         | )          | (81 | ) |
| Net  cash provided by (used in) financing activities                         |       | 4,941                          |       | (139 | ) |
|                                                                         |       |                           |       |   |   |
| **Net decrease in cash and cash equivalents**                                |       | (1,112                         | )          | (13,566 | ) |
| Cash  and cash equivalents at beginning of period                            |       | 7,409                          |       | 35,999 |   |
| **Cash and cash equivalents at end of period**                               |       | $                              | 6,297      |   | $ | 22,433 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

4

----

Table ofContents

 

**ARYx THERAPEUTICS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

In this report, “ARYx,”“we,” “us” and “our” refer to ARYx Therapeutics, Inc. “Common Stock”refers to ARYx’s common stock, par value $0.001 per share.

 

**1.  Organization and Summary of SignificantAccounting Policies**

 

***TheCompany***

 

We are a biopharmaceutical company focused on developing a portfolio ofinternally discovered product candidates designed to eliminate known safetyissues associated with well-established, commercially successful drugs. We useour RetroMetabolic Drug Design technology to design structurally uniquemolecules that retain the efficacy of these original drugs but are metabolizedthrough a potentially safer pathway to avoid specific adverse side effectsassociated with these compounds. Our product candidate portfolio includes anoral anticoagulant, tecarfarin (ATI-5923), designed to have the same therapeuticbenefits as warfarin, currently in Phase 2/3 clinical development for thetreatment of patients who are at risk for the formation of dangerous bloodclots; an oral antiarrhythmic agent, budiodarone (ATI-2042), designed to havethe efficacy of amiodarone in Phase 2 clinical development for thetreatment of atrial fibrillation, a form of irregular heartbeat; an oralprokinetic agent, ATI-7505, designed to have the same therapeutic benefits ascisapride in Phase 2 clinical development for the treatment of chronicconstipation, gastroparesis, functional dyspepsia, irritable bowel syndromewith constipation, and gastroesophageal reflux disease; and a novel,next-generation atypical antipsychotic agent, ATI-9242, currently inPhase 1 clinical development for the treatment of schizophrenia and otherpsychiatric disorders. Additionally, we have several product candidates inpreclinical development. Each of our product candidates is an orally available,patentable new chemical entity designed to address similar indications as thoseof the original drug upon which each is based. Our product candidates targetwhat we believe to be multi-billion dollar market opportunities.

 

We were incorporated in the State of California on February 28,1997 and reincorporated in the State of Delaware on August 29, 2007. Wemaintain a wholly owned subsidiary, ARYx Therapeutics Limited, with registeredoffices in the United Kingdom, which has had no operations since its inceptionin September 2004 and was established only to serve as a legal entity asrequired in support of our clinical trial activities conducted in Europe. Wecurrently are focused on the human drug development business and operate in asingle business segment with regard to the development of human pharmaceuticalproducts.

 

In February 2010, we retained Cowen and Company, or Cowen, toexplore and recommend strategic alternatives for the Company going forward.Concurrently, we restructured our operations in order to conserve resources andsupport the process of reviewing strategic alternatives. This followed aninitial reduction in our workforce headcount in October 2009. Throughthese two restructuring steps, our headcount was reduced from 73 to 17employees. We took these steps since we have three compounds at proof-of-conceptstage but do not have sufficient cash resources to develop these productcandidates further or to complete licensing agreements in a timely manner witha high level of certainty. Cowen is expected to present alternatives formaximizing the value of our assets in the near-term. Those alternatives couldinclude partnerships on one or more of our product candidates, or the sale ofour assets, in whole or in part, or some similar arrangement through which thevalue of our assets to stockholders could be optimized. Our operations haveconsumed a substantial amount of cash since inception and we expect to continueto incur net losses for the foreseeable future. Our ability to continueoperations will be dependent on our ability to obtain additional funding. Wemay seek to raise necessary additional funds through public or private equity,debt financings, collaborative arrangements with corporate partners or othersources. For instance, our most recent source of funding has been throughutilization of the Commerce Court equity line facility. However, as of March 26,2010, we had issued the maximum amount of common stock available under thefacility and therefore will no longer be able to utilize the facility. We willlikely seek additional sources of funding to allow us to continue ouroperations as we explore strategic options available to us.

 

***Basisof Presentation***

 

The accompanyingunaudited condensed consolidated financial statements include the accounts ofour wholly-owned subsidiary, ARYx Therapeutics, Ltd. All intercompanyaccounts and transactions have been eliminated. These unaudited condensedconsolidated financial statements have been prepared in accordance with U.S.generally accepted accounting principles, or GAAP, for interim financialinformation on the same basis as the annual financial statements and withinstructions to Form 10-Q and Rule 10-01 of Regulation S-X.Accordingly, they do not include all of the information 

 

5

----

Table ofContents

 

and footnotes required bygenerally accepted accounting principles for complete financial statements.These interim financial statements include all adjustments (consisting only ofnormal recurring adjustments) that management believes are necessary for thefair presentation of the balances and results for the periods presented.Interim financial results are not necessarily indicative of results to beexpected for the full fiscal year or any future interim period.

 

The balance sheetdata at December 31, 2009 has been derived from our audited consolidatedfinancial statements for the year ended December 31, 2009, contained inour Annual Report on Form 10-K. The unaudited condensed consolidatedfinancial statements and related disclosures contained in this report have beenprepared with the presumption that users of the interim financial statementshave read or have access to our audited financial statements for the precedingyear. Accordingly, these interim financial statements should be read inconjunction with our audited financial statements and notes thereto for theyear ended December 31, 2009, contained in our Annual Report on Form 10-K.

 

***Risks andUncertainties***

 

As of March 31,2010, we had cash, cash equivalents and marketable securities on hand in theamount of $6.3 million, current payables and accrued liabilities of approximately $1.8 millionand approximately $5.4 million in current notes and interest payable. As of March 31, 2010, we hadoutstanding non-current liabilities of $5.7 million. Since our inception, we haveincurred significant net operating losses and, as of March 31, 2010, wehad an accumulated deficit of $193.5 million. We have generated no revenuefrom product sales to date and we have funded operations principally from thesale of our convertible preferred and common stock and payments received underour collaboration agreements. We have not achieved sustainable profitabilityand anticipate that we will continue to incur significant net losses for theforeseeable future. There can be no assurances that we will achieve positivecash flow in the foreseeable future or at all. Additionally, we do not anticipate that our cash on hand asof March 31, 2010 will be sufficient to fund our operations through December 31,2010. These factors raise substantial doubt about our ability to continue asa going concern. Management’s plans as to these matters are described above.These financial statements do not include any adjustments that might resultfrom the outcome of this uncertainty.

 

We have no products that have received regulatory approval. Anyproducts we develop will require approval from the U.S. Food and DrugAdministration or foreign regulatory agencies prior to commercial sales. Therecan be no assurance that our products will receive the necessary approvals. Ifwe are denied such approvals or such approvals are delayed, it could have amaterial adverse effect to our operations. To achieve profitable operations, wemust successfully develop, test, manufacture and market products. There can beno assurance that any such products can be developed successfully ormanufactured at an acceptable cost and with appropriate performancecharacteristics, or that such products will be successfully marketed. Thesefactors could have a material adverse effect on our future financial results.

 

Financial instruments that potentially subject us to a concentration ofcredit risk consist of cash, cash equivalents and marketable securities. Wedeposit excess cash and cash equivalents with multiple financial institutionsin the United States. Deposits in these financial institutions may exceed theamount of insurance provided on such deposits. We have not experienced anylosses on our deposits of cash and cash equivalents.

 

***Useof Estimates***

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make judgments,assumptions and estimates that affect the reported amounts in the consolidatedfinancial statements and accompanying notes. On an ongoing basis, we evaluateour critical accounting policies and estimates, including those related toclinical trial accruals and stock-based compensation. Management bases itsestimates on historical experience and on assumptions believed to be reasonableunder the circumstances. Actual results could differ from those estimates.

 

***ComprehensiveLoss***

 

Comprehensive loss is comprised of net loss and other comprehensiveincome/loss. The only component of our other comprehensive income/loss is theunrealized gains and losses on our marketable securities. Comprehensive lossfor the three months ended March 31, 2010 and 2009 was $6.4 millionand $9.9 million, respectively.

 

***NetLoss Per Share***

 

Basic net loss per share is computed by dividing net loss by theweighted average number of fully vested common shares outstanding during theperiod. Diluted net loss per share is computed by giving effect to allpotential dilutive common shares, including stock options and warrants. For allperiods presented in this report, stock options and warrants were not includedin the computation of diluted net loss per share because the inclusion wouldprovide an antidilutive effect.

 

6

----

Table of Contents

 

The following table presents the calculation of basic and diluted netloss per share:

 
| ** **                                                                      | ** ** | **Three Months Ended March 31,**       | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **2010**                                    | ** ** | **2009** | ** ** |
| ** **                                                                      | ** ** | **(in thousands, except per share amount)** | ** ** |
| *Numerator:*                                                                    |       |                                        |       |   |   |
| Net loss                                                                        |       | $                                           | (6,390     | ) | $ | (9,838 | ) |
| *Denominator:*                                                                  |       |                                        |       |   |   |
| Weighted average common shares outstanding                                      |       | 29,357                                      |       | 27,359 |   |
| Less: Weighted average unvested restricted common  shares                       |       | (8                                          | )          | (14 | ) |
| Weighted average shares used in computing basic  and diluted net loss per share |       | 29,349                                      |       | 27,345 |   |
| Basic and diluted net loss per share                                            |       | $                                           | (0.22      | ) | $ | (0.36 | ) |

 

***IncomeTaxes***

 

We use the asset andliability method of accounting for income taxes in accordance with ASCTopic 740, *Income Taxes*.Deferred tax assets and liabilities are determined based on differences betweenfinancial reporting and the tax basis of assets and liabilities and aremeasured using enacted tax rates and laws that will be in effect when thedifferences are expected to reverse. A valuation allowance is provided when itis more likely than not that some portion or all of a deferred tax asset willnot be realized.

 

Aspermitted under the provisions of ASC Topic 740, we will classify interestand penalties related to unrecognized tax benefits as part of our income taxprovision, although there have been no such interest or penalties recognizedto-date.

 

***RecentAccounting Pronouncements***

 

In January 2010, the FASB issued ASU No. 2010-06, whichrevised guidance intended to improve disclosures related to fair valuemeasurements. This guidance requires new disclosures as well as clarifiescertain existing disclosure requirements. New disclosures under this guidancerequire separate information about significant transfers in and out of Level 1and Level 2 and the reason for such transfers, and also require purchases,sales, issuances, and settlements information for Level 3 measurement to beincluded in the rollforward of activity on a gross basis. ASU No. 2010-06also clarifies the requirement to determine the level of disaggregation forfair value measurement disclosures and the requirement to disclose valuationtechniques and inputs used for both recurring and nonrecurring fair valuemeasurements in either Level 2 or Level 3. The new disclosures andclarifications of existing disclosures are effective for interim and annualreporting periods beginning after December 15, 2009, except for thedisclosures about purchases, sales, issuances, and settlements in the rollforward activity in Level 3 fair value measurements.  Those disclosures are effective for fiscalyears beginning December 15, 2010, and for the interim periods withinthose fiscal years.  We do not expectadoption of this pronouncement to have a material impact to our financialstatements.

 

**2. Fair Value Measurement**

 

The following tables summarize the fair value of our financial assetsas of March 31, 2010 and December 31, 2009 that were recorded at fairvalue on a recurring basis consistent with the fair value hierarchy provisions of ASC 820.

 
| ** **                                           | ** ** | ** **                 | ** ** | **March 31, 2010**                                                                        | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Total  Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** |
| ** **                                           | ** ** | ** **                 | ** ** | **(in thousands)**                                                                             | ** ** | ** ** | ** ** |
| **Financial Assets Held:**                           |       |                       |       |                                                                                                |       |   |   |   |   |
| Money market funds                                   |       | $                          | 6,100      |                                                                                                | $          | — |   | $ | 6,100 |   | $ | — |   |
| Certificate of deposit                               |       | 150                        |       | 150                                                                                                 |       | — |   | — |   |
| Auction rate securities:                             |       |                       |       |                                                                                                |       |   |   |   |   |
| Beginning balance as of January 1, 2009         |       | 353                        |       | —                                                                                              |       | — |   | 353 |   |
| Purchases                                            |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Sales and maturities                                 |       | (370                       | )          | —                                                                                              |       | — |   | (370 | ) |
| Transfers in (out) of Level 2 and  Level 3 |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Gain on sale of marketable securities                |       | 17                         |       | —                                                                                              |       | — |   | 17 |   |
| Ending balance as of December 31, 2009          |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Total                                                |       | $                          | 6,250      |                                                                                                | $          | 150 |   | $ | 6,100 |   | $ | — |   |

 

7

----

Table of Contents

 
| ** **                                           | ** ** | ** **                 | ** ** | **December 31, 2009**                                                                     | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Total  Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** |
| ** **                                           | ** ** | ** **                 | ** ** | **(in thousands)**                                                                             | ** ** | ** ** | ** ** |
| **Financial Assets Held:**                           |       |                       |       |                                                                                                |       |   |   |   |   |
| Money market funds                                   |       | $                          | 7,192      |                                                                                                | $          | — |   | $ | 7,192 |   | $ | — |   |
| Certificate of deposit                               |       | 150                        |       | 150                                                                                                 |       | — |   | — |   |
| Auction rate securities:                             |       |                       |       |                                                                                                |       |   |   |   |   |
| Beginning balance as of January 1, 2009         |       | 367                        |       | —                                                                                              |       | — |   | 367 |   |
| Purchases                                            |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Sales and maturities                                 |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Transfers in (out) of Level 2 and  Level 3 |       | —                     |       | —                                                                                              |       | — |   | — |   |
| Loss on marketable securities                        |       | (14                        | )          | —                                                                                              |       | — |   | (14 | ) |
| Ending balance as of December 31, 2009          |       | 353                        |       | —                                                                                              |       | — |   | 353 |   |
| Total                                                |       | $                          | 7,695      |                                                                                                | $          | 150 |   | $ | 7,192 |   | $ | 353 |   |

 

Our financial assetsvalued using Level 1 inputs consist primarily of certificates of deposit at afinancial institution.  Our financialassets valued using Level 2 inputs consist of cash held in money market funds withfair values that are determined by our institutional portfolio managers whosevaluations are based upon market-corroborated inputs such as broker/dealerquotes, reported trades, bids and offers that we believe are reasonable.Previously, the fair value of our auction rate security was measured usingLevel 3 inputs as determined by a discounted cash flow model that consideredexpected cash flows from the auction rate instrument including expectedinterest payments, market yields for similarly rated instruments, our estimatesof time to liquidity for the security, and a marketability discount. Transfersbetween levels are determined and recognized at the end of each reportingperiod.

 

In February 2010, wesold our remaining auction rate instrument at a price equal to $370,000 or 74%of par value plus accrued interest. We recognized a total realized loss of$130,000 as a result of the sale of the security. Prior to December 31,2009, we had recognized an estimated unrealized other-than-temporary loss of$147,000 resulting in a gain of $17,000 recognized during the first quarter of2010.

 

**3.  Debt Financing**

 

As of March 31, 2010,we have loan commitments outstanding with Lighthouse Capital Partners V, L.P.,or Lighthouse, General Electric Commercial Finance, or GE, and Oxford FinanceCorporation, or Oxford.  The totalprincipal amount borrowed under the Lighthouse agreements was$19.0 million and the total unpaid principal balance outstanding as of March 31,2010, was $7.9 million. We recorded interest expense related to theLighthouse loan agreement, including amortization of expense related to theterminal payment and the warrants issued under the agreement, of $410,000 and$460,000 for the three months ended March 31, 2010 and 2009,respectively.  The total principal amountborrowed under the GE agreements was $1.9 million and the total unpaidprincipal balance outstanding as of March 31, 2010, was $33,000. Werecorded interest expense related to the GE loan agreements of $1,600 and$9,000 for the three months ended March 31, 2010 and 2009,respectively.  The total principal amountborrowed under the Oxford loan agreement was $1.0 million and the totalunpaid principal balance outstanding as of March 31, 2010, was $625,000.We recorded interest expense related to the Oxford loan agreement, includingamortization of expense related to the terminal payment and the warrant issuedunder the agreement, of $22,500 and $31,000 for the three months ended March 31,2010 and 2009, respectively.

 

**4.  Equity Financing**

 

On October 6, 2009, we entered into a common stock purchaseagreement, or the Purchase Agreement, with Commerce Court Small Cap ValueFund, Ltd., or Commerce Court, providing for a financing arrangement thatis sometimes referred to as a committed equity line financing facility. ThePurchase Agreement provides that, upon the terms and subject to the conditionsset forth in the Purchase Agreement, Commerce Court is committed to purchase upto $35.0 million of shares of our common stock over the 24-month term ofthe Purchase Agreement under certain specified conditions and 

 

8

----

Table ofContents

 

limitations,provided that in no event may we sell under the Purchase Agreement more than5,380,090 shares of common stock, which is equal to one share less than 20% ofour outstanding shares of common stock on October 6, 2009, the closingdate of the Purchase Agreement, less the number of shares of common stock weissued to Commerce Court on the closing date as Commitment Shares describedbelow. Furthermore, in no event will Commerce Court be obligated to purchaseany shares of our common stock which, when aggregated with all other shares ofour common stock then beneficially owned by Commerce Court, would result in thebeneficial ownership by Commerce Court of more than 9.9% of the thenoutstanding shares of our common stock.

 

On January 4, 2010, we delivered notice to Commerce Court, assubsequently amended, to effect a draw down of up to $1.4 million. Thefirst trading day of the 10-day pricing period for this draw down was January 5,2010. In connection with this draw down, we issued an aggregate of 490,864shares of our common stock to Commerce Court, at a purchase price ofapproximately $2.85 per share and an aggregate purchase price of$1.4 million. The settlement date for this draw down was January 20,2010. The share price at which Commerce Court purchased these shares from uswas established under the Purchase Agreement by reference to the volumeweighted average prices of our common stock on The NASDAQ Global Market duringthe pricing period, net a discount of approximately 6.1% per share. We receivednet proceeds from the sale of these shares of approximately $1.38 millionafter deducting our offering expenses of approximately $25,000, including aplacement agent fee of $14,000 paid to Reedland Capital Partners connectionwith this draw down.

 

On February 19, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was February 22, 2010. Inconnection with this draw down, we issued an aggregate of 2,764,546 shares ofour common stock to Commerce Court, at a purchase price of approximately $1.19per share and an aggregate purchase price of approximately $3.29 million.The settlement date for this draw down was March 8, 2010. The share priceat which Commerce Court purchased these shares from us was established underthe Purchase Agreement by reference to the volume weighted average price of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 7.0% per share. We received net proceeds from thesale of these shares of approximately $3.24 million after deducting ourestimated offering expenses of approximately $45,000, including a placementagent fee of $33,000 paid to Reedland Capital Partners in connection with thisdraw down.

 

On March 11, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was March 12, 2010. In connectionwith this draw down, we issued an aggregate of 1,710,784 shares of our commonstock to Commerce Court, at a purchase price of approximately $1.07 per shareand an aggregate purchase price of approximately $1.83 million. Thesettlement date for this draw down was March 26, 2010. The share price atwhich Commerce Court purchased these shares from us was established under thePurchase Agreement by reference to the volume weighted average price of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 7.0% per share. We received net proceeds from thesale of these shares of approximately $1.8 million after deducting ourestimated offering expenses of approximately $30,000, including a placementagent fee of $18,311 payable to Reedland Capital Partners in connection with thisdraw down.

 

As of March 26, 2010, we had issued the maximum amount of commonstock available for sale under the Commerce Court Purchase Agreement andtherefore we will no longer be able to utilize the facility for additionalfunding.

 

**5.  Warrants**

 

We issue freestanding warrants from time to time pursuant to variouscontractual arrangements. As of March 31, 2010, the following warrants topurchase our common stock were issued and outstanding:

 
| **Warrant Holder** | ** ** | **Issue Date** | ** ** | **In Connection With** | ** ** | **Warrant to Purchase** | ** ** | **Shares** | ** ** | **Exercise  Price  (per share)** | ** ** | **Expire Date** | ** ** |
|-------------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------|------------|------------|------------|---------------------------------------|------------|----------------------|------------|
| ATEL                    |       | 12/23/2002          |       | Leasing  arrangement             |       | Common  Stock                     |       | 5,611      |       | $                                     | 8.91       |                 | 11/13/2012 |   |
| Lighthouse(1)           |       | 10/19/2007          |       | Debt  financing                  |       | Common  Stock                     |       | 83,332     |       | $                                     | 10.80      |                 | (1         | ) |
| Lighthouse(2)           |       | 10/17/2008          |       | Debt  restructure                |       | Common  Stock                     |       | 158,770    |       | $                                     | 3.975      |                 | (2         | ) |
| Various investors(3)    |       |                | (3)        | Private  placement of equity     |       | Common  Stock                     |       | 2,769,864  |       | $                                     | 2.64       |                 | 11/14/2013 |   |
| Oxford(4)               |       | 12/31/2008          |       | Equipment  financing             |       | Common  Stock                     |       | 8,547      |       | $                                     | 2.34       |                 | 12/31/2013 |   |
|                    |       |                |       |                             |       |                              |       | 3,026,124  |       |                                  |       |                 |       |

 

----

(1)                                  Exercisable, inwhole or in part, at anytime at the option of the holder or deemed to have beenautomatically exercised in full immediately prior to the expiration of thewarrant; expires at the earlier of (i) the close of business on October 19,2014, or (ii) the effective date of a merger, as defined in the agreement.

 

9

----

Table of Contents

 

(2)                                  Exercisable, inwhole or in part, at anytime at the option of the holder or deemed to have beenautomatically exercised in full immediately prior to the expiration of thewarrant; expires at the earlier of (i) the close of business on October 17,2013, or (ii) the effective date of a merger, as defined in the agreement.

 

(3)                                  Warrants topurchase 2,446,928 shares of our common stock were issued on November 14,2008 and warrants to purchase 447,936 shares of our common stock were issued onNovember 24, 2008, of which warrants to purchase 322,936 shares of ourcommon stock are currently outstanding; the warrants are exercisable, in wholeor in part, at anytime at the option of the holder for a term of five yearsfrom November 14, 2008.

 

(4)                                  Exercisable, inwhole or in part, at anytime at the option of the holder or deemed to have beenautomatically exercised in full immediately prior to the expiration of thewarrant if the fair market value of one share of our common stock is greaterthan the exercise price of the warrant on such date.

 

We follow guidance under ASC 480 to measure the fair value of thesewarrants on date of issuance. The fair value of the warrant issued to ATEL for$42,000 was capitalized as a prepayment on a lease and was amortized tointerest expense over the 36 month lease term. The fair value of the firstwarrant issued to Lighthouse for $738,000 was capitalized in three separatetranches as debt issuance cost with the first tranche amortized to interestexpense over the funding commitment period ended December 31, 2005. Theremainder was amortized to interest expense over the duration of theinterest-only period plus the term of the loan over 42 months. The fairvalue of the second warrant issued to Lighthouse for $523,000 was capitalizedin two separate tranches as debt issuance cost with the first tranche amortizedto interest expense over the funding commitment period ended March 1,2008, and the remainder amortized to interest expense over the duration of theinterest-only period plus the term of the loan over 36 months. The fairvalue of the third warrant issued to Lighthouse for $396,000 was capitalized asdebt issuance cost and amortized to interest expense over the duration of theinterest-only period plus the term of the restructured loan over36 months. The fair value of the warrants issued in connection with theOxford equipment loan for $17,000 was capitalized as debt issuance cost andwill be amortized to interest expense over the duration of the loan over36 months.

 

We follow guidance under ASC 718, *Compensation-StockCompensations*, and considered the fair value of the warrants issuedto investors participating in the November 2008 private placement ofequity as cost of equity financing and accordingly, we recorded the fair valueof the warrants to contra-equity. The aggregate fair value of the warrantsissued to the investors was approximately $4.0 million determined usingthe Black-Scholes option valuation model with the following assumptions:risk-free interest rate of 2.44%, contractual life of five years according tothe terms of the warrants, no dividend yield and volatility of 79%.

 

The fair value of our capitalized warrants issued in connection withthe placement of our long-term debt was amortized to interest expense asfollows:

 
| ** **                | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                | ** ** | **(in thousands)**                    | ** ** |
| Lighthouse—Warrant 1 |       | $                                     | 14         |   | $ | 14 |   |
| Lighthouse—Warrant 2 |       | 13                                    |       | 13 |   |
| Lighthouse—Warrant 3 |       | 27                                    |       | 27 |   |
| Oxford                    |       | 1                                     |       | 1 |   |
|                      |       | $                                     | 55         |   | $ | 55 |   |

 

**6. ****Stock-Based Compensation**

 

The components of ourstock-based compensation expense recognized for the three months ended March 31,2010 and 2009 were as follows:

 
| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| ** **                           | ** ** | **(in thousands)**                               | ** ** |
| Research and development:            |       |                                             |       |   |   |
| Officer compensation                 |       | $                                                | (70        | ) | $ | 68 |   |
| Employee and consultant compensation |       | (154                                             | )          | 151 |   |
| Selling, general and administrative: |       |                                             |       |   |   |
| Director and officer compensation    |       | 147                                              |       | 271 |   |
| Employee and consultant compensation |       | (41                                              | )          | 38 |   |
| Total compensation expense           |       | $                                                | (118       | ) | $ | 528 |   |

 

10

----

Table of Contents

 

For the three months ended March 31,2010, our total stock-based compensation expense was a net credit, or areduction to our expense, due to the forfeiture of stock options that hadpreviously been granted to employees that were terminated as part of ourrestructuring of operations. We issued an aggregate 596 shares of our commonstock upon the exercise of stock options during the three month period ended March 31,2010.

 

**7.  ****Restructuring of Operations**

 

OnFebruary 18, 2010, we announced a restructuring of operations whichincluded a substantial reduction in force from 56 employees to 17 employees.The positions impacted were across all business functions, including the researchand development, clinical, operations and general and administrativedepartments. The restructuring plan was primarily designed to reduce operatingexpenses and conserve cash resources as we explore various strategic options.The restructuring was substantially completed during the first quarter of 2010.Additionally, we announced the retention of Cowen and Company, an investmentbank, to help us explore strategic alternatives to realize optimal value forour late-stage assets.

 

Employees affected by the reduction in force wereprovided with severance payments, payments for healthcare benefits andoutplacement assistance. Severance payments to employees terminated as part ofthe February 2010 restructuring consisted of 50% cash and 50% ARYx commonstock in order to minimize the associated cash expense. The total number ofcommon shares issued related to severance pay was 460,940 shares. All cashseverance payments and common stock were paid and issued as of March 31, 2010.

 

Asa result of the February 2010 restructuring of operations, we incurred anaggregate restructuring charge of approximately $1.1 million in the first quarterof 2010 including costs for severance pay, employee benefits and outplacementservices. The restructuring charge included approximately $0.9 million of cash expendituresand approximately $0.2 million ofnon-cash charges, net of adjustments related to stock compensation expense forforfeited stock options. Included within our selling, general andadministrative expenses was $1.4 million of expense related to therestructuring. Our research and development expenses included a net reductionto expense of approximately $0.3 million related to the forfeiture of stockoptions by terminated employees within our research and development functions.During the first quarter of 2010 we made an assessment in accordance with ASC 360,Property and Equipment, to determine if there had been any material impairmentof assets resulting from the February 2010 restructuring and concludedthat given the range of possible outcomes related to our exploration ofstrategic alternatives, no material impairment had occurred.

 

11

----

Table ofContents

 

**ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

*Thefollowing discussion of our financial condition and the results of operationsshould be read in conjunction with the condensed consolidated financialstatements and notes to condensed consolidated financial statements included elsewhere in this quarterly report on Form 10-Q.This discussion contains forward looking statements that involve risks anduncertainties. When reviewing the discussion below, you should keep in mind thesubstantial risks and uncertainties that characterize our business. Inparticular, we encourage you to review the risks and uncertainties described inPart II - Item 1A. “RISK FACTORS” elsewhere in this report. Theserisks and uncertainties could cause actual results to differ materially fromthose projected in forward-looking statements contained in this report orimplied by past results and trends. Forward-looking statements are statementsthat attempt to forecast or anticipate future developments in our business; weencourage you to review the examples of our forward-looking statements underthe heading “Cautionary Note Regarding Forward-Looking Statements” that appearsat the end of this discussion. These statements, like all statements in thisreport, speak only as of their date (unless another date is indicated), and weundertake no obligation to update or revise these statements in light of futuredevelopments.*

 

**Overview**

 

We are a biopharmaceutical company focused on developing a portfolio ofinternally discovered product candidates designed to eliminate known safetyissues associated with well-established, commercially successful drugs. We useour RetroMetabolic Drug Design technology to design structurally uniquemolecules that retain the efficacy of these original drugs but are metabolizedthrough a potentially safer pathway to avoid specific adverse side effectsassociated with these compounds. Our product candidate portfolio includes anoral anticoagulant, tecarfarin (ATI-5923), designed to have the sametherapeutic benefits as warfarin, currently in Phase 2/3 clinicaldevelopment for the treatment of patients who are at risk for the formation ofdangerous blood clots; an oral antiarrhythmic agent, budiodarone (ATI-2042),designed to have the efficacy of amiodarone in Phase 2 clinicaldevelopment for the treatment of atrial fibrillation, a form of irregularheartbeat; an oral prokinetic agent, ATI-7505, designed to have the sametherapeutic benefits as cisapride in Phase 2 clinical development for thetreatment of chronic constipation, gastroparesis, functional dyspepsia,irritable bowel syndrome with constipation, and gastroesophageal refluxdisease; and a novel, next-generation atypical antipsychotic agent, ATI-9242,currently in Phase 1 clinical development for the treatment ofschizophrenia and other psychiatric disorders. Additionally, we have severalproduct candidates in preclinical development. Each of our product candidatesis an orally available, patentable new chemical entity designed to addresssimilar indications as those of the original drug upon which each is based. Ourproduct candidates target what we believe to be multi-billion dollar marketopportunities.

 

We were incorporated in the State of California on February 28,1997 and reincorporated in the State of Delaware on August 29, 2007. Wemaintain a wholly-owned subsidiary, ARYx Therapeutics Limited, with registeredoffices in the United Kingdom, which has had no operations since its inceptionin September 2004 and was established to serve only as a legal entity asrequired in support of our clinical trial activities conducted in Europe.

 

In February 2010, we retained Cowen and Company, or Cowen, toexplore and recommend strategic alternatives for the Company going forward.Concurrently, we restructured our operations in order to conserve resources andsupport the process of reviewing strategic alternatives. This followed an initialreduction in our workforce headcount in October 2009. Through these tworestructuring steps, our headcount was reduced from 73 to 17 employees. We tookthese steps since we have three compounds at proof-of-concept stage but do nothave sufficient cash resources to develop these product candidates further orto complete licensing agreements in a timely manner with a high level ofcertainty. Cowen is expected to present alternatives for maximizing the valueof our assets in the near-term. Those alternatives could include partnershipson one or more of our product candidates, or the sale of our assets, in wholeor in part, or some similar arrangement through which the value of our assetsto stockholders could be optimized. As of March 31, 2010, we had approximately$6.3 million in cash, cash equivalents and marketable securities on handwhich is less than the amount needed for us to maintain our current operationsfor the next 12 months. Our operations have consumed a substantial amountof cash since inception and we expect to continue to incur net losses for theforeseeable future. Our ability to continue operations will be dependent on ourability to obtain additional funding. We may seek to raise necessary additionalfunds through public or private equity, debt financings, collaborativearrangements with corporate partners or other sources. For instance, our mostrecent source of funding has been through utilization of the Commerce Courtequity line facility. However, as of March 26, 2010, we had issued themaximum amount of common stock available under the facility and therefore willno longer be able to utilize the facility. We will likely seek additionalsources of funding to allow us to continue our operations as we explorestrategic options available to us.

 

12

----

Table of Contents

 

Since our inception, we have incurred significant net losses, and weexpect to continue to incur net losses for the foreseeable future as we explorestrategic options for the company. We are unable to predict the extent of anyfuture losses or the degree of success we may have in the exploration andexecution of our strategic options.

 

We have established proof of concept with our three leading productcandidates, tecarfarin, budiodarone and ATI-7505, which retain the efficacy ofcertain commercially successful drugs for well established chronic marketswhile being metabolized through a potentially safer pathway than suchdrugs.  The following is a summary of ourproduct candidates:

 

***Tecarfarin***

 

Tecarfarinis an oral anticoagulant agent in Phase 2/3 clinical development for thetreatment of patients who are at risk for the formation of dangerous blood clots,such as those with atrial fibrillation or those at risk of venousthromboembolism. Tecarfarin was designed to have the same therapeutic benefitsas the drug warfarin which for over 50 years has been the oralanticoagulant of choice. Despite its widespread use, warfarin has severalsignificant limitations. It is metabolized by CYP450 and has many drug-druginteractions that often lead to serious side effects. We designed tecarfarin tobe metabolized through the esterase pathway, eliminating metabolism throughCYP450 and avoiding drug-drug interactions. Warfarin also has a very steep doseresponse curve which means that a small change in dose may lead to asubstantial change in the anticoagulation status of the patient. These twofactors can create significant challenges in maintaining therapeutic levels ofwarfarin and this can put patients at risk for either life-threatening clottingor bleeding, especially in patients with compromised CYP450 clearance. Inpreclinical testing and in clinical testing to date, it appears that tecarfarinmay be inherently more stable than warfarin due to its predictable metabolismthrough the esterase pathway that has a much larger capacity than CYP450. Thelevel of anticoagulation produced by both warfarin and tecarfarin is measuredby the standard assay known as International Normalized Ratio, or INR.

 

Wehave treated over 400 patients with tecarfarin in trials in which we measuredits ability to maintain those patients within a target therapeutic range of INRof 2.0 to 3.0 (2.5 to 3.5 for heart valve patients). Two of the clinical trialsperformed were Phase 2 trials (CLN-504 and CLN-509) and the third was therecently completed Phase 2/3 trial, EmbraceAC (CLN-505). In each of thesethree trials, the results were nearly identical. Patients on tecarfarin had atime in target therapeutic range of INR of 71.5% (CLN-504), 73.9% (CLN-509),and 74% (CLN-505). Statistical significance was achieved in CLN-504 whencomparing the tecarfarin response to the same patients’ historical experiencewith warfarin: 71.5% time within therapeutic range versus 59.3% time withintherapeutic range, respectively (p=0.0009). However, statistical significancewas not achieved at the primary endpoint in the 607-patient CLN-505 clinicaltrial, directly measuring the ability of tecarfarin to maintain patients withinthe target therapeutic range of INR as compared to warfarin patients. Theendpoint was missed due to the unprecedented time within therapeutic range forthe warfarin-treated patients of 73.2% (p=0.506). We believe the warfarinoutcome resulted from the intense monitoring and dose control provided by thetrial’s central dosing methodology, executed in accord with our agreement onthe trial design with the U.S. Food and Drug Administration, or FDA. In asubgroup responder analysis of those CLN-505 patients taking medications whichinhibit CYP450 metabolism and which can cause drug-drug interactions, thetecarfarin group showed a significantly larger proportion of responderscompared to the warfarin group (67.9% versus 53.8% respectively p=0.0676). Aresponder is defined as a patient who is in range for more than 65% of the timeduring the treatment period. In addition, about one-third of the CLN-505patients who were in the tecarfarin treatment arm and were stable on the drugat the end of the trial period continued to be treated with tecarfarin in asafety follow-up extension, allowing treatment on the agent for at least oneyear. During this extension phase, tecarfarin patients were monitored an averageof once every four weeks. This group’s average time in therapeutic range of INRwas 78.4% of the time treated during the extension phase.

 

Basedupon feedback from the FDA subsequent to the completion of the CLN-505 clinicaltrial, we believe only one additional Phase 3 trial needs to be conductedto seek regulatory approval of tecarfarin. This trial would also directlycompare tecarfarin’s ability to maintain patients in a targeted therapeuticrange of INR compared to warfarin but in a “real-world” setting in whichmonitoring and dosing decisions would be made at the trial sites, which wouldbe similar to how warfarin is typically dosed and titrated in clinicalpractice. We believe tecarfarin should compare favorably against warfarin in areal-world setting due to its inherent properties and based upon the clinicalresults we have collected to date. We believe this favorable result will be incontrast to the well-established published data reporting the typical time intherapeutic range of INR expected in patients treated with warfarin in similarhistorical trials. In our most recent discussions, the FDA confirmed that theability to maintain patients within the targeted INR will likely be anacceptable surrogate and primary endpoint for tecarfarin’s clinicaldevelopment, and that the data collected in the CLN-505 clinical trial could beused to support the registration of tecarfarin. Using INR as a surrogatemeasure for the primary endpoint should reduce the size of our planned secondPhase 3 clinical trial compared to clinical trials measuring survivalrates or other outcomes. We have submitted, in writing under a Special ProtocolAssessment (SPA), our proposed design of the second Phase 3 clinicaltrial. We expect to 

 

13

----

Table of Contents

 

receivea response from the FDA under the normal SPA process. With the assistance ofCowen, we are seeking to identify the best path to maximize the value oftecarfarin and lead to its full development and eventual commercialization, inthe event requisite regulatory approval is obtained.

 

***Budiodarone***

 

Budiodaroneis an oral antiarrhythmic agent in Phase 2 clinical development for thetreatment of patients with atrial fibrillation. Budiodarone was designed tohave the efficacy of amiodarone, a drug that has been used for many years,despite its adverse side effects, because physicians believe based on their ownexperience, as well as extensive clinical trial results, that amiodarone is themost effective drug for treating patients with atrial fibrillation. Amiodaroneaccumulates in many different organs and can only be metabolized andsubsequently cleared from the body by CYP450. This accumulation can lead toserious side effects that are not immediately reversible upon withdrawal of thedrug. Since budiodarone is predominantly metabolized through the esterasesfound extensively in the organs, it should avoid safety issues associated withaccumulation and have fewer drug-drug interactions. We have completed aPhase 2 pilot trial (CLN-208) with budiodarone involving six atrialfibrillation patients with implanted recordable pacemakers who did not respondto previous drug therapy. This pilot trial suggested that the effect ofbudiodarone improved as the dose increased. Based upon the results of thispilot trial, we conducted an additional Phase 2b clinical trial to furtherdemonstrate the efficacy of budiodarone in patients with atrial fibrillation.The clinical trial, which enrolled 72 patients, was a multi-centered,randomized, double blind, placebo-controlled trial of the efficacy and safetyof budiodarone in patients with paroxysmal atrial fibrillation, or PAF. Allpatients entering this trial had previously implanted dual chamber pacemakerswith diagnostic and recording capability. In December 2008, we announcedsuccessful top-line efficacy results from this Phase 2b clinical trial. Byachieving statistical significance at the two highest doses of the threetested, the results essentially mirrored the findings of the earlierPhase 2 pilot trial also conducted in paroxysmal atrial fibrillationpatients. The Phase 2b trial also demonstrated that patients in the trialquickly returned to their pre-treatment level of atrial fibrillation once thetreatment ended. We have also announced the complete safety results from thisPhase 2b clinical trial that indicate that budiodarone is generally safeand well-tolerated, and appears to avoid the tissue accumulation evident withamiodarone. In conjunction with Cowen and Company, we are seeking to identifythe best path to maximize the value of budiodarone and lead to its fulldevelopment and eventual commercialization, in the event requisite regulatoryapproval is obtained.

 

***ATI-7505***

 

ATI-7505 is an oral prokinetic agent that has beenshown to speed up the passage of contents through the gut. We have successfullycompleted four Phase 2 clinical trials for the treatment of multiplegastrointestinal disorders including gastroesophageal reflux disease, or GERD,functional dyspepsia and chronic idiopathic constipation. ATI-7505 was designedto have the same therapeutic benefits as cisapride, a drug marketed by Johnson &Johnson under the brand name Propulsid in the United States and othercountries. Launched in 1993, cisapride was withdrawn from the market in 2000due to serious cardiovascular side effects. These side effects occurred asblood levels of cisapride rose significantly when CYP450 clearance wasinhibited due to the co administration of other drugs that were cleared by thesame metabolic pathway. We designed ATI-7505 to be metabolized through theesterase pathway, eliminating metabolism through CYP450 as well as eliminatingthe off-target cardiovascular effects. Nearly 1,000 patients and subjects havebeen treated with ATI-7505 as part of our clinical trial program. In June 2006,we entered into a collaboration agreement with Procter & GamblePharmaceuticals, Inc., or P&G, to develop and commercialize ATI-7505.On July 2, 2008, we received notice from P&G that it elected toexercise its option to terminate the collaboration agreement effective July 2,2008. P&G subsequently announced that it is exiting pharmaceutical drugdevelopment. Upon termination of the collaboration agreement by P&G, allrights to ATI-7505 reverted to ARYx. Also on July 2, 2008, we announcedthe overall successful results of a Thorough QT trial, or TQT, on ATI-7505,which we believe supports the agent’s favorable cardiac safety profile. On August 22,2008, we announced the results of a Phase 2b clinical trial testing thesafety and efficacy of ATI-7505 in patients with chronic idiopathicconstipation. The clinical trial, conducted by P&G, was designed to enroll400 patients evaluating four doses of the agent compared to placebo. As aresult of the termination of the collaboration between ARYx and P&G, thetrial was terminated early after only 214 patients had been enrolled. In spiteof the early termination of the trial, ATI-7505 achieved statisticalsignificance at the trial’s primary endpoint in the 80 mg twice-dailydose. In addition, all doses tested demonstrated a clinically meaningful anddesired increase in spontaneous bowel movements over baseline compared toplacebo after one week of treatment. We have had an end of Phase 2 meeting withthe FDA to seek their guidance on the size and design of the Phase 3 programrequired for registration. Based upon the results of that meeting, we believewe have a clear path forward in chronic idiopathic constipation that includessafety data in line with ICH guidelines. With the assistance of Cowen, we areseeking to identify the best path to maximize the value of ATI-7505 and lead toits full development and eventual commercialization, in the event requisiteregulatory approval is obtained.

 

14

----

Table of Contents

 

***ATI-9242***

 

ATI-9242 is a novel antipsychotic agent inPhase 1 clinical development for the treatment of schizophrenia and otherpsychiatric disorders. ATI-9242’s receptor profile is targeted at the treatmentof both the positive and the negative symptoms of schizophrenia as well as theimprovement of cognitive function. To date, preclinical work has supported thisprofile. ATI-9242 is also designed to avoid certain drug-drug interactions byavoiding CYP450 enzymes for metabolism, as well as reduce certain metabolicproblems associated with this class of therapy, including weight gain andtype 2 diabetes.

 

***Restructuring of Operations***

 

On October 29, 2009,we announced a restructuring of operations which included a reduction inpersonnel from 73 employees to 56 employees. The staff reduction affected allfunctions within the company and was accompanied by changes within theorganizational structure to improve the efficiency of our operations. Werecognized a charge of approximately $375,000 related to the restructuringduring the fourth quarter of 2009 which included costs for severance pay,extended healthcare benefits and outplacement services for the exitingemployees. Additionally, we made an assessment to determine if there had beenany material impairment of assets resulting from the restructuring andconcluded that no material impairment had occurred.

 

OnFebruary 18, 2010 we announced an additional restructuring of operationswhich included a substantial reduction in force from 56 employees to 17employees. The positions impacted were across all business functions, includingthe research and development, clinical, operations and general andadministrative departments. The restructuring plan was primarily designed toreduce operating expenses and conserve cash resources as we explore variousstrategic options. The restructuring was substantially completed during thefirst quarter of 2010. Additionally, we announced the retention of Cowen andCompany, an investment bank, to help us explore strategic alternatives torealize optimal value for our late-stage assets.

 

Employees affected by the reductions in force wereprovided with severance payments, continuation of current benefits andoutplacement assistance. Severance payments to employees terminated as part ofthe February 2010 restructuring consisted of 50% cash and 50% ARYx commonstock in order to minimize the associated cash expense, with an aggregate460,940 shares of common stock issued under our equity incentive plan as aseverance payout.

 

Asa result of the February 2010 restructuring of operations, we incurred anaggregate restructuring charge of approximately $1.1 million in the first quarterof 2010 including costs for severance pay, employee benefits and outplacementservices. The restructuring charge included approximately $0.9 million of cash expendituresand approximately $0.2 million ofnon-cash charges, net of adjustments related to stock compensation expense. Aspart of the restructuring effort and during the course of our continuingoperations, we will be assessing on a quarterly basis any possible impairmentof assets related to idle facilities and equipment resulting from the February 2010restructuring and may incur additional expense related to any such impairment.During the first quarter of 2010 we made an assessment in accordance with ASC 360 todetermine if there had been any material impairment of assets resulting fromthe February 2010 restructuring and concluded that given the range ofpossible outcomes related to our exploration of strategic alternatives, nomaterial impairment had occurred. As a result of our restructuring activities,we anticipate a substantial reduction in our future operating expensesas compared to our spending levels in 2009.

 

As of March 31, 2010, we had cash, cash equivalents and marketablesecurities on hand in the amount of $6.3 million, current payables andaccrued liabilities of approximately $1.8 million and approximately$5.4 million in current notes and related interest payable. As of March 31,2010, we had outstanding non-current liabilities of $5.7 million. Sinceour inception, we have incurred significant net operating losses and, as of March 31,2010, we had an accumulated deficit of $193.5 million. We have notachieved sustained profitability and anticipate that we will continue to incursignificant net losses for the foreseeable future. There can be no assurancesthat we will achieve positive cash flow in the foreseeable future or at all.Additionally, we do not expect that our cash on hand as of March 31, 2010will be sufficient to fund our operations during the following 12-month period.For the year ended December 31, 2009 our auditor, Ernst & YoungLLP, issued an audit opinion which included an explanatory paragraph raisingsubstantial doubt about our ability to continue as a going concern.

 

***Research and Development Expense***

 

Our research and development expense consists of expenses incurred inidentifying, testing and developing our product candidates. These expensesconsist primarily of fees paid to contract research organizations and otherthird parties to assist us in managing, monitoring and analyzing our clinicaltrials, clinical trial costs paid to sites and investigators’ fees, costs ofnonclinical studies including toxicity studies in animals, costs of contractmanufacturing services, costs of materials 

 

15

----

Table of Contents

 

usedin clinical trials and nonclinical studies, laboratory related expenses,research and development support costs including certain regulatory, qualityassurance, project management and administration, allocated expenses such asfacilities and information technology that are used to support our research anddevelopment activities and related personnel expenses, including stock-basedcompensation. Research and development costs are expensed as incurred.

 

Clinical trial costs are a significant component of our research anddevelopment expense. Currently, we conduct our clinical trials primarilythrough coordination with contract research organizations and other third-partyservice providers. We recognize research and development expense for theseactivities based upon a variety of factors, including actual and estimatedpatient enrollment, clinical site initiation activities, direct pass-throughcosts and other activity-based factors.

 

The following table summarizes our research and development expense forthe three months ended March 31, 2010 and 2009:

 
| ** **                                                     | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                     | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**                    | ** ** |
| Direct research and development expense by product  candidate: |       |                                  |       |   |   |
| Tecarfarin                                                     |       | $                                     | 254        |   | $ | 2,831 |   |
| Budiodarone                                                    |       | 40                                    |       | 638 |   |
| ATI-7505                                                       |       | 17                                    |       | 52 |   |
| ATI-9242                                                       |       | 112                                   |       | (107 | ) |
| Other research programs                                        |       | 56                                    |       | 44 |   |
| Total direct research and development expense                  |       | 479                                   |       | 3,458 |   |
| Personnel, administrative and other expense                    |       | 1,763                                 |       | 3,331 |   |
| Total research and development expense                         |       | $                                     | 2,242      |   | $ | 6,789 |   |

 

From our inception through March 31, 2010, we estimate thatapproximately $40.5 million of expense was incurred for our tecarfarinproduct candidate, approximately $25.2 million was incurred for ourbudiodarone product candidate, approximately $22.7 million was incurredfor our ATI-7505 product candidate, approximately $5.2 million wasincurred for our ATI-9242 product candidate, and approximately$71.9 million was incurred for costs related to our research anddevelopment personnel, administrative and other research programs.

 

The expenditures summarized in the above table reflect costs directlyattributable to each product candidate and to our other research programs. Wedo not allocate salaries, employee benefits, or other indirect costs to ourproduct candidates or other research programs and have included those expensesin “personnel, administrative and other expense” in the above table.

 

At this time, due to the risks inherent in our business and given thevarious stages of development of our product candidates, we are unable toestimate with any certainty the costs we will incur in support of our productcandidates. Clinical development timelines, the probability of success anddevelopment costs can differ materially from expectations. In addition, wecannot forecast with any degree of certainty which product candidates may besubject to future collaborations, when such arrangements may be secured, if atall, and to what degree such arrangements would affect our current operatingplans and capital requirements.

 

The process of developing and obtaining FDA approval of products iscostly and time consuming. Development activities and clinical trials can takeyears to complete, and failure can occur at any time during the development andclinical trial process. In addition, the results from early clinical trials maynot be predictive of results obtained in subsequent and larger clinical trials,and product candidates in later stages of clinical trials may fail to show thedesired safety and efficacy despite having progressed successfully throughinitial clinical testing. Although our approach to identifying and developingnew product candidates is designed to mitigate risk, the successful developmentof our product candidates is highly uncertain. Further, even if our productcandidates are approved for sale, they may not be successfully commercializedand therefore the future revenue we anticipate may not materialize.

 

If we fail to complete the development of any of our product candidatesin a timely manner, it could have a material effect on our operations,financial position and liquidity. In addition, any failure by us or ourpartners to obtain, or any delay in obtaining, regulatory approvals for ourproduct candidates could have a material adverse effect on our results ofoperations. However, as we explore strategic alternatives, we expect to expendno efforts or resources towards further development of our product candidates.A further discussion of the risks and uncertainties associated with completingour programs on schedule, or at all, and certain consequences of failing to doso are discussed in Part II—Item 1A. “Risk Factors” section of thisreport.

 

16

----

Table of Contents

 

**CriticalAccounting Policies and Significant Estimates**

 

We have prepared ourconsolidated financial statements in accordance with U.S. generally acceptedaccounting principles. Accordingly, we have had to make estimates, assumptionsand judgments that affect the amounts reported in our consolidated financialstatements. These estimates, assumptions and judgments about future events andtheir effects on our results cannot be determined with certainty, and are madebased upon our historical experience and on other assumptions that are believedto be reasonable under the circumstances. These estimates may change as newevents occur or additional information is obtained, and we may periodically befaced with uncertainties, the outcomes of which are not within our control andmay not be known for a prolonged period of time.

 

Our critical accountingpolicies are more fully described in Note 1 of the audited consolidatedfinancial statements for the year ended December 31, 2009, which areincluded in our annual report on Form 10-K filed with the Securities andExchange Commission. There have been no material changes in our criticalaccounting policies and significant estimates during the three months ended March 31,2010.

 

**Resultsof Operations**

 

***Comparison of Three Months Ended March 31, 2010 and2009***

 

***Revenue***

 

Norevenue was recorded for the three months ended March 31, 2010 or 2009.

 

***Research and Development Expense***

*** ***
| ** **                       | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------|------------|----------------------------------|------------|------------|------------|------------|------------|
| ** **                       | ** ** | **March 31,**               | ** ** | **Change** | ** ** |
| ** **                       | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                       | ** ** | **(in thousands, except %)**     | ** ** |
| Research and development expense |       | $                                | 2,242      |       | $          | 6,789      |       | $ | (4,547 | ) | -67 | % |
|                                  |            |                                  |            |            |            |            |            |  |  |  |  |  |

 

For the threemonths ended March 31, 2010, as compared to the same period in 2009, ourresearch and development expense decreased by $4.5 million, or 67%. Thedecrease was due to:

 

·                  a $2.6 million reduction in expenditures relatedto our tecarfarin product candidate due to the substantial completion of ourPhase 2/3 EmbraceAC clinical study in the second quarter of 2009;

 

·                  a $0.6 million reduction in expendituresrelated to the completion of a Phase 2b clinical study for ourbudiodarone product candidate in early 2009; and

 

 

·                  a $1.3 million reduction in non-projectspecific research and development costs and research and development personnelcosts primarily due to the restructuring of our operations in October 2009and February 2010.

 

 

***Selling, General andAdministrative Expense***

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | **March 31,**               | ** ** | **Change** | ** ** |
| ** **                                  | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(in thousands, except %)**     | ** ** |
| Selling, general and administrative expense |       | $                                | 3,777      |       | $          | 2,603      |       | $ | 1,174 |   | 45 | % |
|                                             |            |                                  |            |            |            |            |            |  |  |  |  |  |

 

The increase inselling, general and administrative expense for the three months ended March 31,2010 as compared to the same period in 2009 was primarily due to costs relatedto our February 2010 restructuring of operations of $1.4 million,partially offset by a reduction in our on-going operating costs as a result ofour restructuring efforts.

 

17

----

Table of Contents

 

***Interest and Other Income, Net***

 
| ** **                     | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|----------------------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | **March 31,**               | ** ** | **Change** | ** ** |
| ** **                     | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **                     | ** ** | **(in thousands, except %)**     | ** ** |
| Interest and other income, net |       | $                                | 63         |       | $          | 54         |       | $ | 9 |   | 17 | % |
|                                |            |                                  |            |            |            |            |            |  |  |  |  |  |

 

Interest and other income, net of otherexpenses, consist primarily of interest income from our investments in moneymarket funds and marketable securities, realized gains or losses from the saleof marketable securities and certain expenses such as state franchise tax. Theincrease in interest and other income for the three months ended March 31,2010 as compared to the same period in 2009 was primarily due to a partial state franchise taxrebate recognized in the first quarter of 2010 and a realized gain ofapproximately $18,000 related to the sale of our auction rate security holdingoffset by lower interest income due to lower invested cash balances.

 

***Interest Expense***

*** ***
| ** **       | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------|------------|----------------------------------|------------|------------|------------|------------|------------|
| ** **       | ** ** | **March 31,**               | ** ** | **Change** | ** ** |
| ** **       | ** ** | **2010**                         | ** ** | **2009**   | ** ** | **$**      | ** ** | **%** | ** ** |
| ** **       | ** ** | **(in thousands, except %)**     | ** ** |
| Interest expense |       | $                                | 434        |       | $          | 500        |       | $ | -66 |   | -13 | % |
|                  |            |                                  |            |            |            |            |            |  |  |  |  |  |

 

The decrease in interest expense for the threemonths ended March 31, 2010 as compared to the same period in 2009 wasprimarily due to a reduction of our debt balances outstanding resulting fromthe contractual pay down of our debt obligations.

 

**Liquidityand Capital Resources**

 
| ** **                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **March 31,**               | ** ** |
| ** **                  | ** ** | **2010**                         | ** ** | **2009** | ** ** |
| ** **                  | ** ** | **(in thousands)**          | ** ** |
| Cash (used in) provided by: |       |                             |       |   |   |
| Operating activities        |       | (6,423                           | )          | (11,685 | ) |
| Investing activities        |       | 370                              |       | (1,742 | ) |
| Financing activities        |       | 4,941                            |       | (139 | ) |
| Total cash (used) provided  |       | (1,112                           | )          | (13,566 | ) |

 

As of March 31, 2010, the Company had cash, cash equivalents and marketablesecurities on hand in the amount of $6.3 million, current payables andaccrued liabilities of approximately $1.8 million and approximately$5.4 million in current notes and related interest payable. As of March 31,2010, the Company had outstanding non-current liabilities of $5.7 million.Since our inception, we have incurred significant net operating losses and, asof March 31, 2010, we had an accumulated deficit of $193.5 million.We have not achieved sustained profitability and anticipate that we willcontinue to incur significant net losses for the foreseeable future. There canbe no assurances that we will achieve positive cash flow in the foreseeablefuture or at all. Additionally, we do not expect that cash on hand as of March 31,2010 will be sufficient to fund our operations during the following 12-month period.

Net cash used inoperating activities was $6.4 million and $11.7 million for the threemonths ended March 31, 2010 and 2009, respectively. Net cash used in eachof these periods was primarily used towards the funding of our operating costsand expenses in connection with the conduct of our research, development andadministrative activities. The three month period ended March 31, 2010included approximately $0.9 million of cash expenditure related to our February 2010restructuring of operations.

 

Cash used in, orprovided by, investing activities primarily related to purchases, sales andmaturities of marketable securities, as well as changes in our restricted cashbalances and levels of capital expenditure. For the three months ended March 31,2010, net sales of marketable securities was $0.4  million as compared tonet purchases of marketable securities of $1.7 million for the same periodin 2009. Purchases of property and equipment were zero and $77,000 for thethree months ended March 31, 2010 and 2009, respectively.

 

Net cash provided by financing activities for the three months ended March 31,2010 was $4.9 million which was primarily related to proceeds from the sale ofcommon stock pursuant to the Commerce Court equity line agreement, partiallyoffset by principal and interest payments on our long-term debt. For the threemonths ended March 31, 2009, net cash used in financing activities was$139,000. Net cash used in financing activities for the three months ended March 31,2009 primarily consisted of principal payments on our long-term debt.

 

18

----

Table of Contents

 

As of March 31, 2010, we have loan commitments outstanding withLighthouse Capital Partners V, L.P., or Lighthouse, General Electric CommercialFinance, or GE, and Oxford Finance Corporation, or Oxford.  The total principal amount borrowed under theLighthouse agreements was $19.0 million and the total unpaid principalbalance outstanding as of March 31, 2010, was $7.9 million. Werecorded interest expense related to the Lighthouse loan agreement, includingamortization of expense related to the terminal payment and the warrants issuedunder the agreement, of $410,000 and $460,000 for the three months ended March 31,2010 and 2009, respectively.  The totalprincipal amount borrowed under the GE agreements was $1.9 million and thetotal unpaid principal balance outstanding as of March 31, 2010, was$33,000. We recorded interest expense related to the GE loan agreements of$1,600 and $9,000 for the three months ended March 31, 2010 and 2009,respectively.  The total principal amountborrowed under the Oxford loan agreement was $1.0 million and the totalunpaid principal balance outstanding as of March 31, 2010, was $625,000.We recorded interest expense related to the Oxford loan agreement, includingamortization of expense related to the terminal payment and the warrant issuedunder the agreement, of $22,500 and $31,000 for the three months ended March 31,2010 and 2009, respectively.

 

***Equity Line Financing Facility***

 

On October 6, 2009, we entered into a common stock purchaseagreement, or the Purchase Agreement, with Commerce Court Small Cap ValueFund, Ltd., or Commerce Court, providing for a financing arrangement thatis sometimes referred to as a committed equity line financing facility. ThePurchase Agreement provided that, upon the terms and subject to the conditionsset forth in the Purchase Agreement, Commerce Court would be committed topurchase up to $35.0 million of shares of our common stock over the24-month term of the Purchase Agreement under certain specified conditions.Under the terms of the Purchase Agreement, in no event could we sell more than5,380,090 shares of common stock, which is equal to one share less than 20% ofour outstanding shares of common stock on October 6, 2009, the closingdate of the Purchase Agreement, less the number of shares of common stock weissued to Commerce Court on the closing date as Commitment Shares describedbelow. Furthermore, in no event would Commerce Court be obligated to purchaseany shares of our common stock which, when aggregated with all other shares ofour common stock then beneficially owned by Commerce Court, would result in thebeneficial ownership by Commerce Court of more than 9.9% of the thenoutstanding shares of our common stock. We issued to Commerce Court, upon execution of thePurchase Agreement, 114,200 shares of our common stock, or the CommitmentShares.

 

On December 11, 2009, we delivered notice to Commerce Court toeffect a draw down of up to $1.0 million. The first trading day of the10-day pricing period for this draw down was December 14, 2009. Inconnection with this draw down, we issued an aggregate of 413,896 shares of ourcommon stock to Commerce Court, at a per share purchase price of approximately$2.42 and an aggregate purchase price of $1.0 million. The settlement datefor this draw down was December 30, 2009. The per share price at whichCommerce Court purchased these shares from us was established under thePurchase Agreement by reference to the volume weighted average prices of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of 7.0% per share. We received net proceeds from the sale of theseshares of approximately $781,000 after deducting our offering expenses ofapproximately $219,000 including a placement agent fee of $10,000 paid toReedland Capital Partners, an Institutional Division of Financial West Group,member FINRA/SIPC. Of the total offering cost, approximately $180,000 wasincurred as one time expenses related to the filing of a registration statementon Form S-1 covering the resale of the shares of Common Stock sold toCommerce Court and legal fees incurred upon entering into the PurchaseAgreement with Commerce Court.

 

On January 4, 2010, we delivered notice to Commerce Court, assubsequently amended, to effect a draw down of up to $1.4 million. Thefirst trading day of the 10-day pricing period for this draw down was January 5,2010. In connection with this draw down, we issued an aggregate of 490,864shares of our common stock to Commerce Court, at a purchase price of approximately$2.85 per share and an aggregate purchase price of $1.4 million. Thesettlement date for this draw down was January 20, 2010. The share priceat which Commerce Court purchased these shares from us was established underthe Purchase Agreement by reference to the volume weighted average prices ofour common stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 6.1% per share. We received net proceeds from thesale of these shares of approximately $1.38 million after deducting ouroffering expenses of approximately $25,000, including a placement agent fee of$14,000 paid to Reedland Capital Partners connection with this draw down.

 

On February 19, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was February 22, 2010. Inconnection with this draw down, we issued an aggregate of 2,764,546 shares ofour common stock to Commerce Court, at a purchase price of approximately $1.19per share and an aggregate purchase price of approximately $3.29 million.The settlement date for this

 

19

----

Table ofContents

 

drawdown was March 8, 2010. The share price at which Commerce Court purchasedthese shares from us was established under the Purchase Agreement by referenceto the volume weighted average price of our common stock on The NASDAQ GlobalMarket during the pricing period, net a discount of approximately 7.0% pershare. We received net proceeds from the sale of these shares of approximately$3.24 million after deducting our estimated offering expenses ofapproximately $45,000, including a placement agent fee of $33,000 paid toReedland Capital Partners in connection with this draw down.

 

On March 11, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was March 12, 2010. In connectionwith this draw down, we issued an aggregate of 1,710,784 shares of our commonstock to Commerce Court, at a purchase price of approximately $1.07 per shareand an aggregate purchase price of approximately $1.83 million. Thesettlement date for this draw down was March 26, 2010. The share price atwhich Commerce Court purchased these shares from us was established under thePurchase Agreement by reference to the volume weighted average price of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 7.0% per share. We received net proceeds from thesale of these shares of approximately $1.8 million after deducting ourestimated offering expenses of approximately $30,000, including a placementagent fee of $18,311 payable to Reedland Capital Partners in connection withthis draw down.

 

As of March 26, 2010, we had issued the maximum amount of commonstock available under the Commerce Court Purchase Agreement and therefore willno longer be able to utilize the facility.

 

Our future funding requirements will depend upon many factors,including:

 

·                  the extent of our success inmonetizing the value of our current product candidate portfolio;

 

·                  the size, complexity andcost of our remaining business operations;

 

·                  the terms and timing of anycollaborative, licensing and other arrangements that we may establish;

 

·                  the cost, timing andoutcomes of regulatory approvals;

 

·                  the timing, receipt andamount of sales or royalties generated, if any, from our product candidates;and

 

·                  the cost of preparing,filing, prosecuting, defending and enforcing any patent claims and otherintellectual property rights.

 

Our ability to continue operations will be dependent on our ability toobtain additional funding and such funding may not be available to us onacceptable terms, or at all. We may seek to raise necessary additional fundsthrough public or private equity, debt financings, collaborative arrangementswith corporate partners or other sources. For instance, our most recent sourceof funding has been through utilization of the Commerce Court equity line facilityas described above. However, given our full utilization of the Commerce Courtfacility, we will seek alternative sources of funding to allow us to continueour operations as we explore strategic options available to us. If we areunable to raise additional funds when needed, we may not be able to continueour current operations and we may not have sufficient resources to fullyexplore the strategic options available to us. If we raise additional fundsthrough the issuance of debt securities, these securities could have rightsthat are senior to the holders of our common stock and could contain covenantsthat restrict our operations. If we raise additional funds by issuing equitysecurities, dilution to our existing stockholders may result. In addition, if weraise additional funds through the sale of equity securities, new investorscould have rights superior to our existing stockholders. To the extent that weraise additional capital through licensing or other arrangements, we may berequired to relinquish, on terms that are not favorable to us, rights to someof our technologies or product candidates that we would otherwise seek todevelop or commercialize ourselves for a higher profit margin. The terms offuture financings may restrict our ability to raise additional capital, whichcould delay or prevent the further development of our product candidates or ourability to fully explore our strategic options. Our failure to raise capitalwhen needed may harm our business and operating results.

 

**ContractualObligations**

 

There were no material changes to our contractualobligations from those disclosed in our annual report on Form 10-K filedwith the Securitiesand Exchange Commission on March 30,2010, other than scheduled payments made through March 31, 2010.

 

 

20

----

Table of Contents

 

**RecentAccounting Pronouncements**

 

SeeNote 1 of the Notes to our Condensed Consolidated Financial Statements includedelsewhere in this report for recent accounting pronouncements that could havean effect on us.

 

**Off-BalanceSheet Arrangements**

 

Sinceinception, except for standard operating leases, we have not engaged in anyoff-balance sheet arrangements, including the use of structured finance,special purpose entities or variable interest entities.

 

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

 

Therewere no material changes to our market risk from those disclosed in our annualreport on Form 10-K filed with the Securities and Exchange Commission on March 30,2010.

 

**ITEM 4T.CONTROLS AND PROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

As of March 31,2010, an evaluation was performed by management, with the participation of ourChief Executive Officer and Chief Financial Officer, of the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15-d and 15(e) under the Securities Exchange Act of 1934, as amended).Disclosure controls and procedures are controls and procedures that aredesigned to ensure that information required to be disclosed in our reportsfiled or submitted under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. Based on thatevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that, subject to the limitations described below, our disclosurecontrols and procedures were effective as of March 31, 2010.

 

***Limitations on the Effectiveness of Controls***

 

Ourmanagement, including our Chief Executive Officer and Chief Financial Officer, does notexpect that our disclosure controls and procedures or our internal controlswill prevent all error and all fraud. A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the company have been detected. These inherent limitations include therealities that judgments in decision-making can be faulty, and that breakdownscan occur because of simple error or mistake. Additionally, controls can becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the control. The design of any systemof controls also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions. Over time,control may become inadequate because of changes in conditions, or the degreeof compliance with the policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and may not be detected.

 

***Changes in Internal Control overFinancial Reporting***

 

Nochange was made in our internal control over financial reporting during thequarter ended March 31, 2010 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

21

----

Table of Contents

 

**PART II — OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

From time to timewe are involved in legal proceedings arising in the ordinary course of ourbusiness. We believe there is no litigation pending that could have,individually or in the aggregate, a material adverse effect on our results ofoperations or financial condition.

 

**ITEM 1A.RISK FACTORS**

 

*We have identified the following risks and uncertaintiesthat may have a material adverse effect on our business, financial condition orresults of operations. The risks described below are not the only ones we face.Additional risks not presently known to us or that we currently believe areimmaterial may also significantly impair our business operations. Our businesscould be harmed by any of these risks.**The trading price of ourcommon stock could decline due to any of these risks, and our investors maylose all or part of their investment.**We have marked with an asterisk(*) those risks described below that reflect substantive changes from therisks described in our Annual Report on Form 10-K  for the year ended December 31, 2008,filed with the Securities and Exchange Commission on March 27, 2009. Inassessing these risks, you should also refer to the other information containedin this quarterly report on Form 10-Q, including our financial statementsand related notes.*

 

**Risks Related to Our Business**

 

***We will need substantial additionalfunding and may be unable to raise capital when needed, which would force us tolimit or cease our operations and related product development programs.***

 

As of March 31, 2010, we had $6.3 million in cash, cashequivalents and marketable securities on hand which is less than the amountneeded for us to maintain our current operations for the next 12 months.Our ability to continue operations is dependent upon our ability to obtain substantialadditional capital. Our operations have consumed substantial amounts of cashsince inception, and we expect to continue to incur net losses for theforeseeable future as we explore strategic options in an effort to optimize thevalue of our assets. While we are currently exploring strategic optionsavailable to us, including collaboration arrangements to continue thedevelopment and potential commercialization of one or more of our lead productcandidates or the sale of any or all of our assets, we cannot forecast with anydegree of certainty whether a strategic transaction and/or collaborationarrangement will be achieved on optimal terms or at all. However, should suchcollaboration arrangements fail to provide sufficient revenue to fund ouroperations adequately, we will need to raise additional capital to fund ouroperations and complete development of our product candidates. Our futurefunding requirements will depend on many factors, including:

 

·                  the terms and timing of anycollaborative, licensing and other arrangements that we may establish, if any;

 

·                  the extent of our success inmonetizing the value of our current product candidate portfolio;

 

·                  the cost, timing andoutcomes of regulatory approvals;

 

·                  the size, complexity andcost of our remaining business operations;

 

·                  the timing, receipt andamount of sales or royalties, if any, from our potential products; and

 

·                  the cost of preparing,filing, prosecuting, defending and enforcing any patent claims and otherintellectual property rights.

 

Until we can generate a sufficient amount of collaboration or productrevenue to finance our cash requirements, which we may never do, we expect tofinance future cash needs primarily through public or private equity offerings,debt arrangements and/or a possible collaboration or license of developmentand/or commercialization rights to one or more of our product candidates. We donot know whether additional funding will be available to us on acceptableterms, or at all.

 

If we raise additional funds by issuing equity securities, ourstockholders will experience dilution. Any debt financing or additional equitythat we raise may contain terms that are not favorable to our stockholders orus. If we raise additional funds through collaboration and licensing arrangementswith third parties, we may be required to relinquish some rights to ourtechnologies or our product candidates, grant licenses on terms that are notfavorable to us or enter into a collaboration arrangement for a productcandidate at an earlier stage of development or for a lesser amount than wemight otherwise choose.

 

22

----

Table ofContents

 

We do not expect our existing capital resources to be sufficient toenable us to fund the completion of the development of any of our productcandidates. Additional funds may not be available when we need them on termsthat are acceptable to us, or at all. If adequate funds are not available on atimely basis, we may:

 

·                  terminate or delay futureclinical trials for one or more of our product candidates;

 

·                  further reduce our headcountand capital or operating expenditures; or,

 

·                  curtail future drug researchand development programs that are designed to identify new product candidates.

 

As we explore strategic options, no significant development activity iscurrently underway on any of our product candidates and therefore we are notable to advance their development.

 

***We have incurred significantoperating losses since inception and expect to continue to incur substantialand increasing losses for the foreseeable future. We may never achieve orsustain profitability.***

 

We have a limited operating history and have incurred significantlosses since our inception. As of March 31, 2010, we had an accumulateddeficit of approximately $193.5 million. We expect to continue to incurnet losses for the foreseeable future as we explore strategic options availableto us. These losses have had and will continue to have an adverse effect on ourstockholders’ equity and working capital.

 

Because of the numerous risks and uncertainties associated with drugdevelopment, we are unable to predict with certainty the costs we will incur insupport of our product candidates as we pursue strategic options, includingpotential collaboration arrangements. Currently, we have no products approvedfor commercial sale, and, to date, we have not generated any product revenue.We have financed our operations primarily through the sale of equitysecurities, capital lease and equipment financings, debt financings and asingle corporate partnership with Procter & Gamble Pharmaceuticals, Inc.,or P&G, that was terminated in July 2008. We have devotedsubstantially all of our efforts to research and development, includingclinical trials. If we are unable to develop and commercialize any of ourproduct candidates, if development is delayed, if sales revenue from anyproduct candidate approved by the U.S. Food and Drug Administration, or theFDA, is insufficient or if we fail to enter into partnering arrangements forour product candidates on terms favorable to us, we may never becomeprofitable. Even if we do become profitable, we may not be able to sustain orincrease our profitability on a quarterly or annual basis.

 

***Our loan agreements imposerestrictions on us that may adversely affect our ability to operate ourbusiness.***

 

Certain of our loan agreements with our lenders contain covenants thatrestrict or limit, among other things, our ability to create liens supportingindebtedness, sell assets, make certain distributions, and incur additionaldebt. In addition, our debt agreements contain, and those we enter into in thefuture may contain, financial covenants and other limitations with which wewill need to comply. Our ability to comply with these covenants may be affectedby many events beyond our control, and we cannot assure you that our futureoperating results will be sufficient to comply with the covenants or, in theevent of a default under any of our debt agreements, to remedy that default.

 

Our failure to comply with the covenants in our loan agreements andother related transactional documents could result in events of default. Uponthe occurrence of such an event of default, the lenders could elect to declareall amounts outstanding under a particular facility to be immediately due andpayable and terminate all commitments, if any, to extend further credit. Anevent of default or an acceleration under one loan agreement could cause across-default or cross-acceleration of another loan agreement. Suchcross-default or cross-acceleration could have a wider impact on our liquiditythan might otherwise arise from a default or acceleration of a single loanfacility. If an event of default occurs, or if other loan agreementscross-default, and the lenders under the affected loan agreements acceleratethe maturity of any loans or other debt outstanding to us, we may not havesufficient liquidity to repay amounts outstanding under such loan agreements.

 

Our ability to repay, extend or refinance our existing debt obligationsand to obtain future credit will depend primarily on our operating performanceand ability to raise additional capital to continue our operations, which willbe affected by general economic, financial, regulatory, business and otherfactors, many of which are beyond our control. Our 

 

23

----

Table of Contents

 

abilityto refinance existing debt obligations will also depend upon the currentconditions in the credit markets and the availability of credit generally. Ifwe are unable to meet our debt service obligations or are unable to obtainfuture credit on acceptable terms, if at all, we could be forced to restructureor refinance our indebtedness, seek additional equity capital or sell orliquidate our assets. In such an event, we may be unable to obtain financing orsell our assets on acceptable terms, or at all.

 

***General economic conditions,including concerns regarding the current global recession and creditconstraints may negatively impact our business, results of operations, andfinancial condition.***

 

As widely reported, financial markets in the U.S. and other globalmarkets have been experiencing extreme disruption in the past year, including,among other things, extreme volatility in security prices, declining valuationsof certain investments, severely diminished liquidity and credit availability, thefailure or sale of various financial institutions and an unprecedented level ofgovernment intervention. Business activity across a wide range of industriesand regions is greatly reduced and local governments and many businesses are inserious difficulty due to the lack of consumer spending and the lack ofliquidity in the credit markets. As a company having no commercial operations,such a protracted downturn may hurt our business in a number of ways, includingthe impact on our ability to access capital and credit markets to meet ourfinancing objectives to allow us to continue our operations, and on our abilityto manage our cash balance, current portfolio of cash equivalents orinvestments in marketable securities. While we are unable to predict the likelyduration and severity of the adverse conditions in the U.S. and othercountries, any of the circumstances mentioned above could adversely affect ourbusiness, financial condition, operating results and cash flow or cashposition.

 

***Our success depends substantially onour most advanced product candidates, which are still under development. If weare unable to bring any or all of these product candidates to market, orexperience significant delays in doing so, our ability to generate productrevenue and our likelihood of success will be harmed.***

 

We have three product candidates in late stage clinical development,with tecarfarin in Phase 2/3, and budiodarone and ATI-7505 inPhase 2b. A fourth product candidate, ATI-9242, entered into aPhase 1 clinical trial in April 2008. Our ability to generate productrevenue in the future will depend heavily on the successful development andcommercialization of these product candidates. Our other product candidates arein the discovery stage. Any of our product candidates could be unsuccessful fora variety of reasons, including that they:

 

·                  may not demonstrateacceptable safety and efficacy in preclinical trials or clinical trials orotherwise may not meet applicable regulatory standards for approval;

 

·                  may not offer therapeutic,safety or other improvements over existing or future drugs used to treat thesame conditions;

 

·                  may not be capable of beingproduced in commercial quantities at acceptable costs; or

 

·                  may not be accepted in themedical community or by third-party payors.

 

We do not expect any of our current product candidates to becommercially available in the next several years, if at all. If we are unableto make our product candidates commercially available, we will not generateproduct revenues and we will not be successful. The results of our clinicaltrials to date do not provide assurance that acceptable efficacy or safety willbe shown upon completion of Phase 3 clinical trials.

 

***We expect to depend on collaborativearrangements to complete the development and commercialization of each of ourproduct candidates. Potential collaborative arrangements will likely place thedevelopment of our product candidates outside of our control and will likelyrequire us to relinquish important rights or may otherwise be on termsunfavorable to us.***

 

The strategic options we are currently pursuing include potentialcollaborative arrangements with third parties to develop and commercialize eachof our lead product candidates. Dependence on collaborative arrangements fordevelopment and commercialization of our product candidates will subject us toa number of risks, including:

 

·                  we may not complete acollaborative arrangement in time to avoid delays in clinical development, ifat all, and if no collaborative arrangement is achieved, product developmentmay be halted altogether. Currently, there are no clinical activities underwayon any of our product candidates;

 

24

----

Table of Contents

 

·                  we may not be able tocontrol the amount and timing of resources that our collaborators may devote tothe development or commercialization of product candidates or to theirmarketing and distribution;

 

·                  collaborators may delayclinical trials, provide insufficient funding for a clinical trial program,stop a clinical trial or abandon a product candidate, repeat or conduct newclinical trials or require a new formulation of a product candidate forclinical testing;

 

·                  we may have limited controlover our clinical trial design;

 

·                  disputes may arise betweenus and our collaborators that result in the delay or termination of theresearch, development or commercialization of our product candidates or thatresult in costly litigation or arbitration that diverts management’s attentionand resources;

 

·                  our collaborators mayexperience financial difficulties;

 

·                  collaborators may notproperly maintain or defend our intellectual property rights or may use ourproprietary information in such a way as to invite litigation that couldjeopardize or invalidate our proprietary information or expose us to potentiallitigation;

 

·                  business combinations orsignificant changes in a collaborator’s business strategy may adversely affecta collaborator’s willingness or ability to fulfill its obligations under anyarrangement;

 

·                  a collaborator couldindependently move forward with a competing product candidate developed eitherindependently or in collaboration with others, including our competitors; and

 

·                  any collaborative arrangementmay be terminated or allowed to expire, which would delay the development andmay increase the cost of developing our product candidates.

 

***Collaborative arrangements do notcurrently exist for any of our product candidates. If we do not establish collaborationsfor each of our budiodarone, tecarfarin, ATI-7505 and ATI-9242 productcandidates or future product candidates, we may have to alter our developmentand commercialization plans.***

 

The strategic options we are currently pursuing include potentialcollaborations with leading pharmaceutical and biotechnology companies toassist us in furthering the development and potential commercialization of someof our product candidates, including budiodarone, tecarfarin, ATI-7505 andATI-9242. We are seeking partners because the commercialization of each of ourfirst four product candidates involves a large, primary care market that mustbe served by large sales and marketing organizations and because we do notcurrently have the capabilities to perform Phase 3 clinical trials. Weface significant competition in seeking appropriate collaborators, and thesecollaborations are complex and time-consuming to negotiate and document. We maynot be able to negotiate collaborations on acceptable terms, if at all. We areunable to predict when, if ever, we will enter into any collaborations becauseof the numerous risks and uncertainties associated with establishingcollaborations. If we are unable to negotiate an acceptable collaboration, wemay have to curtail the development of a particular product candidate, reduceor delay its development program or one or more of our other developmentprograms, delay its potential commercialization or reduce the scope of oursales or marketing activities or increase our expenditures and undertakedevelopment or commercialization activities at our own expense. If we elect toincrease our expenditures to fund development or commercialization activitieson our own, we may need to obtain additional capital, which may not beavailable to us on acceptable terms, if at all. If we do not have sufficientfunds, we will not be able to bring our product candidates to market andgenerate product revenues.

 

***The commercial success of ourpotential collaborations will depend in part on the development and marketingefforts of our potential partners, over which we will have limited control. Ifour collaborations are unsuccessful, our ability to develop and commercializeand to generate future revenue from the sale of our products will be significantlyreduced.***

 

Our dependence on future collaboration arrangements will subject ourcompany to a number of risks. Our ability to develop and commercialize each ofour product candidates will depend on our and our potential collaborationpartner(s)’ ability to establish the safety and efficacy of each respectiveproduct candidate, obtain and maintain regulatory approvals and achieve marketacceptance of the product candidate(s) once commercialized. Our potentialcollaboration partner(s) may elect to delay or terminate development ofour product candidates, independently develop products that compete with ours,or fail to commit sufficient resources to the marketing and distribution of ourproduct candidates. The termination of a collaboration agreement may cause usto incur additional and unanticipated costs that may be material to ouroperations.

 

25

----

Table ofContents

 

Business combinations, significant changes in business strategy,litigation and/or financial difficulties may also adversely affect thewillingness or ability of our potential collaboration partners to fulfill theirobligations to us. If a partner fails to perform in the manner we expect, ourpotential to develop and commercialize the respective product candidate(s) throughother collaborations and to generate future revenue from the sale of theproduct candidate(s) may be significantly reduced. If a conflict ofinterest arises between us and our collaboration partner(s), they may act intheir own self-interest and not in the interest of our company or ourstockholders. If a collaboration partner breaches or terminates theircollaboration agreement with us or otherwise fails to perform their obligationsthereunder in a timely manner, the clinical development or commercialization ofthe respective product candidate(s) could be delayed or terminated. Forexample, we experienced this when P&G terminated our collaborationagreement to develop and commercialize ATI-7505, and we may experience asimilar result with potential collaboration partners in the future with respectto any of our product candidates.

 

***If we are not able to obtainrequired regulatory approvals, we will not be able to commercialize our productcandidates, our ability to generate revenue will be materially impaired and ourbusiness will not be successful.***

 

Our product candidates and the activities associated with theirdevelopment and commercialization are subject to comprehensive regulation bythe FDA and other federal and state regulatory agencies in the United Statesand by comparable authorities in other countries. The inability to obtain FDAapproval or approval from comparable authorities in other countries wouldprevent us and our collaborative partners from commercializing our productcandidates in the United States or other countries. Future collaborativeagreements will likely cause us to give up control of interactions andregulatory approval processes with the FDA and other regulatory bodies. We orour partners may never receive regulatory approval for the commercial sale ofany of our product candidates. We have only limited experience in preparing andfiling the applications necessary to gain regulatory approvals and have notreceived regulatory approval to market any of our product candidates in anyjurisdiction. The process of applying for regulatory approval is expensive andtime-consuming, and can vary substantially based upon the type, complexity and noveltyof the product candidates involved.

 

Because our product candidates are modeled after drugs which are knownto have safety problems, the FDA and other regulatory agencies may requireadditional safety testing which may delay our clinical progress, increase ourexpected costs or make further development unfeasible. For instance, because ofknown problems with the drug after which it was modeled, we were required toconduct significant monitoring for cardiac toxicity in our clinical trials ofATI-7505.

 

Changes in regulatory approval policies during the development period,changes in, or the enactment of, additional regulations or statutes or changesin the regulatory review team for each submitted product application may causedelays in the approval or rejection of an application. Even if the FDA or aforeign regulatory agency approves a product candidate, the approval may imposesignificant restrictions on the indicated uses, conditions for use, labeling,advertising, promotion, marketing and/or production of such product and mayimpose requirements for post-approval trials, including additional research anddevelopment and clinical trials. The FDA and other agencies also may imposevarious civil or criminal sanctions for failure to comply with regulatoryrequirements, including substantial monetary penalties and withdrawal ofproduct approval.

 

The FDA has substantial discretion in the approval process and mayrefuse to accept any application or decide that our data are insufficient forapproval and require additional preclinical, clinical or other trials. Forexample, varying interpretations of the data obtained from preclinical andclinical testing could delay, limit or prevent regulatory approval of a productcandidate. Moreover, the FDA may not agree that certain target indications areapprovable. For instance, the FDA has never approved a drug for postprandialdistress syndrome, or PDS, and we cannot be certain that the FDA will recognizePDS as an indication for which ATI-7505 or other drugs can be approved. Asanother example, while we believe we have clear direction from the FDA as tothe development path for our tecarfarin product candidate based on our variousdiscussions, the FDA may change its judgment on the appropriate developmentpathway for tecarfarin at any time. Similarly, the clinical trials to berequired by the FDA for approval of new anti-arrythmic therapies may change asthe FDA considers the approval of similar therapies submitted by competingpharmaceutical companies.

 

We will need to obtain regulatory approval from authorities in foreigncountries to market our product candidates in those countries. We have not yetinitiated the regulatory process in any foreign jurisdictions. Approval by oneregulatory authority does not ensure approval by regulatory authorities inother jurisdictions. If we fail to obtain approvals from foreign jurisdictions,the geographic market for our product candidates would be limited.

 

26

----

Table of Contents

 

***Safety issues relating to ourproduct candidates or the original drugs upon which our product candidates havebeen modeled, or relating to approved products of third parties that are similarto our product candidates, could give rise to delays in the regulatory approvalprocess.***

 

Discovery of previously unknown problems with an approved product mayresult in restrictions on its permissible uses, including withdrawal of themedicine from the market. Each of the opportunities upon which we have chosento focus is based upon our belief that our RetroMetabolic Drug Designtechnology can be used to create a new product based upon an existing productwhich is efficacious in treating a specific condition, but which has a knownsafety problem. Each of our four lead product candidates is modeled on drugswhich have significant safety problems. Budiodarone is modeled on amiodaronewhich is used, but not approved, for atrial fibrillation in spite of knownsafety problems due to its accumulation in the body and interaction with otherdrugs. Both amiodarone and budiodarone contain iodine which can accumulate inthe thyroid and must be monitored for safety purposes. In addition, budiodaroneis partially metabolized by CYP450 and, at certain levels has caused drug-druginteractions with warfarin, which increased INR and could increase the risk ofhemorrhage complications. Tecarfarin is modeled on warfarin which is known tohave safety risks because of its potential for bleeding and for interactionswith numerous other drugs as listed on the package insert for the product.ATI-7505 is modeled on cisapride which was withdrawn from the market due tofatal cardiac problems. ATI-9242 is modeled to retain certain of the positivefeatures of the class of atypical antipsychotic drugs while lessening certainof the safety issues that vary but exist within the class. The receptor profilewhich yields the positive and avoids the negative features of this class ofdrugs is a matter of great debate. While we have designed ATI-9242 to have anappropriate balance across a very complex set of receptors, we may havetargeted an inappropriate profile or the profile attained may result in anunanticipated lack of efficacy or safety problems. Although we have designedour drugs to largely address each of the original drugs’ key safety problems,we will need to continue to demonstrate this through continued clinicaltesting. It is possible that the FDA may impose additional requirements on thedevelopment or approval of our products because of its concern about theoriginal drug’s safety problems. These potential additional barriers coulddelay, increase the cost of, or prevent the commercialization of our productcandidates.

 

Our product candidates are engineered to be broken down by the body’snatural metabolic processes in a manner we believe to be safer than that of theoriginal drug. There can be no assurance that the products we develop willactually be metabolized as we expect. While we have designed the breakdownproducts to be safe, it is possible that there will be unexpected toxicity associatedwith these breakdown products that could cause our products to be poorlytolerated by, or toxic to, humans. Additionally, while we believe we haveaddressed the key safety problem of each of the original drugs, it is possiblethat our change to the chemical structure may result in new unforeseen safetyissues. Any unexpected toxicity or suboptimal tolerance of our products woulddelay or prevent commercialization of these product candidates. Additionally,problems with approved products marketed by third parties that utilize the sametherapeutic target as our product candidates could adversely affect thedevelopment of our product candidates. For example, the product withdrawals ofVioxx by Merck & Co., Inc. and Bextra by Pfizer because ofsafety issues caused other drugs that have the same therapeutic target, such asCelebrex from Pfizer, to receive additional scrutiny from regulatoryauthorities. Another prokinetic, tegaserod marketed by Novartis PharmaceuticalsCorporation as Zelnorm, was temporarily withdrawn from the market and thenreintroduced in a very limited manner due to certain cardiac effects reportedlyrelated to its off-target effects. It is possible that we or a futurecollaboration partner may be required by regulatory agencies to perform tests,in addition to those we have planned, in order to demonstrate that ATI-7505does not have the safety problems associated with Zelnorm. Any failure or delayin commencing or completing clinical trials or obtaining regulatory approvalsfor our product candidates would delay commercialization of our productcandidates and severely harm our business and financial condition.

 

***Any failure or delay in commencingor completing clinical trials for our product candidates could severely harmour business.***

 

To date, we have not completed the clinical trial program of anyproduct candidate. The commencement and completion of clinical trials for ourproduct candidates may be delayed or terminated as a result of many factors,including:

 

·                  our inability or theinability of our collaborators or licensees to manufacture or obtain from thirdparties materials sufficient for use in preclinical and clinical trials;

 

·                  delays in patientenrollment, which we previously experienced in certain trials, and variabilityin the number and types of patients available for clinical trials;

 

·                  difficulty in maintainingcontact with patients after treatment, resulting in incomplete data;

 

·                  poor effectiveness ofproduct candidates during clinical trials;

 

27

----

Table ofContents

 

·                  poor patient compliancewhile participating in one of our clinical trials;

 

·                  unforeseen safety issues orside effects; and

 

·                  governmental or regulatorydelays and changes in regulatory requirements, policies and guidelines.

 

Any delay in commencing or completing clinical trials for our productcandidates would delay commercialization of our product candidates and severelyharm our business and financial condition. It is also possible that none of ourproduct candidates will complete clinical trials in any of the markets in whichour collaborators or we intend to sell those product candidates. Accordingly,our collaborators or we would not receive the regulatory approvals needed tomarket our product candidates, which would severely harm our business andfinancial condition.

 

***We rely on third parties to conductour clinical trials. If these third parties do not perform as contractuallyrequired or expected, we may not be able to obtain regulatory approval for orcommercialize our product candidates.***

 

We do not have the ability to independently conduct clinical trials forour product candidates, and thus for each of our product candidates we mustrely on third parties such as contract research organizations, medicalinstitutions, clinical investigators and contract laboratories, to conduct ourclinical trials. We have, in the ordinary course of business, entered intoagreements with these third parties. To date, we have utilized numerous vendorsto provide clinical trial management, data collection and analysis andlaboratory and safety analysis services in the conduct of our clinical trials.In addition, to date we have conducted our clinical trials at numerous sites inNorth America and Europe. Nonetheless, we are responsible for confirming thateach of our clinical trials is conducted in accordance with its generalinvestigational plan and protocol. Moreover, the FDA requires us to comply withregulations and standards, commonly referred to as good clinical practices, forconducting and recording and reporting the results of clinical trials to assurethat data and reported results are credible and accurate and that the trialparticipants are adequately protected. Our reliance on third parties that we donot control does not relieve us of these responsibilities and requirements. Ifthese third parties do not successfully carry out their contractual duties orregulatory obligations or meet expected deadlines, if the third parties need tobe replaced or if the quality or accuracy of the data they obtain iscompromised owing to the failure to adhere to our clinical protocols orregulatory requirements or for other reasons, our clinical trials may beextended, delayed, suspended or terminated, and we may not be able to obtainregulatory approval for, or successfully commercialize, our product candidates.

 

***If some or all of our patentsexpire, are invalidated or are unenforceable, or if some or all of our patentapplications do not yield issued patents or yield patents with narrow claims,competitors may develop competing products using our intellectual property andour business will suffer.***

 

Our success will depend in part on our ability to obtain and maintainpatent and trade secret protection for our technologies and product candidatesboth in the United States and other countries. When referring to “our” patentsand other intellectual property in this section, we are referring both topatents and other intellectual property that we own or license. We rely oncomposition of matter patents for the compounds we develop. We cannot guaranteethat any patents will issue from any of our pending or future patentapplications. Alternatively, a third party may successfully circumvent ourpatents. Our rights under any issued patents may not provide us with sufficientprotection against competitive products or otherwise cover commerciallyvaluable products or processes, and we cannot guarantee that our issued patentswill not be held invalid or unenforceable.

 

The degree of future protection for our proprietary technologies andproduct candidates is uncertain because legal means afford only limitedprotection and may not adequately protect our rights or permit us to gain orkeep our competitive advantage. For example, as applied to both existing andfuture patents and other intellectual property:

 

·                  we might not have been thefirst to make the inventions covered by each of our pending patent applicationsand issued patents;

 

·                  we might not have been thefirst to file patent applications for the disclosed inventions;

 

·                  others may independentlydevelop similar or alternative technologies or duplicate our technologies;

 

·                  it is possible that none ofour pending patent applications will result in issued patents;

 

28

----

Table ofContents

 

·                  any patents issued to us orour collaborators may not provide protection for commercially viable productsor may be successfully challenged by third parties;

 

·                  the patents of others mayhave an adverse effect on our ability to do business;

 

·                  regulators or courts mayretroactively diminish the value of our intellectual property; or,

 

·                  due to financialconstraints, we may choose to not maintain or further prosecute certain patentsin certain geographies and thereby lose patent protection in those geographies.

 

Even if valid and enforceable patents cover our product candidates andtechnologies, the patents will provide protection only for a limited amount oftime. As our product candidates are based on a parent drug where much researchhas been conducted, we may encounter many competitive patents from coveredanalogs of the parent drug. Our know-how and trade secrets may only provide acompetitive advantage for a short amount of time, if at all. Furthermore, wecannot guarantee that our patents, present or future, will have scopesufficient to prevent competing products.

 

Our ability and our potential collaborators’ ability to obtain andenforce patents is highly uncertain because of the complexity of the scientificand legal issues involved and the subjective nature of issues upon whichreasonable minds may differ. Legislative, judicial, and administrative bodies,both foreign and domestic, may issue laws, decisions, and regulations,respectively, that (a) detrimentally affect our ability to obtainprotection for our technologies, (b) increase our costs of obtaining andmaintaining patents, (c) detrimentally affect our ability to enforce ourexisting patents, (d) narrow the scope of our patent protection, and/or (e) otherwisediminish the value of our intellectual property in at least the following ways:1) U.S. Federal Courts and foreign judicial authorities may renderdecisions that alter the application of the patent laws and detrimentallyaffect our ability to enforce our patents and obtain patent protection for ourtechnologies; 2) the U.S. Patent and Trademark Office, or USPTO, andforeign counterparts may change the nature of how patent applications areexamined and issue regulations that detrimentally affect our ability to obtainpatent protection for our technologies and/or increase the costs for obtainingand maintaining protection; and/or 3) Congress and other foreignlegislative bodies may make changes to their respective patent laws that maymake obtaining and enforcing patents more difficult and/or costly, and/orotherwise diminish the value of our intellectual property or narrow the scopeof our patent protection.

 

Even if patents are issued regarding our product candidates or methodsof using them, those patents can be challenged by our competitors who can arguethat such patents are invalid and/or unenforceable. Defending against suchchallenges could be costly, and the outcome is inherently uncertain and mayresult in the loss of some or all of our rights. Patents also may not protectour product candidates if competitors devise ways of making these or similarproduct candidates without legally infringing our patents. The Federal Food,Drug and Cosmetic Act and FDA regulations and policies provide incentives tomanufacturers to challenge patent validity or create modified, non-infringingversions of a drug in order to facilitate the approval of generic substitutes.These same types of incentives encourage manufacturers to submit new drugapplications that rely on literature and clinical data not prepared for or bythe drug sponsor.

 

Similarly, we may choose to challenge the patents and other rightsalleged or asserted by third parties. Such challenges, whether judicial oradministrative in nature, could be costly and the outcome uncertain. A negativeoutcome could detrimentally affect our ability to do business.

 

In addition, we may enter into agreements to license technologies andpatent rights. Should we fail to comply with the terms of those licenseagreements, including payment of any required maintenance fees or royalties, orshould the licensors fail to maintain their licensed interest in the licensedpatents, we could lose the rights to those technologies and patents, which mayhave a detrimental affect on our ability to do business.

 

As of March 31, 2010, we held 44 issued or allowed U.S. patentsand had 15 patent applications pending before the USPTO. For some of ourinventions, corresponding foreign patent protection is pending. Of the 44 U.S.patents that we hold, 39 patents are compound and composition related, havingexpiration dates from 2013 to 2025. Our composition of matter patent forbudiodarone, our compound for the treatment of atrial fibrillation, issued in April 2002and has an expiration date in 2020. The composition of matter patent fortecarfarin, our compound for anticoagulation, issued in August 2007 andhas an expiration date in 2025. The composition of matter patent for ATI-7505,our compound for the treatment of gastrointestinal disorders, issued in February 2007and has an expiration date in 2025. Our composition of matter patentapplications for ATI-9242, our product candidate for the treatment ofschizophrenia and other psychiatric disorders, are currently pending, one inthe United States and 15 in foreign jurisdictions. Although third parties maychallenge our rights to, or the scope or validity of, our patents, to date wehave not received any communications from third parties challenging our patentsor patent applications covering our clinical candidates.

 

29

----

Table ofContents

 

While budiodarone, tecarfarin and ATI-7505 are all covered in theUnited States by issued composition of matter patents, additional patentapplications would be required to extend patent protection beyond 2020, 2025and 2025, respectively (assuming the validity and enforceability of the currentcomposition of matter patents). We cannot guarantee that any patents will beissued from our pending or future patent applications, and any patents thatissue from such pending or future patent applications would be subject to thesame risks described herein for currently issued patents.

 

Our research and development collaborators may have rights to publishdata and other information in which we have rights. In addition, we sometimesengage individuals or entities to conduct research that may be relevant to ourbusiness. The ability of these individuals or entities to publish or otherwisepublicly disclose data and other information generated during the course oftheir research is subject to certain contractual limitations. In most cases,these individuals or entities are at the least precluded from publiclydisclosing our confidential information and are only allowed to disclose otherdata or information generated during the course of the research after we havebeen afforded an opportunity to consider whether patent and/or otherproprietary protection should be sought. If we do not apply for patentprotection prior to such publication or if we cannot otherwise maintain the confidentialityof our technology and other confidential information, then our ability toreceive patent protection or protect our proprietary information may bejeopardized.

 

***Failure to adequately protect ourtrade secrets and other intellectual property could substantially harm ourbusiness and results of operations.***

 

We also rely on trade secrets to protect our technology, especiallywhere we do not believe that patent protection is appropriate or obtainable.This is particularly true for our RetroMetabolic Drug Design technology.However, trade secrets are difficult to protect. Our employees, consultants,contractors, outside scientific collaborators and other advisors are requiredto sign confidential disclosure agreements but they may unintentionally orwillfully disclose our confidential information to competitors. Enforcing aclaim that a third party illegally obtained and is using our trade secrets isexpensive and time-consuming, and the outcome is unpredictable. Failure toobtain or maintain trade secret protection could adversely affect ourcompetitive business position.

 

***Third-party claims of intellectualproperty infringement would require us to spend significant time and money andcould prevent us from developing or commercializing our products.***

 

Our commercial success depends in part on not infringing the patentsand proprietary rights of other parties and not breaching any licenses that wehave entered into with regard to our technologies and products. Because othersmay have filed, and in the future are likely to file, patent applicationscovering products or other technologies that are similar or identical to ours,patent applications or issued patents of others may have priority over ordominate our patent applications or issued patents or otherwise prevent us fromcommercializing our technologies. There are numerous issued and pendingapplications related to the original molecules and analogs from which ourproducts are engineered. If such pending patents issuing from such pendingapplications are determined to be valid and construed to cover our products,the development and commercialization of any or all could be negativelyaffected and even prevented. We do not believe that our activities infringe thepatents of others or that the patents of others inhibit our freedom to operate,but we cannot guarantee that we have identified all United States and foreignpatents and patent applications that pose a risk of infringement. We may beforced to litigate if an intellectual property dispute arises, and it ispossible that others may choose to challenge our position and that a judge orjury will disagree with our conclusions. We could incur substantial costs inlitigation if we are required to defend against patent suits brought by thirdparties. If we do not successfully defend an infringement action, are unable tohave infringed patents declared invalid, and do not obtain a license to thepatented technology, we may,

 

·                  incur substantial monetarydamages;

 

·                  encounter significant delaysin marketing our products; and

 

·                  be unable to conduct orparticipate in the manufacture, use or sale of our products or methods oftreatment.

 

Similarly, if we initiate suits to defend our patents, such litigationcould be costly and there is no assurance we would have the resources to defendour patents or that we would be successful in such processes. Any legal actionagainst our collaborators or us claiming damages and seeking to enjoincommercial activities relating to the affected products and processes could, inaddition to subjecting us to potential liability for damages, require ourcollaborators or us to obtain a license to continue to manufacture or marketthe affected products and processes. Licenses required under any of thesepatents may not be available on commercially acceptable terms, if at all.Failure to obtain such licenses could materially and adversely affect ourability to develop, commercialize and sell our product candidates. We believethat there may continue to be significant litigation in the biotechnology andpharmaceutical industry regarding patent and other intellectual property rights.If we become involved in litigation, it could consume a substantial portion ofour management and financial resources and we may not prevail in any such litigation.

 

30

----

Table ofContents

 

Furthermore, our commercial success will depend, in part, on ourability to continue to conduct research to identify additional productcandidates in current indications of interest or opportunities in otherindications. Some of these activities may involve the use of genes, geneproducts, screening technologies and other research tools that are covered bythird-party patents. In some instances, we may be required to obtain licensesto such third-party patents to conduct our research and development activities,including activities that may have already occurred. It is not known whetherany license required under any of these patents would be made available oncommercially acceptable terms, if at all. Failure to obtain such licenses couldmaterially and adversely affect our ability to maintain a pipeline of potentialproduct candidates and to bring new products to market. If we are required todefend against patent suits brought by third parties relating to third-partypatents that may be relevant to our research activities, or if we initiate suchsuits, we could incur substantial costs in litigation. Moreover, the results ofany such litigation are uncertain, and an adverse result from any legal actionin which we are involved could subject us to damages and/or prevent us fromconducting some or potentially all of our research and development activities.

 

***If third parties do not manufactureour product candidates in sufficient quantities or at an acceptable cost,clinical development and commercialization of our product candidates would bedelayed.***

 

We presently do not have sufficient quantities of our productcandidates to complete clinical trials of any of our lead product candidates.We do not currently own or operate manufacturing facilities, and we rely andexpect to continue to rely on a small number of third-party manufacturers andactive pharmaceutical ingredient formulators for the production of clinical andcommercial quantities of our product candidates. We do not have long-termagreements with any of these third parties, and our agreements with theseparties are generally terminable at will by either party at any time. If forany reason, these third parties are unable or unwilling to perform under ouragreements or enter into new agreements, we may not be able to locatealternative manufacturers or formulators or enter into favorable agreements withthem. Any inability to acquire sufficient quantities of our product candidatesin a timely manner from these third parties could delay clinical trials andprevent us from developing and commercializing our product candidates in acost-effective manner or on a timely basis.

 

The starting materials for the production of budiodarone are providedby the following vendors: SCI Pharmtech, Inc., Lexen Inc., Panchim,Julich GmbH and Weylchem Inc. To date, Ricerca,Biosciences, LLC, ScinoPharm Ltd. and SCI Pharmtech have produced allof budiodarone’s active pharmaceutical ingredient. Historically, we have reliedon Ricerca, ScinoPharm and SCI Pharmtech as single-source suppliers forbudiodarone’s active pharmaceutical ingredients. In the event that Ricerca,Biosciences, LLC, ScinoPharm Ltd. or SCI Pharmtech is unable orunwilling to serve as the supplier of budiodarone, we might not be able tomanufacture budiodarone’s active pharmaceutical ingredient. This could delaythe development of, and impair our ability to, commercialize budiodarone. Toproduce budiodarone drug product, drug substance is processed into50 milligram or 200 milligram capsule forms by Patheon Inc. ofMississauga, Ontario.

 

The starting materials for the production of tecarfarin are provided bySynquest Labs, Inc. and Chem Uetikon, GmbH. To date, the activepharmaceutical ingredient for tecarfarin has been produced by ChemShop BVof the Netherlands and Corum Inc. of Taiwan on an ongoing purchase orderbasis. Should ChemShop BV or Corum Inc. be unable or unwilling toserve as the supplier of tecarfarin, a delay in the development of tecarfarincould occur, impairing our ability to commercialize tecarfarin on our existingtimeline. Tecarfarin’s active pharmaceutical ingredient is processed into1 milligram, 2 milligram, 5 milligram or 10 milligramtablets by QS Pharma of Boothwyn, PA.

 

The starting materials for the production of ATI-7505 are provided bythe following vendors: SCI Pharmtech, Inc., Corum, Inc. andLexen Inc. To produce ATI-7505 drug products, drug substance is processedinto 20 milligram or 40 milligram tablet form by PharmaceuticsInternational, Inc. of Hunt Valley, MD (PII). In the event that any ofthese vendors are unable or unwilling to produce sufficient quantities ofmaterial for the manufacture of ATI-7505, the development and/orcommercialization of ATI-7505 could be delayed or impaired. A 500 kg quantityof ATI-7505 active pharmaceutical ingredient (API) is currently in storage atPII. This drug supply is owned by Procter & Gamble and is being storedat our expense. We believe this is sufficient supply to conduct the requiredPhase 3 program for registration. However, Procter & Gamble mayterminate this arrangement at any time and dispose of the API material, or itmay prove not to be adequate for the entire Phase 3 program.

 

The starting materials for the production of ATI-9242 are provided bythe following vendors: Corum Inc., Alfa Aesar, ApolloScientific Ltd., and SKECHEM. To date, the active pharmaceuticalingredient for ATI-9242 has been produced exclusively by Corum Inc. inTaiwan. In the event that Corum Inc. is unable or unwilling to serve asthe supplier of 

 

31

----

Table ofContents

 

ATI-9242,we would not be able to manufacture ATI-9242’s active pharmaceuticalingredient. This could delay the development of, and impair our ability to,commercialize ATI-9242. To produce ATI-9242 drug product, drug substance isprocessed into 20 milligram capsule form by Xcelience LLC ofTampa, FL.

 

All of our current arrangements with third-party manufacturers andsuppliers for the production of our product candidates are on a purchase orderbasis. We currently do not have long-term supply contracts with any of thethird-party manufacturers and suppliers for our product candidates, and theyare not required to supply us with products for any specified periods, in anyspecified quantities or at any set price, except as may be specified in aparticular purchase order. We have no reason to believe that any of the currentmanufacturers and suppliers for our product candidates is the sole source forthe materials they supply us. However, if we were to lose one of these vendorsand were unable to obtain an alternative source on a timely basis or on termsacceptable to us, our clinical and production schedules could be delayed. Inaddition, to the extent that any of these vendors uses technology ormanufacturing processes that are proprietary, we may be unable to obtaincomparable materials from alternative sources.

 

***If we are required to obtainalternate third-party manufacturers, it could delay or prevent the clinicaldevelopment and commercialization of our product candidates.***

 

We may not be able to maintain or renew our existing or any otherthird-party manufacturing arrangements on acceptable terms, if at all. If weare unable to continue relationships with our current suppliers, or to do so atacceptable costs, or if these suppliers fail to meet our requirements for theseproduct candidates for any reason, we would be required to obtain alternativesuppliers. Any inability to obtain qualified alternative suppliers, includingan inability to obtain or delay in obtaining approval of an alternativesupplier from the FDA, would delay or prevent the clinical development andcommercialization of these product candidates.

 

Changes in manufacturing site, process or scale can trigger additionalregulatory requirements that could delay our ability to perform certainclinical trials or obtain product approval.

 

The manufacturing and formulation of each of our lead productcandidates that have been tested in humans to date has been performed byentities other than those that will likely manufacture the products for futureclinical trials or commercial use. There is a possibility that analysis offuture clinical trials will show that the results from our earlier clinicaltrials have not been replicated. The failure to replicate these earlier clinicaltrials would delay our clinical development timelines. New impurity profilesthat occur as a result of changing manufacturers may lead to delays in clinicaltrial testing and approvals.

 

***Use of third-party manufacturers mayincrease the risk that we will not have adequate supplies of our productcandidates.***

 

Our current and anticipated future reliance on third-partymanufacturers will expose us and our future collaborative partners to risksthat could delay or prevent the initiation or completion of our clinicaltrials, the submission of applications for regulatory approvals, the approvalof our product by the FDA or the commercialization of our products, and mayresult in higher costs or lost product revenues. In particular, our contractmanufacturers could:

 

·                  encounter difficulties inachieving volume production, quality control and quality assurance or suffershortages of qualified personnel, which could result in their inability tomanufacture sufficient quantities of drugs to meet our clinical schedules or tocommercialize our product candidates;

 

·                  terminate or choose not torenew manufacturing agreements, based on their own business priorities, at atime that is costly or inconvenient for us;

 

·                  fail to establish and followFDA-mandated current good manufacturing practices, or cGMPs, which are requiredfor FDA approval of our product candidates, or fail to document their adherenceto cGMPs, either of which could lead to significant delays in the availabilityof material for clinical trials and delay or prevent marketing approval for ourproduct candidates; and

 

·                  breach or fail to perform asagreed under manufacturing agreements.

 

32

----

Table ofContents

 

If we are not able to obtain adequate supplies of our productcandidates, it will be more difficult for us to develop our product candidatesand compete effectively. Our product candidates and any products that we maydevelop may compete with other product candidates and products for access to manufacturingfacilities.

 

In addition, Lexen, SCI Pharmtech, Scinopharm, Corum Inc. andChemShop BV are located outside of the United States. This may give riseto difficulties in importing our product candidates or their components intothe United States as a result of, among other things, FDA import inspections,incomplete or inaccurate import documentation, or defective packaging.

 

***If our preclinical trials do notproduce successful results or our clinical trials do not demonstrate safety andefficacy in humans, we will not be able to commercialize our productcandidates.***

 

To obtain the requisite regulatory approvals to market and sell any ofour product candidates, we must demonstrate, through extensive preclinical andclinical trials that the product candidate is safe and effective in humans. Todate, we have not completed all required clinical trials of any productcandidate. Preclinical and clinical testing is expensive, can take many yearsand has an uncertain outcome. A failure of one or more of our clinical trialscould occur at any stage of testing. In addition, success in preclinicaltesting and early clinical trials does not ensure that later clinical trialswill be successful, and interim results of a clinical trial do not necessarilypredict final results. We may experience numerous unforeseen events during, oras a result of, preclinical testing and the clinical trial process, which coulddelay or prevent our ability to commercialize our product candidates,including:

 

·                  regulators or institutionalreview boards may not authorize us to commence a clinical trial at aprospective trial site;

 

·                  our preclinical or clinicaltrials may produce negative or inconclusive results, which may require us toconduct additional preclinical or clinical testing or to abandon developmentprojects;

 

·                  we may suspend or terminateour clinical trials if the participating patients are being exposed tounacceptable health risks;

 

·                  regulators or institutionalreview boards may suspend or terminate clinical research for various reasons,including noncompliance with regulatory requirements;

 

·                  the effects of our productcandidates may not be the desired effects or may include undesirable sideeffects; and

 

·                  our preclinical or clinicaltrials may show that our product candidates are not superior to the originaldrugs on which our product candidates are modeled.

 

For instance, our preclinical and clinical trials may indicate that ourproduct candidates cause unexpected drug-drug interactions and result inadverse events. For example, budiodarone’s preclinical trials contain resultsthat have led to our decision to monitor for such effect in the clinic and maycontinue to be monitored in the clinic in the future. Inhibition of testicularfunction was observed in one animal species as part of these trials. No sucheffect has been observed to date in the clinic and monitoring continues. Inpublished trials, a similar effect is thought to be correlated with theaccumulation of amiodarone in tissues. A possible renal effect was alsoobserved at high doses in our rat and dog toxicology trials for budiodarone.While we have and will continue to monitor patients for these effects, there isno assurance these effects will not occur in patients as part of our clinicaltrials for budiodarone, and have a resulting adverse effect on our ability toobtain requisite regulatory approval to market and sell budiodarone. Similarly,in the clinical testing of budiodarone in patients whose condition alsorequired treatment with warfarin, dose adjustments of warfarin were sometimesrequired. As is common to most clinical trials, the potential for drug-druginteractions will be monitored. As another example, due to the result of ourPhase 2/3 clinical trial of tecarfarin, additional clinical trials oftecarfarin will be necessary in order to demonstrate clinical superiority towarfarin. Even if we adequately demonstrate that tecarfarin is safe andeffective and obtain FDA approval, we may not be permitted to market it assuperior to warfarin. In a canine toxicology trial of ATI-7505 performed by ourformer collaboration partner, P&G, six deaths occurred at doses that were10 and 20 times greater than doses currently being used in clinicaltrials. Our clinical trials to date have indicated only mild to moderate sideeffects in humans. However, further observation is warranted.

 

Even when our product candidates do not cause any adverse effects,clinical trials of efficacy may show that our product candidates do not havesignificant effects on target symptoms or may be inconclusive. For example, inthe EmbraceAC trial, tecarfarin demonstrated efficacy essentially the same asin earlier Phase 2 trials but did not achieve the 

 

33

----

Table ofContents

 

primaryendpoint of superiority over warfarin, as measured by time in therapeuticrange. ATI-7505 was tested in two Phase 2 clinical trials in which theprimary endpoints were not met in comparison to placebo. Although these trialsdid support ATI-7505’s efficacy against certain symptoms as secondaryendpoints, if future trials show that ATI-7505 is not sufficiently efficaciousto justify its use as a therapy, our business and prospects may be materiallyadversely affected. In addition, we may need to reformulate the ATI-9242 drugproduct should we find in our on-going Phase 1 testing that adequate bloodlevels are not achieved with our current formulation.

 

Unforeseen events could cause us to experience significant delays in,or the termination of, clinical trials. Any such events would increase ourcosts and could delay or prevent our ability to commercialize our productcandidates, which would adversely impact our financial results.

 

***Our product candidates will remainsubject to ongoing regulatory review even if they receive marketing approval.If we fail to comply with continuing regulations, we could lose these approvalsand the sale of our products could be suspended.***

 

Even if we receive regulatory approval to market a particular productcandidate, the approval could be conditioned on our conducting additionalcostly post-approval trials, implementing a Risk Evaluation and MitigationStrategy, or REMS, if the FDA determines that a REMS is necessary to ensure thebenefits of the drug outweigh the risks, or could limit the indicated usesincluded in our labeling. Moreover, the product may later cause adverse effectsthat limit or prevent its widespread use, force us to withdraw it from themarket or impede or delay our ability to obtain regulatory approvals inadditional countries. In addition, the manufacturer of the product and itsfacilities will continue to be subject to FDA review and periodic inspectionsto ensure adherence to applicable GMP regulations. After receiving marketingapproval, the manufacturing, labeling, packaging, adverse event reporting,storage, advertising, promotion and record keeping related to the product willremain subject to extensive regulatory requirements.

 

If we fail to comply with the regulatory requirements of the FDA andother applicable U.S. and foreign regulatory authorities or previously unknownproblems with our products, manufacturers or manufacturing processes arediscovered, we could be subject to administrative or judicially imposedsanctions, including:

 

·                  restrictions on theproducts, manufacturers or manufacturing processes;

 

·                  warning letters;

 

·                  civil or criminal penaltiesor fines;

 

·                  injunctions;

 

·                  product seizures, detentionsor import bans;

 

·                  voluntary or mandatoryproduct recalls and publicity requirements which could vary in foreignjurisdictions;

 

·                  suspension or withdrawal ofregulatory approvals;

 

·                  total or partial suspensionof production; and

 

·                  refusal to approve pendingapplications for marketing approval of new drugs or supplements to approvedapplications.

 

***We are not currently pursuingadditional research candidates using our RetroMetabolic Drug Design technology.***

 

Because we have limited financial and managerial resources, we must focuson pursuing our strategic alternatives related to our later-stage programs andare not pursuing product candidates for the opportunities that we believeremain amenable to our RetroMetabolic Drug Design. We are not currentlypursuing additional research candidates using our Retrometabolic Drug Design technology.As a result, we may forego or delay pursuit of opportunities with other productcandidates or other indications that later prove to have greater commercialpotential. Our resource allocation decisions may cause us to fail to capitalizeon viable commercial products or profitable market opportunities. During ourrecent restructuring, a significant portion of our research and developmentcapability was dismantled. It would require significant time and effort toreestablish these capabilities if discovering or developing earlier-stageprograms becomes part of our strategic focus in the future.

 

34

----

Table ofContents

 

***The commercial success of anyproducts that we may develop will depend upon the degree of market acceptanceamong physicians, patients, healthcare payors and the medical community.***

 

Any products that we may develop may not gain market acceptance amongphysicians, patients, healthcare payors and the medical community. If theseproducts do not achieve an adequate level of acceptance, we may not generatematerial product revenues and we may not become profitable. The degree ofmarket acceptance of any of our product candidates, if approved for commercialsale, will depend on a number of factors, including:

 

·                  demonstration of efficacyand safety in clinical trials;

 

·                  demonstration that we haveadequately addressed the specific safety problem of the original molecule;

 

·                  the prevalence and severityof any side effects;

 

·                  potential or perceivedadvantages over alternative treatments;

 

·                  perceptions about therelationship or similarity between our product candidates and the original drugupon which each RetroMetabolic Drug Design candidate was based;

 

·                  advantage over other drugsmay not be sufficiently great enough to obtain premium pricing;

 

·                  the timing of market entryrelative to competitive treatments;

 

·                  the ability to offer ourproduct candidates for sale at competitive prices;

 

·                  relative convenience andease of administration;

 

·                  the strength of marketingand distribution support;

 

·                  sufficient third-partycoverage or reimbursement; and

 

·                  the product labeling orproduct insert required by the FDA or regulatory authorities in othercountries.

 

***If we are unable to enter intoagreements with third parties to market and sell our product candidates, we maybe unable to generate product revenue.***

 

We do not have a sales and marketing organization and have noexperience in the sales, marketing and distribution of pharmaceutical products.It is our intention to use collaborative arrangements to gain access to largesales and marketing organizations in order to commercialize our productcandidates. If we do not enter into a collaborative agreement with partnerswhich give us access to a large sales and marketing organization, we may decideto engage contract sales organizations, pharmaceutical or other healthcarecompanies with an existing sales and marketing organization, and distributionsystem, to sell, market and distribute our products. If we enter intoarrangements with third parties to perform sales, marketing and distributionservices, our product revenues are likely to be lower than if we market andsell any products that we develop ourselves. We may not be able to establishthese sales and distribution relationships on acceptable terms, or at all. Ifwe are not able to partner with a third party, we will have difficultycommercializing our product candidates, which would adversely affect ourbusiness and financial condition.

 

***Our ability to generate revenue fromany products that we may develop will depend on reimbursement and drug pricingpolicies and regulations.***

 

Many patients may be unable to pay for any products that we maydevelop. In the United States, many patients will rely on Medicare, Medicaid,private health insurers and other third-party payors to pay for their medicalneeds. Our ability to achieve acceptable levels of reimbursement for drugtreatments by governmental authorities, private health insurers and otherorganizations will have an effect on our ability to successfully commercialize,and attract collaborative partners to invest in the development of, our productcandidates. We cannot be sure that reimbursement in the United States, Europeor elsewhere

 

35

----

Table ofContents

 

willbe available for any products that we may develop, and any reimbursement thatmay become available may be decreased or eliminated in the future. Third-party payorsincreasingly are challenging prices charged for medical products and services,and many third-party payors may refuse to provide reimbursement for particulardrugs when an equivalent generic drug is available. Although we believe thatthe safety profile of any products that we may develop will be sufficientlydifferent from the original drugs from which they are modeled to be consideredunique and not subject to substitution by a generic of the original drug in thecase of budiodarone and tecarfarin, it is possible that a third-party payor mayconsider our product candidate and the generic original drug as equivalents andonly offer to reimburse patients for the generic drug. In the case of ATI-7505,the original molecule, cisapride, was withdrawn from the market and no genericversion exists, but there are many competitive products which may limit theamount we can charge for this product candidate. There are five atypicalantipsychotics which currently dominate an estimated $16.0 billion marketfor such drugs. Most will be generic competitors of ATI-9242 if it ever reachesthe marketplace. While we have designed ATI-9242 to have the improved efficacyand safety features over the existing atypical antipsychotics, these desiredfeatures may not be proven in clinical testing or payors may be unwilling topay a higher price for improved features when generic alternatives areavailable. Even if we show improved safety with our product candidates, pricingof the existing original drug may limit the amount we will be able to chargefor each of our product candidates. If reimbursement is not available or isavailable only at limited levels, we may not be able to successfullycommercialize our product candidates, and may not be able to obtain asatisfactory financial return on products that we may develop.

 

The trend toward managed healthcare in the United States and thechanges in health insurance programs, as well as legislative proposals toreform healthcare or reduce government insurance programs, may result in lowerprices for pharmaceutical products, including any products that may be offeredby us. In addition, any future regulatory changes regarding the healthcareindustry or third-party coverage and reimbursement may affect demand for anyproducts that we may develop and could harm our sales and profitability.

 

***If our competitors are able todevelop and market products that are more effective, safer or less costly thanany products that we may develop, our commercial opportunity will be reduced oreliminated.***

 

The pharmaceutical industry is highly competitive, with a number ofestablished, large pharmaceutical companies, as well as smaller companies. Manyof these companies have greater financial resources, marketing capabilities andexperience in obtaining regulatory approvals for product candidates than wecurrently do. There are many pharmaceutical companies, biotechnology companies,public and private universities, government agencies and research organizationsactively engaged in research and development of products which may target thesame markets as our product candidates. We expect any of the potential productswe develop to compete on the basis of, among other things, product efficacy andsafety, time to market, price, extent of adverse side effects experienced andconvenience of administration and drug delivery. One or more of our competitorsmay develop products based upon the principles underlying our proprietarytechnologies earlier than us, obtain approvals for such products from the FDAmore rapidly than us or develop alternative products or therapies that aresafer, more effective and/or more cost effective than any future productsdeveloped by us. We also expect to face competition in our efforts to identityappropriate collaborators or partners to help commercialize our productcandidates in our target commercial areas.

 

Competition for tecarfarin for use as an oral anticoagulant willcontinue to come from generic coumadin due to its pricing and the years ofexperience physicians and patients have with the drug. Other oralanticoagulants are in development throughout the pharmaceutical andbiotechnology industry. Most of these development programs fall into either thefactor Xa or direct thrombin inhibitor categories. We are aware that Johnson &Johnson in collaboration with Bayer AG has a factor Xa before the FDA forapproval, and that Bristol-Myers Squibb Company in collaboration with Pfizer, Inc.,and Merck/Portola Pharmaceuticals, Inc. each have factor Xa programsin Phase 2 or Phase 3 testing. We are aware of a direct thrombininhibitor, dabigitran from Boehringer-Ingelheim GmbH, that producedPhase 3 results in September 2009 in a clinical trial treating atrialfibrillation patients in which dabigatran was shown to be superior to warfarinat one of its two doses tested. The first direct thrombin inhibitor presentedto the FDA for approval, ximelagatran, previously marketed as Exanta byAstraZeneca plc, has not been recommended for approval due toidiosyncratic liver toxicity problems. Although we believe tecarfarin’smechanism of action (VKOR inhibition as with warfarin) and broadly availableinexpensive monitoring methodology (INR) provide an advantage, thesefactor Xa and direct thrombin inhibitor programs will likely provide majorcompetition in this market. In addition, there may be other compounds of whichwe are not aware that are at an earlier stage of development and may competewith our product candidates. If any of those compounds are successfullydeveloped and approved, they could compete directly with our productcandidates.

 

We believe generic amiodarone will continue to provide competition tobudiodarone for the treatment of atrial fibrillation, even though it is notlabeled for use in atrial fibrillation in the United States. Amiodarone willcontinue to be used off-label in spite of its safety problems because of itsgeneric pricing. Sanofi-Aventis has been granted approval and launched 

 

36

----

Table of Contents

 

in the United States its antiarrhythmictherapy Multaq® (dronedarone). Approval was also granted bythe European Union in November 2009 and launch is underway. We believeMultaq® will provide substantial competition tobudiodarone in the treatment of atrial fibrillation. Other treatments foratrial fibrillation, such as sotalol, marketed by Bayer HealthCarePharmaceuticals, Inc., flecainide marketed by 3M Company and propafenone,marketed by GlaxoSmithKline, do not have equivalent efficacy to amiodarone butwill continue to compete in the atrial fibrillation marketplace. CardiomePharma Corporation’s oral product, vernakalant, for the treatment of atrialfibrillation, was licensed to Merck in April 2009. This compound, which isin Phase 2 testing, is hoped to have efficacy equal to or better thanflecainide or sotalol, but with reduced pro-arrhythmic effects. There are othercompanies developing devices or procedures to treat atrial fibrillation throughablation, including CryoCor, Inc. and CryoCath Technologies, Inc.

 

Competition for ATI-9242 will likely come from the five largest sellingatypical antipsychotics: Risperdal by Janssen Pharmaceutica, Seroquel byAstraZeneca Pharmaceuticals LP, Zyprexa by Eli Lilly and Company, Abilifyby Bristol-Myers Squibb/Otsuka America Pharmaceutical, Inc., and Geodon byPfizer Inc., which sold a collective $15.7 billion in 2007. It islikely that virtually all of these would be sold as generic versions by thetime ATI-9242 could come to market. Other antipsychotics are in developmentwhich may also be competitive to ATI-9242.

 

ATI-7505 has potential use in five indications: chronic constipation,functional dyspepsia, GERD, gastroparesis and IBS with constipation. Some ofthese indications may not be recognized by the FDA as sufficiently defined toenable regulatory approval of a drug for treatment. ATI-7505 is a prokineticagent which has been shown to increase motility in the upper and lowergastrointestinal tract, including the ability to improve gastric emptying andcolonic motility. Products which affect the gastrointestinal system’s motilitycould be useful in the treatment of each of these disorders. Other prokineticsare on the market or in development which will also be competitive to ATI-7505,including tegaserod, marketed by Novartis Pharmaceuticals Corporation asZelnorm, which was withdrawn from the market and is currently available throughan investigational new drug (IND) process, TD-5108 being developed by Theravance,and erythromycin. Another prokinetic compound in development in Europe, withthe potential for commercialization in the United States and Asia, isprucalopride from Movetis. Prucalopride has been approved for commercializationin certain European countries for the treatment of chronic constipation inwomen but has not yet been launched. Trials are on-going in Europe testingprucalopride in the treatment of chronic constipation in men. Johnson &Johnson has rights to prucalopride in North American and certain Europeancountries and we expect prucalopride to provide competition in markets aroundthe world. Ironwood Pharmaceuticals and Forest Laboratories are jointlydeveloping linaclotide, a guanylate cyclase C agonist, in North America for thetreatment of chronic constipation and irritable bowel syndrome. They havecompleted two Phase 3 trials in North America with positive efficacyresults. Ironwood has licensed development and commercialization rights tolinaclotide in both Europe and Asia, and we expect linaclotide to providecompetition in specific lower GI tract indications. We believe the mostsignificant competition to ATI-7505 for the treatment of GERD is proton pumpinhibitors and H2 blockers, which are currently on the market in both prescriptionformulations and strengths as well as in over-the-counter forms. Many majorpharmaceutical companies currently market proton pump inhibitors and H2blockers generating worldwide sales of over $17.0 billion in 2006.ATI-7505 is targeted at the approximately 20-25% of GERD patients who do notreceive adequate relief from proton pump inhibitors, which reduce the creationof acid in the stomach. ATI-7505 will face competition from the prokinetics aswell as many inexpensive over-the-counter indications for the treatment ofthese gastrointestinal disorders.

 

***If we fail to attract and keepsenior management and key scientific personnel, we may be unable tosuccessfully develop or commercialize our product candidates, if we choose todo so.***

 

Our success depends on our ability to attract, retain and motivatehighly qualified management, clinical and scientific personnel and on ourability to develop and maintain important relationships with leadingclinicians. If we are not able to retain Dr. Goddard, our Chairman andChief Executive Officer, Dr. Milner, our President, Research andDevelopment, Mr. Varian, our Chief Operating Officer and Chief FinancialOfficer, and Dr. Druzgala, our Senior Vice President and Chief ScientificOfficer, we may not be able to successfully complete our ongoing effort toexplore strategic options or develop or commercialize our product candidates,if we choose to do so. Our ability to retain and incentivize our seniormanagement and key scientific personnel may be impaired by the October 2009and February 2010 terminations of a substantial portion of our workforce,including Dr. Daniel Canafax, our former Vice President and ChiefDevelopment Officer, and this recent primary focus to explore strategic optionsto optimize the value of our assets. Competition for experienced scientists maylimit our ability to hire and retain highly qualified personnel on acceptableterms, if we choose to do so. In addition, none of our employees haveemployment commitments for any fixed period of time and could leave ouremployment at will. We carry “key person” insurance in the amount of$1.0 million for each of Drs. Milner and Druzgala, but do not carry “keyperson” insurance covering any other members of senior management or keyscientific personnel. If we fail to retain qualified personnel, we may beunable to continue our ongoing strategic process.

 

37

----

Table of Contents

 

***Our workforce reductions in October 2009and February 2010 and any future workforce and expense reductions may havean adverse impact on our internal programs, our ability to retain key personneland may be distracting to management.***

 

In October 2009, our board of directors committed to arestructuring plan that resulted in a reduction in force affecting 17 employeesin order to improve operational efficiencies. In February 2010, our boardcommitted to a further reduction in force affecting 37 employees in order tofurther reduce operating expenses and conserve cash resources as we explorevarious strategic options. In light of our continued need for funding andexpense control, we may be required to implement further workforce and expensereductions in the future. Further workforce and expense reductions could resultin reduced progress on our internal programs. In addition, employees, whetheror not directly affected by a reduction, may seek future employment with ourbusiness partners or competitors. Although our employees are required to sign aconfidentiality agreement at the time of hire, the confidential nature ofcertain proprietary information may not be maintained in the course of any suchfuture employment. Further, we believe that our future success will depend inlarge part upon our ability to retain highly skilled personnel. We may havedifficulty retaining such personnel as a result of a perceived risk of futureworkforce and expense reductions. In addition, the implementation of therestructuring program may result in the diversion of efforts of our executivemanagement team and other key employees, which could adversely affect ourbusiness.

 

***While we are not currently planningto commercialize our product candidates using our own resources, we may need tohire additional employees in order to continue to develop or commercialize ourproduct candidates, if we choose to do so. Any inability to manage futuregrowth could harm our ability to develop or commercialize our productcandidates, increase our costs and adversely impact our ability to competeeffectively.***

 

In order to further develop or commercialize our product candidates, wewill need to expand the number of our managerial, operational, financial andother employees since our recent restructurings severely reduced ourdevelopment capabilities. Because the projected time frame for hiring theseadditional employees depends on access to additional financial resources and onthe development status of our product candidates and because of the numerous risksand uncertainties associated with drug development and our existing capitalresources, we are unable to project if and when we will hire these additionalemployees. While to date we have not experienced difficulties in recruiting,hiring and retaining qualified individuals, the competition for qualifiedpersonnel in the pharmaceutical and biotechnology field is intense.

 

Future growth will impose significant added responsibilities on membersof management, including the need to identify, recruit, maintain and integrateadditional employees. Our future financial performance and our ability tofurther develop and commercialize our product candidates and competeeffectively will depend, in part, on our ability to manage any future growtheffectively.

 

***If product liability lawsuits arebrought against us, we may incur substantial liabilities and may be required tolimit commercialization of any products that we may develop.***

 

We face an inherent risk of product liability exposure related to thetesting of our product candidates in human clinical trials and will face aneven greater risk if we commercially sell any products that we may develop. Ifwe cannot successfully defend ourselves against claims that our productcandidates or products that we may develop caused injuries, we will incursubstantial liabilities. Regardless of merit or eventual outcome, liabilityclaims may result in:

 

·                  decreased demand for anyproduct candidates or products that we may develop;

 

·                  injury to our reputation;

 

·                  withdrawal of clinical trialparticipants;

 

·                  costs to defend the relatedlitigation;

 

·                  increased demands onmanagement’s attention in defending the related litigation;

 

·                  substantial monetary awardsto clinical trial participants or patients;

 

·                  loss of revenue; and

 

·                  the inability tocommercialize any products that we may develop.

 

38

----

Table of Contents

 

We have product liability insurance that covers our clinical trials upto an aggregate $10.0 million annual limit. We intend to expand ourinsurance coverage to include the sale of commercial products if marketingapproval is obtained for any products that we may develop. Insurance coverageis increasingly expensive, and we may not be able to maintain insurancecoverage at a reasonable cost or obtain insurance coverage that will beadequate to satisfy any liability that may arise.

 

***If we use biological and hazardousmaterials in a manner that causes contamination, injury or violates laws, wemay be liable for damages.***

 

Our research and development activities involve the use of potentiallyharmful biological materials as well as hazardous materials, chemicals andvarious radioactive compounds. We cannot completely eliminate the risk ofaccidental contamination or injury from the use, storage, handling or disposalof these materials. In the event of contamination or injury, we could be heldliable for damages that result, and any liability could exceed our resources.We, the third parties that conduct clinical trials on our behalf and the thirdparties that manufacture our product candidates are subject to federal, stateand local laws and regulations governing the use, storage, handling anddisposal of these materials and waste products. The cost of compliance withthese laws and regulations could be significant. The failure to comply withthese laws and regulations could result in significant fines and work stoppages andmay harm our business.

 

Our principal facility is located in California’s Silicon Valley, in anarea with a long history of industrial activity and use of hazardoussubstances, including chlorinated solvents. Certain environmental laws,including the U.S. Comprehensive, Environmental Response, Compensation andLiability Act of 1980, impose strict, joint and several liabilities on currentoperators of real property for the cost of removal or remediation of hazardoussubstances. These laws often impose liability even if the owner or operator didnot know of, or was not responsible for, the release of such hazardoussubstances. As a result, while we have not been notified of any claim againstus, we are not aware of any such release, nor have we been held liable forcosts to address contamination at the property beneath our facility in thepast, we cannot rule out the possibility that this may occur in thefuture. We do not carry specific insurance against such a claim.

 

***Failure to maintain effectiveinternal controls in accordance with Section 404 of the Sarbanes-Oxley Actof 2002 could have a material adverse effect on our business, stock price andability to raise additional capital.***

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires management’sannual review and evaluation of our internal controls and, to the extentrequired, an attestation of the effectiveness of internal controls by ourindependent auditor. While the company believes that all material informationabout the company’s finances is known to management and that we are able tocontinue to provide reasonable assurance about the reliability of our financialreporting to stockholders including that the preparation of financialstatements for external purposes are in accordance with generally acceptedaccounting principles, due to the company’s recent restructuring we no longerhave sufficient personnel to continue with our efforts to maintain and test theinternal controls to the extent reasonably necessary to allow us to certifythat ARYx is in compliance with Section 404 of the Sarbanes-Oxley Act asof December 31, 2010. If we are required to have an auditor attestation inthe first quarter of 2011, and management is unable to certify as to theeffectiveness of internal controls as of December 31, 2010, then it ispossible that we will receive an adverse opinion from our auditor. Similarly,if we conclude at anytime that our internal controls are no longer sufficientto provide reasonable assurance regarding the reliability of our externalfinancial reporting to stockholders, we may be required to make such adisclosure to our stockholders. Either of these events could have a materialadverse effect on our business. We could lose investor confidence in theaccuracy and completeness of our financial reports, which could have an adverseeffect on our stock price and our ability to raise additional capital.

 

***Our principal facility is locatednear known earthquake fault zones, and the occurrence of an earthquake,extremist attack or other catastrophic disaster could cause damage to ourfacilities and equipment, which could require us to cease or curtailoperations.***

 

Our principal facility is located in California’s Silicon Valley nearknown earthquake fault zones and, therefore, is vulnerable to damage fromearthquakes. In October 1989, a major earthquake struck this area andcaused significant property damage and a number of fatalities. We are alsovulnerable to damage from other types of disasters, including power loss,attacks from extremist organizations, fire, floods and similar events. If anydisaster were to occur, our ability to operate our business could be seriouslyimpaired. In addition, the unique nature of our research activities and of muchof our equipment could make it difficult for us to recover from this type ofdisaster. We currently may not have adequate insurance to cover our lossesresulting from disasters or other similar significant business interruptions,and we do not currently plan to purchase additional insurance to cover suchlosses because of the cost of obtaining such coverage. Any significant lossesthat are not recoverable under our insurance policies could seriously impairour business and financial condition. Our current insurance does notspecifically cover property loss or business interruption due to earthquakedamage.

 

39

----

Table of Contents

 

**RisksRelated to Ownership of Our Common Stock**

 

***Our stock price may be extremelyvolatile, and your investment in our common stock could suffer a decline invalue.***

 

You should consider an investment in our common stock risky and investonly if you can withstand a significant loss and wide fluctuations in themarket value of your investment. Investors who purchase our common stock maynot be able to sell their shares at or above the purchase price. Securitymarket prices for securities of biopharmaceutical companies have been highlyvolatile. In addition, the volatility of biopharmaceutical company stocks oftendoes not correlate to the operating performance of the companies represented bysuch stocks. Some of the factors that may cause the market price of our commonstock to fluctuate include:

 

·                  adverse results or delays inour clinical trials;

 

·                  the timing or delay ofachievement of our clinical, regulatory, partnering and other milestones, suchas the commencement of clinical development, the completion of a clinicaltrial, the receipt of regulatory approval or the establishment or terminationof a commercial partnership for one or more of our product candidates;

 

·                  announcement of FDA approvalor non-approval of our product candidates or delays in the FDA review process;

 

·                  actions taken by regulatoryagencies with respect to our product candidates, our clinical trials or oursales and marketing activities;

 

·                  the commercial success ofany product approved by the FDA or its foreign counterparts;

 

·                  regulatory developments inthe United States and foreign countries;

 

·                  changes in the structure ofhealthcare payment systems;

 

·                  any intellectual propertyinfringement lawsuit involving us;

 

·                  announcements oftechnological innovations or new products by us or our competitors;

 

·                  market conditions for thebiotechnology or pharmaceutical industries in general;

 

·                  changes in financialestimates or recommendations by securities analysts;

 

·                  sales of large blocks of ourcommon stock;

 

·                  sales of our common stock byour executive officers, directors and significant stockholders;

 

·                  direct sales of our commonstock through our existing equity line facility or other financingarrangements;

 

·                  restatements of ourfinancial results and/or material weaknesses in our internal controls;

 

·                  the loss of any of our keyscientific or management personnel; and,

 

·                  announcements regarding theongoing exploration of the strategic options available to us.

 

The stock markets in general, and the markets for biotechnology stocksin particular, have experienced extreme volatility and price and volumefluctuations that have often been unrelated or disproportionate to theoperating performance of particular companies. These broad market and industryfactors may seriously harm the market price of our common stock, regardless ofour operating performance. In the past, class action litigation has often beeninstituted against companies whose securities have experienced periods ofvolatility in market price. Any such litigation brought against us could resultin substantial costs, which would hurt our financial condition and results ofoperations, divert management’s attention and resources, and possibly delay ourclinical trials or commercialization efforts.

 

40

----

Table of Contents

 

***The sale of shares of our commonstock under the committed equity line financing facility has resulted indilution to our existing stockholders. If we sell shares of our common stock in future financings or otherarrangements, stockholders may experience additional dilution and, as a result,our stock price may go down.***

 

In October 2009, we entered into a committed equity line financingfacility, or financing arrangement, under which we sold 5,494,290 shares of ourcommon stock to Commerce Court, including the 114,200 shares of common stock weissued to Commerce Court upon the execution and delivery of the PurchaseAgreement . The sale of shares of our common stock pursuant to the financingarrangement has had a dilutive impact on our existing stockholders. CommerceCourt may resell some or all of the shares we have issued to them under thefinancing arrangement and such sales could cause the market price of our commonstock to decline significantly with advances under the financing arrangement.

 

We need to raise substantial additional funding to continue ouroperations and fund additional trials of our product candidates.  We are currently exploring strategic optionsavailable to us, including collaboration arrangements to continue thedevelopment and potential commercialization of one or more of our lead productcandidates or the sale of any or all of our assets.  Any issuance of convertible debt securities,preferred stock or common stock that may be issued in connection with suchstrategic options may be at a discount from then-current trading prices of ourcomment stock.  If we issue additionalcommon or preferred stock or securities convertible into common stock, ourstockholders will experience additional dilution, which may be significant.

 

***Fluctuations in our operatingresults could cause our stock price to decline.***

 

The following factors are likely to result in fluctuations of ouroperating results from quarter to quarter and year to year:

 

·                  adverse results or delays inour clinical trials;

 

·                  the timing or delay ofachievement of our clinical, regulatory, partnering and other milestones, suchas the commencement of clinical development, the completion of a clinicaltrial, the receipt of regulatory approval or the establishment or terminationof a commercial partnership for one or more of our product candidates;

 

·                  announcement of FDA approvalor non-approval of our product candidates or delays in the FDA review process;

 

·                  actions taken by regulatoryagencies with respect to our product candidates, our clinical trials or oursales and marketing activities;

 

·                  the commercial success ofany product approved by the FDA or its foreign counterparts;

 

·                  regulatory developments inthe United States and foreign countries;

 

·                  changes in the structure ofhealthcare payment systems;

 

·                  any intellectual propertyinfringement lawsuit involving us; and

 

·                  announcements oftechnological innovations or new products by us or our competitors.

 

Because of these potential fluctuations in our operating results, aperiod-to-period comparison of our results of operations may not be a goodindication of our future performance. In any particular financial period theactual or anticipated fluctuations could be below the expectations ofsecurities analysts or investors and our stock price could decline.

 

41

----

Table ofContents

 

***If we fail to regain compliance withthe listing requirements of The NASDAQ Global Market, our common stock may bedelisted and the price of our common stock and our ability to access thecapital markets could be negatively impacted.***

 

Our common stock is currently listed on The NASDAQGlobal Market.  We announced on April 9,2010 that we had received a letter, dated April 5, 2010, from the ListingQualifications Department of The NASDAQ Stock Market notifying us that, for thelast 30 consecutive business days, the market value of our listed securitieshad been below the minimum $50.0 million requirement for continued inclusion onThe NASDAQ Global Market pursuant to NASDAQ Listing Rules.  In accordance with NASDAQ Listing Rules, wehave been given 180 calendar days, or until October 4, 2010, to regaincompliance.  To regain compliance, themarket value of our listed securities must close at $50.0 million or more for aminimum of 10 consecutive business days at any time prior to October 4,2010,  If we do not demonstratecompliance by October 4, 2010, the NASDAQ Listing QualificationsDepartment will provide written notification to us that our common stock may bedelisted.  At that time, we may eitherapply for listing on The NASDAQ Capital Market, provided we meet the continuedlisting requirements of that market in accordance with NASDAQ Listing Rules, orappeal the decision to a NASDAQ Listing Qualifications Panel, or Panel.  In the event of an appeal, our securitieswould remain listed on The NASDAQ Global market pending a decision by the Panelfollowing a hearing.  There can be noassurance that, if we do appeal a delisting determination to the Panel, thatsuch appeal would be successful.

 

Additionally, our common stock has recently traded near or below the$1.00 minimum bid price, and had been as low as $0.88 per share as of April 30,2010.  If our common stock continues totrade below the $1.00 minimum bid price for 30 consecutive business days, wewould likely receive a deficiency notice. Following the receipt of a deficiency notice, we expect that we wouldhave 180 calendar days to regain compliance by having our common stock tradeover the $1.00 minimum bid price for at least a 10-day period.  If we were to fail to regain complianceduring the grace period, our common stock would be delisted.

 

If we fail to regain compliance with the listing standards of TheNASDAQ Global Market, we may consider transferring to The NASDAQ CapitalMarket, provided we meet the transfer criteria, which is a lower tier market,or our common stock may be delisted and traded on the over-the-counter bulletinboard network. Moving our listing to The NASDAQ Capital Market could adverselyaffect the liquidity of our common stock. If our common stock were to bedelisted by NASDAQ, we could face significant material adverse consequences,including:

 

·                  a limited availability ofmarket quotations for our common stock;

 

·                  a reduced amount of news andanalyst coverage for us;

 

·                  a decreased ability to issueadditional securities or obtain additional financing in the future;

 

·                  reduced liquidity for our stockholders;

 

·                  potential loss of confidenceby collaboration partners and employees; and

 

·                  loss of institutionalinvestor interest and fewer business development opportunities.

 

***Because a small number of existingstockholders own a large percentage of our voting stock, they may be able tocontrol our management and operations, acting in their best interests and notnecessarily those of other stockholders.***

 

Based on our outstanding shares as of April 30, 2010 (whichexcludes any shares of common stock issuable upon exercise of warrants andoptions outstanding on such date), our executive officers, directors andholders of 5% or more of our outstanding common stock beneficially ownapproximately 50.0% of our common stock. As a result, these stockholders, actingtogether, may be able to significantly influence any matters requiring approvalby our stockholders, including the election of directors and the approval ofmergers or other business combination transactions. The interests of this groupof stockholders may not always coincide with our interests or the interests ofother stockholders. The significant concentration of stock ownership mayadversely affect the trading price of our common stock due to the perceptionthat conflicts of interest may exist or arise.

 

42

----

Table of Contents

 

***Anti-takeover provisions in ourcharter documents and under Delaware law could make an acquisition of us, whichmay be beneficial to our stockholders, more difficult and may prevent attemptsby our stockholders to replace or remove our current management.***

 

Provisions in our certificate of incorporation and our bylaws may delayor prevent an acquisition of us, a change in our management or other changesthat stockholders may consider favorable. These provisions include:

 

·                  a classified board ofdirectors;

 

·                  a prohibition on actions byour stockholders by written consent;

 

·                  the ability of our board ofdirectors to issue preferred stock without stockholder approval, which could beused to adopt a stockholders’ rights plan that would make it difficult for athird party to acquire us;

 

·                  notice requirements fornominations for election to the board of directors; and

 

·                  limitations on the removalof directors.

 

Moreover, we are governed by the provisions of Section 203 of theDelaware General Corporation Law, which prohibits a person who owns in excessof 15% of our outstanding voting stock from merging or combining with us for aperiod of three years after the date of the transaction in which the personacquired in excess of 15% of our outstanding voting stock, unless the merger orcombination is approved in a prescribed manner.

 

***Future sales of our common stock inthe public market could cause our stock price to drop substantially.***

 

Sales of a substantial number of shares of our common stock in thepublic market, or the perception that these sales might occur, could depressthe market price of our common stock and could impair our ability to raisecapital through the sale of additional equity securities.

 

As of April 30, 2010, we had 33,461,975 shares of common stockoutstanding, which excludes any shares of common stock issuable upon exerciseof warrants and options outstanding as of such date. The shares outstanding arefreely tradable without restriction in the public market unless held by anaffiliate of ours. Shares held by our affiliates are eligible for sale in thepublic market either in accordance with an effective resale registrationstatement with the Securities and Exchange Commission or pursuant to the volumelimitations and manner of sale requirements under Rule 144. Any commonstock that is either subject to outstanding options or warrants or reserved forfuture issuance under our 2001 Equity Incentive Plan, 2007 Equity IncentivePlan, 2007 Non-Employee Directors’ Stock Option Plan and 2007 Employee StockPurchase Plan could also become eligible for sale in the public market to theextent permitted by the provisions of various vesting agreements, and Rules 144and 701 under the Securities Act. If these additional shares are sold, or if itis perceived that they will be sold, in the public market, the trading price ofour common stock could decline.

 

Certain of our affiliates have rights with respect to registration of asignificant number of our shares of common stock under the Securities Act. Ifsuch holders, by exercising their registration rights, cause a large number ofsecurities to be sold in the public market, these sales could have an adverseeffect on the market price for our common stock and may impair our ability toraise additional capital. In addition, as of December 31, 2009, we havefiled three registration statements on Form S-8 under the Securities Actto register up to an aggregate of 5,005,132 shares of our common stock forissuance under our stock option and employee stock purchase plans, and intendto file additional registration statements on Form S-8 to register theshares automatically added each year to the share reserves under these plans.

 

**ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

On October 6, 2009, we entered into a common stock purchaseagreement, or the Purchase Agreement, with Commerce Court Small Cap ValueFund, Ltd., or Commerce Court, providing for a financing arrangement thatis sometimes referred to as a committed equity line financing facility. ThePurchase Agreement provided that, upon the terms and subject to the conditionsset forth in the Purchase Agreement, Commerce Court would be committed topurchase up to $35.0 million of shares of our common stock over the24-month term of the Purchase Agreement under certain specified conditions.Under the terms of the Purchase Agreement, in no event could we sell more than5,380,090 shares of common stock, which is equal to one share less than 20% ofour outstanding shares of common stock on October 6, 2009, the closingdate of the Purchase 

 

43

----

Table of Contents

 

Agreement, less the number of shares ofcommon stock we issued to Commerce Court on the closing date as CommitmentShares described below. Furthermore, in no event would Commerce Court beobligated to purchase any shares of our common stock which, when aggregatedwith all other shares of our common stock then beneficially owned by CommerceCourt, would result in the beneficial ownership by Commerce Court of more than9.9% of the then outstanding shares of our common stock. We issued to Commerce Court, uponexecution of the Purchase Agreement, 114,200 shares of our common stock, or theCommitment Shares.

 

Commerce Court is an “underwriter” within the meaning of Section 2(a)(11)of the Securities Act of 1933, as amended. The Purchase Agreement provided thatCommerce Court would use an unaffiliated broker-dealer to effectuate all sales,if any, of common stock that it may purchase from us pursuant to the PurchaseAgreement. In partial consideration for Commerce Court’s execution and deliveryof the Purchase Agreement, we issued to Commerce Court upon the execution anddelivery of the Purchase Agreement 114,200 shares of our common stock, or theCommitment Shares, with each share valued at $3.0648, the average of the volumeweighted average prices of our common stock for the 10 trading days immediatelypreceding October 6, 2009. The issuance of the Commitment Shares, togetherwith all other shares of common stock issuable to Commerce Court pursuant tothe terms of the Purchase Agreement, was exempt from registration under theSecurities Act, pursuant to the exemption for transactions by an issuer notinvolving any public offering under Section 4(2) of andRegulation D under the Securities Act.

 

On January 4, 2010, we delivered notice to Commerce Court, assubsequently amended, to effect a draw down of up to $1.4 million. Thefirst trading day of the 10-day pricing period for this draw down was January 5,2010. In connection with this draw down, we issued an aggregate of 490,864shares of our common stock to Commerce Court, at a purchase price ofapproximately $2.85 per share and an aggregate purchase price of$1.4 million. The settlement date for this draw down was January 20,2010. The share price at which Commerce Court purchased these shares from uswas established under the Purchase Agreement by reference to the volumeweighted average prices of our common stock on The NASDAQ Global Market duringthe pricing period, net a discount of approximately 6.1% per share. We receivednet proceeds from the sale of these shares of approximately $1.38 millionafter deducting our offering expenses of approximately $25,000, including aplacement agent fee of $14,000 paid to Reedland Capital Partners, anInstitutional Division of Financial West Group, member FINRA/SIPC, inconnection with this draw down.

 

On February 19, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was February 22, 2010. Inconnection with this draw down, we issued an aggregate of 2,764,546 shares ofour common stock to Commerce Court, at a purchase price of approximately $1.19per share and an aggregate purchase price of approximately $3.29 million.The settlement date for this draw down was March 8, 2010. The share priceat which Commerce Court purchased these shares from us was established underthe Purchase Agreement by reference to the volume weighted average price of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 7.0% per share. We received net proceeds from thesale of these shares of approximately $3.24 million after deducting ourestimated offering expenses of approximately $45,000, including a placementagent fee of $33,000 paid to Reedland Capital Partners in connection with thisdraw down.

 

On March 11, 2010, we delivered notice to Commerce Court, toeffect a draw down under the Purchase Agreement. The first trading day of the10-day pricing period for this draw down was March 12, 2010. In connectionwith this draw down, we issued an aggregate of 1,710,784 shares of our commonstock to Commerce Court, at a purchase price of approximately $1.07 per shareand an aggregate purchase price of approximately $1.83 million. Thesettlement date for this draw down was March 26, 2010. The share price atwhich Commerce Court purchased these shares from us was established under thePurchase Agreement by reference to the volume weighted average price of ourcommon stock on The NASDAQ Global Market during the pricing period, net adiscount of approximately 7.0% per share. We received net proceeds from thesale of these shares of approximately $1.8 million after deducting ourestimated offering expenses of approximately $30,000, including a placementagent fee of $18,311 payable to Reedland Capital Partners in connection withthis draw down.

 

The use of proceeds from our sale of common stock under the CommerceCourt Purchase Agreement has been to fund our continuing operations as weexplore strategic options available to us.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.(REMOVED AND RESERVED)**

 

None.

 

44

----

Table of Contents

 

**ITEM 5.OTHER INFORMATION**

 

Not applicable.

 

**ITEM 6.EXHIBITS**

 

A list of exhibits filed with this report orincorporated herein by reference is found in the Exhibit Index immediatelyfollowing the signature page of this report.

 

45

----

Table of Contents

 

**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

Dated: May 13, 2010

 

 
| ** ** | **ARYx Therapeutics, Inc.** |
|------------|----------------------------------|
|       |                             |   |
|       |                             |   |
|       | By:                              | /s/ John Varian |
|       |                             |   John Varian |
| * *   | * *                         | *  Chief Operating  Officer and Chief Financial Officer* |

 

46

----

Table of Contents

 

**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                                       |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                              |
| 3.2(1)              |       | Amended  and Restated Certificate of Incorporation.                                                                                                                               |
|                |       |                                                                                                                                                                              |
| 3.3(1)              |       | Bylaws.                                                                                                                                                                           |
|                |       |                                                                                                                                                                              |
| 4.1                 |       | Reference  is made to Exhibit 3.2 and 3.3 above.                                                                                                                             |
|                |       |                                                                                                                                                                              |
| 4.2(1)              |       | Specimen  Common Stock Certificate.                                                                                                                                               |
|                |       |                                                                                                                                                                              |
| 4.3(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  September 3, 2003.                                                                        |
|                |       |                                                                                                                                                                              |
| 4.4(1)              |       | Form of  Warrant to purchase shares of Series C preferred stock, issued  December 23, 2002.                                                                        |
|                |       |                                                                                                                                                                              |
| 4.5(1)              |       | Form of  Warrant to purchase shares of Series D preferred stock, issued  March 28, 2005.                                                                           |
|                |       |                                                                                                                                                                              |
| 4.6(1)              |       | Amended  and Restated Investor Rights Agreement by and between the Registrant and  certain of its security holders.                                                               |
|                |       |                                                                                                                                                                              |
| 4.7(1)              |       | Form of  Warrant to purchase shares of Series E preferred stock, issued  October 19, 2007.                                                                         |
|                |       |                                                                                                                                                                              |
| 4.8(2)              |       | Form of  Warrant to purchase shares of common stock, issued October 17, 2008 to  Lighthouse.                                                                            |
|                |       |                                                                                                                                                                              |
| 4.9(3)              |       | Registration  Rights Agreement by and between the Registrant and the investors identified  on the signature pages thereto, dated November 11, 2008.                     |
|                |       |                                                                                                                                                                              |
| 4.10(3)             |       | Form of  Warrant to purchase shares of common stock, issued November 11, 2008 to  several purchasers.                                                                   |
|                |       |                                                                                                                                                                              |
| 4.11(4)             |       | Form of  Warrant to purchase shares of common stock, issued December 31, 2008 to  Oxford Financial Corporation.                                                         |
|                |       |                                                                                                                                                                              |
| 4.12(5)             |       | Registration  Rights Agreement by and between ARYx and Commerce Court Small Cap Value Fund  Ltd., dated October 6, 2009.                                                     |
|                |       |                                                                                                                                                                              |
| 31.1                |       | Certification  of the Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                      |
|                |       |                                                                                                                                                                              |
| 31.2                |       | Certification  of the Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                      |
|                |       |                                                                                                                                                                              |
| 32.1                |       | Certification  of the Chief Executive Officer and Chief Financial Officer pursuant to  18U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |

 

----

*      Indicates management contract, compensatory plan orarrangement.

 

(1)          Previously filed as the likenumbered exhibit to registrant’s Registration Statement on Form S-1 (No. 333-145813),initially filed with the Securities and Exchange Commission on August 30,2007, as amended, and incorporated by reference herein.

 

(2)          Previously filed as thelike-numbered exhibit to registrant’s Current Report on Form 8-K (File No. 001-33782),filed with the SEC on October 23, 2008 and incorporated herein byreference.

 

(3)          Previously filed as thelike-numbered exhibit to registrant’s Current Report on Form 8-K (File No. 001-33782),filed with the SEC on November 12, 2008 and incorporated herein byreference.

 

(4)          Previouslyfiled as the like numbered exhibit to registrant’s Annual Report on Form 10-K(File No. 001-33782), filed with the SEC on March 27, 2009 andincorporate herein by reference.

 

(5)          Previously filed as the like-numberedexhibit to our Current Report on Form 8-K (File No. 001-33782), filedwith the SEC on October 8, 2009 and incorporated herein by reference.

 

----