Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**      | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                   |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                |
| ** ** | **For the quarterly period ended June 30, 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**

 

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**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)

 

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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

 

Asof July 31, 2010, the registrant had 33,461,975 shares of common stockoutstanding.

 

 

 

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**ARYx THERAPEUTICS, INC.**

 

**FORM 10-Q FOR THE QUARTER ENDED June 30,2010**

 

**INDEX**

 
| ** **                                                                                                      | ** **                                                                                  | **Page**   |
|-----------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|------------|
| **PART I  — FINANCIAL INFORMATION**                                                                   |
| ** **                                                                                                      | ** **                                                                                  | ** ** |
| Item 1.                                                                                                         | Condensed Consolidated  Financial Statements (Unaudited)                                    |       |
| Condensed Consolidated Balance Sheets as of  June 30, 2010 and December 31, 2009                      | 2                                                                                           |
| Condensed Consolidated Statements of Operations for  the three and six months ended June 30, 2010 and 2009 | 3                                                                                           |
| Condensed Consolidated Statements of Cash Flow for the  six months ended June 30, 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                                 | 22         |
| Item 4T.                                                                                                        | Controls and Procedures                                                                     | 22         |
|                                                                                                            |                                                                                        |       |
| **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                                                            | 43         |
| Item 4.                                                                                                         | (Removed and  Reserved)                                                                     | 43         |
| Item 5.                                                                                                         | Other Information                                                                           | 43         |
| Item 6.                                                                                                         | Exhibits                                                                                    | 43         |
|                                                                                                            |                                                                                        |       |
| SIGNATURE                                                                                                       | 44                                                                                          |

 

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**PART I— FINANCIAL INFORMATION**

 

**ITEM 1.  CONDENSED FINANCIAL STATEMENTS**

 

**ARYxTHERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands)**

 
| ** **                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ** **                                                 | ** ** | **(unaudited)**   | ** ** | **(Note 1)**          | ** ** |
| **ASSETS**                                                 |       |              |       |                  |       |
| Current assets:                                            |       |              |       |                  |       |
| Cash and cash equivalents                                  |       | $                 | 1,404      |                  | $          | 7,409 |   |
| Marketable securities                                      |       | —            |       | 353                   |       |
| Restricted cash - current                                  |       | 150               |       | 150                   |       |
| Prepaid research and development expenses                  |       | 39                |       | 220                   |       |
| Other prepaid, receivable, and current assets              |       | 594               |       | 675                   |       |
| Total current assets                                       |       | 2,187             |       | 8,807                 |       |
| Restricted cash                                            |       | 800               |       | 1,003                 |       |
| Property and equipment, net                                |       | 1,776             |       | 2,258                 |       |
| Other assets                                               |       | 255               |       | 338                   |       |
| **Total assets**                                           |       | $                 | 5,018      |                  | $          | 12,406 |   |
|                                                       |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIT)**   |       |              |       |                  |       |
| Current liabilities:                                       |       |              |       |                  |       |
| Accounts payable                                           |       | $                 | 443        |                  | $          | 685 |   |
| Accrued compensation                                       |       | 33                |       | 893                   |       |
| Accrued research and development expenses                  |       | 43                |       | 70                    |       |
| Current portion of notes payable                           |       | 3,337             |       | 4,850                 |       |
| Current portion of interest payable                        |       | 1,400             |       | 1,257                 |       |
| Other accrued liabilities                                  |       | 898               |       | 926                   |       |
| Total current liabilities                                  |       | 6,154             |       | 8,681                 |       |
| Deferred lease credit                                      |       | 850               |       | 1,053                 |       |
| Notes payable                                              |       | 3,563             |       | 5,283                 |       |
| Interest payable                                           |       | 384               |       | 305                   |       |
| Commitments and contingencies                              |       |              |       |                  |       |
| Stockholders’ equity (deficit):                       |       |              |       |                  |       |
| Common stock                                               |       | 33                |       | 28                    |       |
| Additional paid-in capital                                 |       | 191,169           |       | 184,165               |       |
| Accumulated deficit                                        |       | (197,135          | )          | (187,109              | )          |
| Total stockholders’ equity (deficit)                  |       | (5,933            | )          | (2,916                | )          |
| Total liabilities and stockholders’ equity  (deficit) |       | $                 | 5,018      |                  | $          | 12,406 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**ARYx THERAPEUTICS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

 
| ** **                                                                    | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                    | ** ** | **June 30,**              | ** ** | **June 30,**            | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                    | ** ** | **2010**                       | ** ** | **2009**                     | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                                          |       |                           |       |                         |       |   |   |   |   |
| Revenue                                                                       |       | $                              | —     |                         | $          | — |   | $ | — |   | $ | — |   |
|                                                                          |       |                           |       |                         |       |   |   |   |   |
| Costs and expenses:                                                           |       |                           |       |                         |       |   |   |   |   |
| Research and development                                                      |       | 1,004                          |       | 6,271                        |       | 3,246 |   | 13,060 |   |
| Selling, general and administrative                                           |       | 2,238                          |       | 2,622                        |       | 6,015 |   | 5,225 |   |
| Total costs and expenses                                                      |       | 3,242                          |       | 8,893                        |       | 9,261 |   | 18,285 |   |
| Loss from operations                                                          |       | (3,242                         | )          | (8,893                       | )          | (9,261 | ) | (18,285 | ) |
|                                                                          |       |                           |       |                         |       |   |   |   |   |
| Interest and other income (expense)                                           |       | (5                             | )          | 11                           |       | 58 |   | 65 |   |
| Interest expense                                                              |       | (389                           | )          | (496                         | )          | (823 | ) | (996 | ) |
| Loss on investments                                                           |       | —                         |       | (14                          | )          | — |   | (14 | ) |
| Net loss                                                                      |       | (3,636                         | )          | (9,392                       | )          | (10,026 | ) | (19,230 | ) |
|                                                                          |       |                           |       |                         |       |   |   |   |   |
| Basic and diluted net loss per share                                          |       | $                              | (0.11      | )                            | $          | (0.34 | ) | $ | (0.32 | ) | $ | (0.70 | ) |
| Weighted average shares used to compute basic and  diluted net loss per share |       | 33,456                         |       | 27,374                       |       | 31,403 |   | 27,359 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**ARYx THERAPEUTICS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,**            | ** ** | **June 30,** | ** ** |
| ** **                                                                   | ** ** | **2010**                     | ** ** | **2009** | ** ** |
| **Cash flows from operating  activities:**                                   | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                            | (10,026    | ) | $ | (19,230 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                         |       |   |   |
| Depreciation and amortization                                                |       | 482                          |       | 636 |   |
| Amortization of warrants                                                     |       | 109                          |       | 109 |   |
| Impairment of long-lived assets                                              |       | —                       |       | 26 |   |
| Stock-based compensation                                                     |       | 639                          |       | 1,161 |   |
| Realized gain (loss) on marketable securities                                |       | (18                          | )          | — |   |
| Change in assets and liabilities:                                            |       |                         |       |   |   |
| Prepaid research and development expenses                                    |       | 181                          |       | 111 |   |
| Other prepaid, receivable, and assets                                        |       | 55                           |       | 229 |   |
| Accounts payable and other accrued liabilities                               |       | (473                         | )          | (2,461 | ) |
| Accrued compensation                                                         |       | (860                         | )          | 146 |   |
| Accrued research and development expenses                                    |       | (27                          | )          | (2,818 | ) |
| Net cash used in operating activities                                        |       | (9,938                       | )          | (22,091 | ) |
|                                                                         |       |                         |       |   |   |
| **Cash flows from investing  activities:**                                   |       |                         |       |   |   |
| Purchases of marketable securities                                           |       | —                       |       | (9,842 | ) |
| Proceeds from sales of marketable securities                                 |       | 370                          |       | — |   |
| Proceeds from maturities of marketable securities                            |       | —                       |       | 8,000 |   |
| Decrease in restricted cash                                                  |       | 204                          |       | — |   |
| Purchases of fixed assets                                                    |       | —                       |       | (89 | ) |
| Net cash provided by (used in) investing  activities                         |       | 574                          |       | (1,931 | ) |
|                                                                         |       |                         |       |   |   |
| **Cash flows from financing  activities:**                                   |       |                         |       |   |   |
| Proceeds from exercise of stock options and  issuance of common stock        |       | 1                            |       | 144 |   |
| Issuance of equity, net of issuance costs                                    |       | 6,369                        |       | (92 | ) |
| Principal payments on notes payable                                          |       | (3,011                       | )          | (96 | ) |
| Net cash provided by (used in) financing  activities                         |       | 3,359                        |       | (44 | ) |
|                                                                         |       |                         |       |   |   |
| **Net decrease in cash and cash  equivalents**                               |       | (6,005                       | )          | (24,066 | ) |
| Cash and cash equivalents at beginning of period                             |       | 7,409                        |       | 35,999 |   |
| **Cash and cash equivalents at end  of period**                              |       | $                            | 1,404      |   | $ | 11,933 |   |

 

The accompanying notes are an integral part ofthese financial statements.

 

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**ARYx THERAPEUTICS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

 

**1.  Organization and Summary ofSignificant Accounting Policies**

 

***The Company***

 

We are a biopharmaceutical company focused ondeveloping a portfolio of internally discovered product candidates designed toeliminate known safety issues associated with well-established, commerciallysuccessful drugs. We use our RetroMetabolic Drug Design technology to designstructurally unique molecules that retain the efficacy of these original drugsbut are metabolized through a potentially safer pathway to avoid specificadverse side effects associated with these compounds. Our product candidateportfolio includes an oral prokinetic agent, naronapride (ATI-7505), designedto have the same therapeutic benefits as cisapride approved for Phase 3 clinicaldevelopment for the treatment of chronic constipation, gastroparesis,functional dyspepsia, irritable bowel syndrome with constipation, andgastroesophageal reflux disease; an oral anticoagulant, tecarfarin (ATI-5923),designed to have the same therapeutic benefits as warfarin, currently inPhase 2/3 clinical development for the treatment of patients who are atrisk for the formation of dangerous blood clots; an oral antiarrhythmic agent,budiodarone (ATI-2042), designed to have the efficacy of amiodarone inPhase 2 clinical development for the treatment of atrial fibrillation, aform of irregular heartbeat; and a novel, next-generation atypicalantipsychotic agent, ATI-9242, currently in Phase 1 clinical developmentfor the treatment of schizophrenia and other psychiatric disorders.Additionally, we have several product candidates in preclinical development.Each of our product candidates is an orally available, patentable new chemicalentity designed to address similar indications as those of the original drugupon which each is based. Our product candidates target what we believe to bemulti-billion dollar market opportunities.

 

We were incorporated in the State of Californiaon February 28, 1997 and reincorporated in the State of Delaware on August29, 2007. We maintain a wholly owned subsidiary, ARYx Therapeutics Limited,with registered offices in the United Kingdom, which has had no operationssince its inception in September 2004 and was established only to serve asa legal entity as required in support of our clinical trial activitiesconducted in Europe. We currently are focused on the human drug developmentbusiness and operate in a single business segment with regard to thedevelopment of human pharmaceutical products.

 

In February 2010 we shifted our primaryfocus to exploring strategic alternatives available to us to complete atransaction that could create significant value for stockholders. Thosealternatives could include partnerships on one or more of the three leadproduct candidates, the sale of company assets, in whole or in part, or someother arrangement through which the value of our assets to stockholders couldbe optimized (“Strategic Process”). Concurrent with beginning the strategicprocess, 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. Through these tworestructuring steps and following the departure in June 2010 of Peter G.Milner, M.D., our former President of Research and Development, our headcounthas been reduced from 73 to 16 employees. The restructuring was necessary as wehave three compounds at proof-of-concept stage but insufficient cash resourcesto develop these product candidates further or to complete licensing agreementsin a timely manner with a high level of certainty. Our operations have consumeda substantial amount of cash since inception and we expect to continue to incurnet losses for the foreseeable future. Our ability to continue operations willbe dependent on our ability to obtain additional funding. We may seek to raisenecessary additional funds through public or private equity, debt financings,collaborative arrangements with corporate partners or other sources. This mayinclude proceeds, if any, from sales of common stock under our at marketissuance sales agreement with McNicoll, Lewis & Vlak LLC and Wm Smith &Co., pursuant to which we may issue and sell up to $6.0 million of our commonstock.  

 

Additionally, on August 13, 2010, we securedbridge financing in two related loan transactions – a bridge loan financing andthe restructuring of our outstanding loans with Lighthouse Capital Partners V,L.P. (“Lighthouse”).  Under the terms ofa secured note and warrant purchase agreement dated August 13, 2010 (the“Agreement”), we may sell secured promissory notes (the “Notes”) in the principalamount of up to $4.0 million and warrants to purchase an aggregate of 2,000,000shares of our common stock to certain existing accredited investors in twotranches (the “Bridge Financing”).  Wecompleted the first tranche for $2.0 million of Notes and warrants to purchase1,000,000 shares of our common stock on August 13, 2010.  The second tranche of $2.0 million of Notesand warrants to purchase 1,000,000 shares of common stock may occur at ouroption on September 30, 2010, subject to the satisfaction of certain conditionsset forth in the Agreement.  Concurrentlywith the initial tranche of the Bridge Financing, we amended our existing loanarrangement with Lighthouse to provide for the conversion of approximately $2.3million of loan payments scheduled for the third quarter of 2010 into a newloan to us by Lighthouse (the “New Commitment”).  Upon the initial closing of the BridgeFinancing, we made an approximately $2.0 million payment to Lighthouse out ofthe proceeds of the initial closing, and Lighthouse immediately loanedapproximately the same amount back to us as part of the New Commitment.  On September 1, 2010, we will make asubsequent payment of approximately $300,000 to Lighthouse, which Lighthousewill immediately loan back to us as the balance of the New Commitment.  We believe the proceeds and anticipatedproceeds from the Bridge Financing, together with the New Commitment and ourcurrently available cash and cash equivalents, are sufficient to fund ouroperations through at least December 31, 2010. We will likely seek additional sources of funding to allow us tocontinue our operations as we continue to explore strategic options availableto us.

 

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***Basis of Presentation***

 

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of our wholly-owned subsidiary, ARYxTherapeutics, Ltd. All intercompany accounts and transactions have beeneliminated. These unaudited condensed consolidated financial statements havebeen prepared in accordance with U.S. generally accepted accounting principles,or GAAP, for interim financial information on the same basis as the annualfinancial statements and with instructions to Form 10-Q andRule 10-01 of Regulation S-X. Accordingly, they do not include all of theinformation and footnotes required by GAAP 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 sheet data at December 31, 2009 hasbeen derived from our audited consolidated financial statements for the yearended December 31, 2009, contained in our Annual Report on Form 10-K.The unaudited condensed consolidated financial statements and relateddisclosures contained in this report have been prepared with the presumptionthat users of the interim financial statements have read or have access to ouraudited financial statements for the preceding year. Accordingly, these interimfinancial statements should be read in conjunction with our audited financialstatements and notes thereto for the year ended December 31, 2009,contained in our Annual Report on Form 10-K.

 

***Risks and Uncertainties***

 

As of June 30, 2010, we had cash, cashequivalents and marketable securities on hand in the amount of $1.4 million,current payables and accrued liabilities of approximately $1.4 million andapproximately $4.7 million in current notes and interest payable. As of June 30,2010, we had outstanding non-current liabilities of $4.8 million. Sinceour inception, we have incurred significant net operating losses and, as of June 30,2010, we had an accumulated deficit of $197.1 million. We have generatedno revenue from product sales to date and we have funded operations principallyfrom the sale of our convertible preferred and common stock and paymentsreceived under our collaboration agreements. We have not achieved sustainableprofitability and anticipate that we will continue to incur significant netlosses for the foreseeable future. There can be no assurances that we willachieve positive cash flow in the foreseeable future or at all. Additionally,we do not anticipate that our cash on hand as of June 30, 2010 will besufficient to fund our operations for the following twelve months. However, webelieve that our cash on hand along with proceeds from the Bridge Financingwill provide us with sufficient funds to operate through the end of 2010. Thesefactors raise substantial doubt about our ability to continue as a goingconcern. Management’s plans as to these matters are described above. Thesefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

 

We have no products that have receivedregulatory approval. Any products we develop will require approval from theU.S. Food and Drug Administration or foreign regulatory agencies prior tocommercial sales. There can be no assurance that our products will receive thenecessary approvals. If we are denied such approvals or such approvals aredelayed, it could have a material adverse effect to our operations. To achieveprofitable operations, we must successfully develop, test, manufacture andmarket products. There can be no assurance that any such products can bedeveloped successfully or manufactured at an acceptable cost and withappropriate performance characteristics, or that such products will besuccessfully marketed. These factors could have a material adverse effect onour future financial results.

 

Financial instruments that potentially subjectus to a concentration of credit risk consist of cash, cash equivalents andmarketable securities. We deposit excess cash and cash equivalents withmultiple financial institutions in the United States. Deposits in thesefinancial institutions may exceed the amount of insurance provided on suchdeposits. We have not experienced any losses on our deposits of cash and cashequivalents.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith GAAP requires management to make judgments, assumptions and estimates thataffect the reported amounts in the consolidated financial statements andaccompanying notes. On an ongoing basis, we evaluate our critical accountingpolicies and estimates, including those related to clinical trial accruals andstock-based compensation. Management bases its estimates on historicalexperience and on assumptions believed to be reasonable under thecircumstances. Actual results could differ from those estimates.

 

***Comprehensive Loss***

 

Comprehensive loss is comprised of net loss andother comprehensive income/loss. The only component of our other comprehensiveincome/loss is the unrealized gains and losses, if any, on our marketablesecurities holdings. Comprehensive loss for the three months ended June 30,2010 and 2009 was $3.6 million and $9.4 million, respectively, andfor the six months ended June 30, 2010 and 2009 was $10.0 million and$19.3 million, respectively.

 

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***Net Loss Per Share***

 

Basic net loss per share is computed bydividing net loss by the weighted average number of fully vested common sharesoutstanding during the period. Diluted net loss per share is computed by givingeffect to all potential dilutive common shares, including stock options andwarrants. For all periods presented in this report, stock options and warrantswere not included in the computation of diluted net loss per share because theinclusion would provide an antidilutive effect.the following table presents thecalculation of basic and diluted net loss per share:

 
| ** **                                                                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                      | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| *Numerator:*                                                                    | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                        |       | $                                    | (3,636     | )                                  | $          | (9,392 | ) | $ | (10,026 | ) | $ | (19,230 | ) |
| *Denominator:*                                                                  |       |                                 |       |                               |       |   |   |   |   |
| Weighted average commons shares outstanding                                     |       | 33,462                               |       | 27,386                             |       | 31,410 |   | 27,372 |   |
| Less: weighted average unvested restricted common  shares                       |       | (6                                   | )          | (12                                | )          | (7 | ) | (13 | ) |
| Weighted average shares used in computing basic  and diluted net loss per share |       | 33,456                               |       | 27,374                             |       | 31,403 |   | 27,359 |   |
| Basic and diluted net loss per share                                            |       | $                                    | (0.11      | )                                  | $          | (0.34 | ) | $ | (0.32 | ) | $ | (0.70 | ) |

 

***Income Taxes***

 

Weuse the asset and liability method of accounting for income taxes in accordancewith ASC 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.

 

As permitted under the provisions of ASC 740, we willclassify interest and penalties related to unrecognized tax benefits as part ofour income tax provision, although there have been no such interest orpenalties recognized to-date.

 

***Recent Accounting Pronouncements***

 

In January 2010, the FASB issued ASUNo. 2010-06, which revised guidance intended to improve disclosures relatedto fair value measurements. This guidance requires new disclosures as well asclarifies certain existing disclosure requirements. New disclosures under thisguidance require separate information about significant transfers in and out ofLevel 1 and Level 2 and the reason for such transfers, and also requirepurchases, sales, issuances, and settlements information for Level 3measurement to be included in the rollforward of activity on a gross basis. ASUNo. 2010-06 also clarifies the requirement to determine the level ofdisaggregation for fair value measurement disclosures and the requirement todisclose valuation techniques and inputs used for both recurring andnonrecurring fair value measurements in either Level 2 or Level 3. The newdisclosures and clarifications of existing disclosures are effective forinterim and annual reporting periods beginning after December 15, 2009,except for the disclosures about purchases, sales, issuances, and settlementsin the roll forward 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 expect adoptionof this pronouncement to have a material impact to our financial statements.

 

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**2. Fair Value Measurement**

 

The following tables summarize the fair value of ourfinancial assets as of June 30, 2010 and December 31, 2009 that wererecorded at fair value on a recurring basis consistent with the fair valuehierarchy provisions of ASC 820.

 
| ** **                                | ** ** | **June 30, 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)**    | ** ** |
|                                      |       |                       |       |   |   |   |   |   |   |
| Money market funds                        |       | 1,222                      |       | — |   | 1,222 |   | — |   |
| Certificate of Deposit                    |       | 150                        |       | 150 |   | — |   | — |   |
| Auction rate securities:                  |       |                       |       |   |   |   |   |   |   |
| Balance as of December 31, 2009      |       | 353                        |       | — |   | — |   | 353 |   |
| Purchases                                 |       | —                     |       | — |   | — |   | — |   |
| Sales and maturities                      |       | (370                       | )          | — |   | — |   | (370 | ) |
| Transfers in (out) of Level 2 and Level 3 |       | —                     |       | — |   | — |   | — |   |
| Gain on sale of securities                |       | 17                         |       | — |   | — |   | 17 |   |
| Ending balance as of June 30, 2010   |       | —                     |       | — |   | — |   | — |   |
| Total                                     |       | $                          | 1,372      |   | $ | 150 |   | $ | 1,222 |   | $ | — |   |
|                                           |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                  | ** ** | **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)**        | ** ** |
|                                        |       |                       |       |   |   |   |   |   |   |
| Money market funds                          |       | 7,192                      |       | — |   | 7,192 |   | — |   |
| Certificate of Deposit                      |       | 150                        |       | 150 |   | — |   | — |   |
| Auction rate securities:                    |       |                       |       |   |   |   |   |   |   |
| Balance as of January 1, 2009          |       | 367                        |       | — |   | — |   | 367 |   |
| Purchases                                   |       | —                     |       | — |   | — |   | — |   |
| Sales and maturities                        |       | —                     |       | — |   | — |   | — |   |
| Transfers in (out) of Level 2 and Level 3   |       | —                     |       | — |   | — |   | — |   |
| Gain on sale of securities                  |       | (14                        | )          | — |   | — |   | (14 | ) |
| Ending balance as of December 31, 2009 |       | 353                        |       | — |   | — |   | 353 |   |
| Total                                       |       | $                          | 7,695      |   | $ | 150 |   | $ | 7,192 |   | $ | 353 |   |
|                                             |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 

Our financial assets valued using Level 1 inputsconsist primarily of certificates of deposit at a financial institution.  Our financial assets valued using Level 2inputs consist of cash held in money market funds with fair values that aredetermined by our institutional portfolio managers whose valuations are basedupon market-corroborated inputs such as broker/dealer quotes, reported trades,bids and offers that we believe are reasonable. Previously, the fair value ofour auction rate security was measured using Level 3 inputs as determined by adiscounted cash flow model that considered expected cash flows from the auctionrate instrument including expected interest payments, market yields forsimilarly rated instruments, our estimates of time to liquidity for thesecurity, and a marketability discount. Transfers between levels are determinedand recognized at the end of each reporting period.

 

**3.  DebtFinancing**

 

As of June 30, 2010, we had loancommitments outstanding with Lighthouse and Oxford Finance Corporation, orOxford.  Prior to June 30, 2010 wealso had loan commitments outstanding with General Electric Commercial Finance,or GE. The total principal amount borrowed under the Lighthouse agreements was$19.0 million and the total unpaid principal balance outstanding as of June 30,2010, was $6.4 million. Additionally, in accordance with the agreements,we had an obligation to pay Lighthouse a $1.4 million interest balloon paymenton July 1, 2010. We recorded interest expense related to the Lighthouseloan agreement, including amortization of expense related to the terminalpayment and the warrants issued under the agreement, of $369,000 and $461,000for the three months ended June 30, 2010 and 2009, respectively, and$779,000 and $921,000 for the six months ended June 30, 2010 and 2009,respectively.  Subsequent to June 30,2010, we entered into a restructured loan agreement with Lighthouse (refer toNote 7. Subsequent Events). The total principal amount borrowed under the GEagreements was $1.9 million and as of June 30, 2010 the loans had beenfully repaid. We recorded interest expense related to the GE loan agreements of$650 and $6,000 for the three months ended June 30, 2010 and 2009,respectively, and $2,250 and $15,000 for the six months ended June 30,2010 and 2009, respectively.  The totalprincipal amount borrowed under the Oxford loan agreement was $1.0 millionand the total unpaid principal balance outstanding as of June 30, 2010,was $543,000. We recorded interest expense related to the Oxford loanagreement, including amortization of expense related to the terminal paymentand the warrant issued under the agreement, of $20,200 and $29,000 for thethree months ended June 30, 2010 and 2009, respectively, and $42,700 and$60,000 for the six months ended June 30, 2010 and 2009, respectively.

 

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**4.  EquityFinancing**

 

On October 6, 2009, we entered into acommon stock purchase agreement, or the Purchase Agreement, with Commerce CourtSmall Cap Value Fund, Ltd., or Commerce Court, providing for a financingarrangement that is sometimes referred to as a committed equity line financingfacility. The Purchase Agreement provides that, upon the terms and subject tothe conditions set forth in the Purchase Agreement, Commerce Court is committedto purchase up to $35.0 million of shares of our common stock over the24-month term of the Purchase Agreement under certain specified conditions andlimitations, provided that in no event may we sell under the Purchase Agreementmore than 5,380,090 shares of common stock, which is equal to one share lessthan 20% of our outstanding shares of common stock on October 6, 2009, theclosing date of the Purchase Agreement, less the number of shares of commonstock we issued to Commerce Court on the closing date as Commitment Sharesdescribed below. Furthermore, in no event will Commerce Court be obligated topurchase any shares of our common stock which, when aggregated with all othershares of our common stock then beneficially owned by Commerce Court, wouldresult in the beneficial ownership by Commerce Court of more than 9.9% of thethen outstanding shares of our common stock.

 

On January 4, 2010, we delivered notice toCommerce Court, as subsequently amended, to effect a draw down of up to$1.4 million. The first trading day of the 10-day pricing period for thisdraw down was January 5, 2010. In connection with this draw down, weissued an aggregate of 490,864 shares of our common stock to Commerce Court, ata purchase price of approximately $2.85 per share and an aggregate purchaseprice of $1.4 million. The settlement date for this draw down wasJanuary 20, 2010. The share price at which Commerce Court purchased theseshares from us was established under the Purchase Agreement by reference to thevolume weighted average prices of our common stock on The NASDAQ Global Marketduring the pricing period, net a discount of approximately 6.1% per share. Wereceived net 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 noticeto Commerce Court, to effect a draw down under the Purchase Agreement. Thefirst trading day of the 10-day pricing period for this draw down wasFebruary 22, 2010. In connection with this draw down, we issued anaggregate of 2,764,546 shares of our common stock to Commerce Court, at apurchase price of approximately $1.19 per share and an aggregate purchase priceof approximately $3.29 million. The settlement date for this draw down wasMarch 8, 2010. The share price at which Commerce Court purchased theseshares from us was established under the Purchase Agreement by reference to thevolume weighted average price of our common stock on The NASDAQ Global Marketduring the pricing period, net a discount of approximately 7.0% per share. Wereceived net proceeds from the sale of these shares of approximately$3.24 million after deducting our offering expenses of approximately$45,000, including a placement agent fee of $33,000 paid to Reedland CapitalPartners in connection with this draw down.

 

On March 11, 2010, we delivered notice toCommerce Court to effect a draw down under the Purchase Agreement. The firsttrading day of the 10-day pricing period for this draw down was March 12,2010. In connection with this draw down, we issued an aggregate of 1,710,784shares of our common stock to Commerce Court, at a purchase price ofapproximately $1.07 per share and an aggregate purchase price of approximately$1.83 million. The settlement date for this draw down was March 26,2010. The share price at which Commerce Court purchased these shares from uswas established under the Purchase Agreement by reference to the volumeweighted average price of our common stock on The NASDAQ Global Market duringthe pricing period, net a discount of approximately 7.0% per share. We receivednet proceeds from the sale of these shares of approximately $1.8 millionafter deducting offering expenses of approximately $30,000, including aplacement agent fee of $18,311 payable to Reedland Capital Partners inconnection with this draw down.

 

As of March 26, 2010, we had issued themaximum amount of common stock available for sale under the Commerce CourtPurchase Agreement and therefore we will no longer be able to utilize thefacility for additional funding.

 

On May 20, 2010, we entered into an at marketissuance sales agreement, or Sales Agreement, with McNicoll, Lewis &Vlak LLC, or MLV, and Wm Smith & Co., or Wm Smith, pursuant to whichwe may issue and sell shares of our common stock having an aggregate offeringprice of up to $6.0 million from time to time through MLV and Wm Smith as oursales agents. Sales of our common stock through MLV and Wm Smith, if any,will be made on The NASDAQ Global Market by means of ordinary brokers’transactions at market prices, in block transactions or as otherwise agreed byus and these sales agents. Subject to the terms and conditions of the SalesAgreement, MLV and Wm Smith will use commercially reasonable efforts to sellour common stock from time to time, based upon our instructions (including anyprice, time or size limits or other customary parameters or conditions we mayimpose). We will pay these sales agents an aggregate commission rate of 3.0% ofthe gross proceeds of the sales price per share of any common stock soldthrough the sales agents under the Sales Agreement. The number of shares we areable to sell under this arrangement will be limited in practice based on thetrading volume of our common stock. As of August 13, 2010 we had notissued or sold any shares of our common stock pursuant to the Sales Agreement.In connection with this financing arrangement, we incurred costs ofapproximately $150,000 that were expensed during the second quarter of 2010 andare included within our selling, general and administrative expense.

 

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**5.  Warrants**

 

We issue freestanding warrants from time totime pursuant to various contractual arrangements. As of June 30, 2010,the following warrants to purchase our common stock were issued andoutstanding:

 
| **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)        | 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  |       |                                  |       |                 |       |

 

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(1)           Exercisable,in whole or in part, at anytime at the option of the holder or deemed to havebeen automatically exercised in full immediately prior to the expiration of thewarrant; expires at the earlier of (i) the close of business onOctober 19, 2014, or (ii) the effective date of a merger, as defined inthe agreement.

 

(2)           Exercisable,in whole or in part, at anytime at the option of the holder or deemed to havebeen automatically exercised in full immediately prior to the expiration of thewarrant; expires at the earlier of (i) the close of business onOctober 17, 2013, or (ii) the effective date of a merger, as defined inthe agreement.

 

(3)           Warrantsto purchase 2,446,928 shares of our common stock were issued onNovember 14, 2008 and warrants to purchase 447,936 shares of our commonstock were issued on November 24, 2008, of which warrants to purchase322,936 shares of our common stock are currently outstanding; the warrants areexercisable, in whole or in part, at anytime at the option of the holder for aterm of five years from November 14, 2008.

 

(4)           Exercisable,in whole or in part, at anytime at the option of the holder or deemed to havebeen automatically 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 thefair value of these warrants on date of issuance. The fair value of the warrantissued to ATEL for $42,000 was capitalized as a prepayment on a lease and wasamortized to interest expense over the 36 month lease term. The fair value ofthe first warrant issued to Lighthouse for $738,000 was capitalized in threeseparate tranches as debt issuance cost with the first tranche amortized tointerest expense over the funding commitment period ended December 31,2005. The remainder was amortized to interest expense over the duration of theinterest-only period plus the term of the loan over 42 months. The fair valueof the second warrant issued to Lighthouse for $523,000 was capitalized in twoseparate tranches as debt issuance cost with the first tranche amortized tointerest 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-Stock Compensations*, and consideredthe fair value of the warrants issued to investors participating in theNovember 2008 private placement of equity as cost of equity financing andaccordingly, we recorded the fair value of the warrants to contra-equity. Theaggregate fair value of the warrants issued to the investors was approximately$4.0 million determined using the Black-Scholes option valuation modelwith the following assumptions: risk-free interest rate of 2.44%, contractuallife of five years according to the terms of the warrants, no dividend yieldand volatility of 79%.

 

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The fair value of our capitalized warrantsissued in connection with the placement of our long-term debt was amortized tointerest expense as follows:

 
| ** **                          | ** ** | **Three Months Ended June  30,** | ** ** | **Six Months Ended********June 30,** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **2010**                         | ** ** | **2009**                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                          | ** ** | **(in thousands)**               | ** ** |
| Lighthouse—Warrant 1           |       | $                                | 13         |                                      | $          | 13 |   | $ | 27 |   | $ | 27 |   |
| Lighthouse—Warrant 2           |       | 13                               |       | 13                                        |       | 26 |   | 26 |   |
| Lighthouse—Warrant 3           |       | 27                               |       | 27                                        |       | 54 |   | 54 |   |
| Oxford                              |       | 1                                |       | 1                                         |       | 2 |   | 2 |   |
| Total warrant amortization  expense |       | $                                | 54         |                                      | $          | 54 |   | $ | 109 |   | $ | 109 |   |

 

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

 

The components of our stock-based compensation expenserecognized for the three and six months ended June 30, 2010 and 2009 wereas follows:

 
| ** **                              | ** ** | **Three Months Ended********June 30,** | ** ** | **Six Months Ended********June 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **2010**                                    | ** ** | **2009**                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                              | ** ** | **(in thousands)**                          | ** ** |
| *Research  and development:*            |       |                                        |       |                                      |       |   |   |   |   |
| Officer compensation                    |       | $                                           | 17         |                                      | $          | 76 |   | $ | (53 | ) | $ | 144 |   |
| Employee and consultant  compensation   |       | (10                                         | )          | 163                                       |       | (164 | ) | 314 |   |
| *Selling,  general and administrative:* |       |                                        |       |                                      |       |   |   |   |   |
| Director and officer  compensation      |       | 130                                         |       | 355                                       |       | 277 |   | 626 |   |
| Employee and consultant  compensation   |       | 25                                          |       | 39                                        |       | (16 | ) | 77 |   |
| Total stock-based  compensation expense |       | $                                           | 162        |                                      | $          | 633 |   | $ | 44 |   | $ | 1,161 |   |

 

We issued an aggregate 596shares of our common stock upon the exercise of stock options during the sixmonths ended June 30, 2010.

 

**7.  Subsequent Events**

 

On August 13, 2010, weentered into the Agreement with certain existing accredited investors (the“Investors”), pursuant to which we agreed to issue and sell in a privateplacement Notes in the aggregate principal amount of up to $4.0 million, andwarrants to purchase up to an aggregate of 2,000,000 shares of our common stock(the “Warrants”), subject to the terms and conditions set forth in theAgreement.  The Notes are secured by asecurity interest in all of the assets of the Company, including ourintellectual property.  

 

On August 13, 2010, weclosed on the initial tranche of $2.0 million of Notes pursuant to the termsand conditions set forth in the Agreement and, as a result, issued Warrants tothe Investors to purchase 1,000,000 shares of our common stock.  The Agreement provides for the sale of asecond tranche of $2.0 million of Notes on September 30, 2010 (together withthe issuance of Warrants to purchase an additional 1,000,000 shares of ourcommon stock), at our option, subject to the satisfaction of certain conditionsset forth in the Agreement.  We must delivernotice of our election to complete the second tranche to the Investors no laterthan September 15, 2010.

 

The Notes accrue interest ata continuously compounding rate of 12.0% per annum.  Unless earlier paid pursuant to the terms ofthe Agreement or accelerated in connection with an event of default, we willmake interest only payments through December 31, 2010, followed by 24 equalmonthly payments of principal and interest through January 1, 2013 (the“Maturity Date”).  In the event we sellany or all of our assets or enter into certain strategic transactions, we maybe required to repay the Notes at an earlier date under the terms of the BridgeFinancing.

 

The Warrants have a purchaseprice of $0.0125 per underlying share of common stock and are exercisable for aterm of five years from the date of issuance at an exercise price of $0.50 pershare.  We are required to file, within60 days after August 13, 2010 (or, in the event we are required to file theregistration statement on a Form S-1, within 90 days after August 13, 2010), aregistration statement registering for resale the shares of common stockissuable upon the exercise of the Warrants pursuant to a Registration RightsAgreement we entered into with the Investors.

 

We anticipate net proceedsof approximately $1.8 million in connection with the initial tranche of theBridge Financing, after deducting certain expenses payable by us. The netproceeds from the initial tranche of the Bridge Financing were used by us tomake an approximately $2.0 million repayment on our existing loan obligationwith Lighthouse pursuant to the terms of our loan arrangement with Lighthouse,as more fully described below. We currently anticipate the proceeds from thesecond tranche of the Bridge Financing, to the extent such closing occurs, tobe used for working capital and other corporate and operational purposes,including permitted payments to our lenders.

 

Concurrently with the BridgeFinancing, we and Lighthouse entered into Amendment No. 8 (the “Amendment”) to thatcertain Loan and Security Agreement No. 4521 dated March 28, 2005, as amended(the “Loan Agreement”). The Amendment provides for the conversion of up toapproximately $2.3 million of loan payments scheduled for the third quarter of2010 into the New Commitment. Upon the closing of the initial tranche of theBridge Financing, we used the net proceeds from such closing to make anapproximately $2.0 million repayment of our loan obligation to Lighthouse and,pursuant to the terms of the Amendment, Lighthouse promptly loanedapproximately the same amount to us as part of the New Commitment. We arerequired to make a subsequent payment of approximately $300,000 to Lighthouseon or about September 1, 2010, which amount Lighthouse has agreed to promptlyloan to us upon receipt of such payment as the balance of the NewCommitment.  

 

                The New Commitmentis due and payable on December 31, 2010 in one lump sum payment equal to theaggregate principal amount plus accrued interest through the due date at astated interest rate of 13.0% per annum. However, if the second tranche of theBridge Financing does not occur, the New Commitment becomes due and payable onSeptember 30, 2010. In the event we enter into certain strategic transactionswith proceeds of at least $40.0 million prior to the applicable due date, theNew Commitment will be amortized and payable in equal monthly installments ofprincipal and interest over the 18 months following the closing of suchstrategic transaction. Upon the occurrence of an event of default orliquidation event, all outstanding amounts under the New Commitment shall beimmediately due and payable.

 

The Amendment furtherprovides that (i) any assignment of the Notes without Lighthouse’s consent or(ii) the failure of the second tranche of the Bridge Financing to occur wouldeach now constitute an event of default under the Loan Agreement.  We also granted Lighthouse a securityinterest in our intellectual property in connection with the Amendment and NewCommitment.  

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion of ourfinancial condition and the results of operations should be read in conjunctionwith the condensed consolidated financial statements and notes to condensedconsolidated financial statements included elsewhere in this quarterly reporton Form 10-Q. This discussion contains forward looking statements thatinvolve risks and uncertainties. When reviewing the discussion below, youshould keep in mind the substantial risks and uncertainties that characterizeour business. In particular, we encourage you to review the risks anduncertainties described in Part II - Item 1A. “RISK FACTORS”elsewhere in this report. These risks and uncertainties could cause actualresults to differ materially from those projected in forward-looking statementscontained in this report or implied by past results and trends. Forward-lookingstatements are statements that attempt to forecast or anticipate futuredevelopments in our business; we encourage you to review the examples of ourforward-looking statements under the heading “Cautionary Note RegardingForward-Looking Statements” that appears at the end of this discussion. Thesestatements, like all statements in this report, speak only as of their date(unless another date is indicated), and we undertake no obligation to update orrevise these statements in light of future developments.*

 

**Overview**

 

We are a biopharmaceutical company focused ondeveloping a portfolio of internally discovered product candidates designed toeliminate known safety issues associated with well-established, commerciallysuccessful drugs. We use our RetroMetabolic Drug Design technology to designstructurally unique molecules that retain the efficacy of these original drugsbut are metabolized through a potentially safer pathway to avoid specificadverse side effects associated with these compounds. Our product candidateportfolio includes an oral prokinetic agent, naronapride (ATI-7505), designedto have the same therapeutic benefits as cisapride approved for Phase 3clinical development for the treatment of chronic constipation, gastroparesis, functionaldyspepsia, irritable bowel syndrome with constipation, and gastroesophagealreflux disease; an oral anticoagulant, tecarfarin (ATI-5923), designed to havethe same therapeutic 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; 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 Californiaon February 28, 1997 and reincorporated in the State of Delaware onAugust 29, 2007. We maintain a wholly-owned subsidiary, ARYx TherapeuticsLimited, with registered offices in the United Kingdom, which has had nooperations since its inception in September 2004 and was established toserve only as a legal entity as required in support of our clinical trialactivities conducted in Europe.

 

In February 2010 we shifted our primaryfocus to exploring strategic alternatives available to us to complete atransaction that could create significant value for stockholders. Thosealternatives could include partnerships on one or more of the three leadproduct candidates, the sale of company assets, in whole or in part, or someother arrangement through which the value of our assets to stockholders couldbe optimized (“Strategic Process”). Concurrent with beginning the strategicprocess, 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 and following the departure in June 2010 ofPeter G. Milner, M.D., our former President of Research and Development, ourheadcount has been reduced from 73 to 16 employees. The restructuring wasnecessary as we have three compounds at proof-of-concept stage but insufficientcash resources to develop these product candidates further or to completelicensing agreements in a timely manner with a high level of certainty. Ouroperations have consumed a substantial amount of cash since inception and weexpect to continue to incur net losses for the foreseeable future. Our abilityto continue operations will be dependent on our ability to obtain additionalfunding. We may seek to raise necessary additional funds through public orprivate equity, debt financings, collaborative arrangements with corporate partnersor other sources. This may include proceeds, if any, from sales of common stockunder our at market issuance sales agreement with McNicoll, Lewis &Vlak LLC and Wm Smith & Co., pursuant to which we may issue and sellup to $6.0 million of our common stock. 

 

Additionally, on August 13, 2010, we secured bridge financing intwo related loan transactions — a bridge loan financing and the restructuringof our outstanding loans with Lighthouse Capital Partners V, L.P.(“Lighthouse”).  Under the terms of a securednote and warrant purchase agreement dated August 13, 2010 (the“Agreement”), we may sell secured promissory notes (the “Notes”) in the principalamount of up to $4.0 million and warrants to purchase an aggregate of 2,000,000shares of our common stock to certain existing accredited investors in twotranches (the “Bridge Financing”).  Wecompleted the first tranche for $2.0 million of Notes and warrants to purchase1,000,000 shares of our common stock on August 13, 2010.  The second tranche of $2.0 million of Notesand warrants to purchase 1,000,000 shares of common stock may occur at ouroption on September 30, 2010, subject to the satisfaction of certainconditions set forth in the Agreement. Concurrently with the initial tranche of the Bridge Financing, weamended our existing loan arrangement with Lighthouse to provide for theconversion of approximately $2.3 million of loan payments scheduled for thethird quarter of 2010 into a new loan to us by Lighthouse (the “NewCommitment”).  Upon the initial closingof the Bridge Financing, we made an approximately $2.0 million payment toLighthouse out of the proceeds of the initial closing, and Lighthouseimmediately loaned approximately the same amount back to us as part of the NewCommitment.  On September 1, 2010,we will make a subsequent payment of approximately $300,000 to Lighthouse,which Lighthouse will immediately loan back to us as the balance of the NewCommitment.  We believe the proceeds andanticipated proceeds from the Bridge Financing, together with the NewCommitment and our currently available cash and cash equivalents, aresufficient to fund our operations through at least December 31, 2010. We will likely seek additional sources of funding to allow us tocontinue our operations as we continue to explore strategic options availableto us.

 

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Since our inception, we have incurredsignificant net losses, and we expect to continue to incur net losses for theforeseeable future as we explore strategic options for the company. We areunable to predict the extent of any future losses or the degree of success wemay have in the exploration and execution of our strategic options.

 

We have established proof of concept with ourthree leading product candidates, tecarfarin, budiodarone and naronapride(ATI-7505), which retain the efficacy of certain commercially successful drugsfor well established chronic markets while being metabolized through apotentially safer pathway than such drugs. The following is a summary of our product candidates:

 

***Naronapride(ATI-7505)***

 

Naronapride (ATI-7505) is an oral prokinetic agentthat has been shown to speed up the passage of contents through the gut. Wehave successfully completed four Phase 2 clinical trials for the treatmentof multiple gastrointestinal disorders including gastroesophageal refluxdisease, or GERD, functional dyspepsia and chronic idiopathic constipation.Naronapride was designed to have the same therapeutic benefits as cisapride, adrug marketed by Johnson & Johnson under the brand name Propulsid inthe United States and other countries. Launched in 1993, cisapride waswithdrawn from the market in 2000 due to serious cardiovascular side effects.These side effects occurred as blood levels of cisapride rose significantlywhen CYP450 clearance was inhibited due to the co administration of other drugsthat were cleared by the same metabolic pathway. We designed naronapride to bemetabolized through the esterase pathway, eliminating metabolism through CYP450as well as eliminating the off-target cardiovascular effects. Nearly 1,000patients and subjects have been treated with naronapride as part of our clinicaltrial program. In June 2006, we entered into a collaboration agreementwith Procter & Gamble Pharmaceuticals, Inc., or P&G, todevelop and commercialize naronapride. On July 2, 2008, we received noticefrom P&G that it elected to exercise its option to terminate thecollaboration agreement effective July 2, 2008. P&G subsequentlyannounced that it is exiting pharmaceutical drug development. Upon terminationof the collaboration agreement by P&G, all rights to naronapride revertedto us. Also on July 2, 2008, we announced the overall successful resultsof a Thorough QT trial, or TQT, on naronapride, which we believe supports theagent’s favorable cardiac safety profile. On August 22, 2008, we announcedthe results of a Phase 2b clinical trial testing the safety and efficacyof naronapride in patients with chronic idiopathic constipation. The clinicaltrial, conducted by P&G, was designed to enroll 400 patientsevaluating four doses of the agent compared to placebo. As a result of thetermination of the collaboration between the company and P&G, the trial wasterminated early after only 214 patients had been enrolled. In spite of theearly termination of the trial, naronapride achieved statistical significanceat the trial’s primary endpoint in the 80 mg twice-daily dose. Inaddition, all doses tested demonstrated a clinically meaningful and desiredincrease in spontaneous bowel movements over baseline compared to placebo afterone week of treatment. We have had an end of Phase 2 meeting with the FDA toseek their guidance on the size and design of the Phase 3 program required forregistration. Based upon the results of that meeting, we believe we have aclear path forward in chronic idiopathic constipation that includes safety datain line with ICH guidelines. Through the Strategic Process, we are seeking toidentify the best path to maximize the value of naronapride and lead to itsfull development and eventual commercialization, in the event requisiteregulatory approval is obtained.

 

***Tecarfarin***

 

Tecarfarin is an oral anticoagulant agent inPhase 2/3 clinical development for the treatment of patients who are atrisk for the formation of dangerous blood clots, such as those with atrialfibrillation or those at risk of venous thromboembolism. Tecarfarin was designedto have the same therapeutic benefits as the drug warfarin which for over50 years has been the oral anticoagulant of choice. Despite its widespreaduse, warfarin has several significant limitations. It is metabolized by CYP450and has many drug-drug interactions that often lead to serious side effects. Wedesigned tecarfarin to be metabolized through the esterase pathway, eliminatingmetabolism through CYP450 and avoiding drug-drug interactions. Warfarin alsohas a very steep dose response curve which means that a small change in dosemay lead to a substantial change in the anticoagulation status of the patient.These two factors can create significant challenges in maintaining therapeuticlevels of warfarin and this can put patients at risk for eitherlife-threatening clotting or bleeding, especially in patients with compromisedCYP450 clearance. In preclinical testing and in clinical testing to date, itappears that tecarfarin may be inherently more stable than warfarin due to itspredictable metabolism through the esterase pathway that has a much largercapacity than CYP450. The level of anticoagulation produced by both warfarinand tecarfarin is measured by the standard assay known as InternationalNormalized Ratio, or INR.

 

We have treated over 400 patients with tecarfarin intrials in which we measured its ability to maintain those patients within atarget therapeutic range of INR of 2.0 to 3.0 (2.5 to 3.5 for heart valvepatients). Two of the clinical trials performed were Phase 2 trials (CLN-504and CLN-509) and the third was a Phase 2/3 trial, EmbraceAC (CLN-505). Ineach of these three trials, the results were nearly identical. Patients ontecarfarin had a time in target therapeutic range of INR of 71.5% (CLN-504),73.9% (CLN-509), and 74% (CLN-505). Statistical significance was achieved inCLN-504 when comparing the tecarfarin response to the same patients’ historicalexperience with warfarin: 71.5% time within therapeutic range versus 59.3% timewithin therapeutic range, respectively (p=0.0009). However, statisticalsignificance was not achieved at the primary endpoint in the 607-patientCLN-505 clinical trial, directly measuring the ability of tecarfarin tomaintain patients within the target therapeutic range of INR as compared towarfarin patients. The endpoint was missed due to the unprecedented time withintherapeutic range for the warfarin-treated patients of 73.2%

 

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(p=0.506). We believe the warfarin outcome resultedfrom the intense monitoring and dose control provided by the trial’s centraldosing methodology, executed in accord with our agreement on the trial designwith the U.S. Food and Drug Administration, or FDA. In a subgroupresponder analysis of those CLN-505 patients taking medications which inhibitCYP450 metabolism and which can cause drug-drug interactions, the tecarfaringroup showed a significantly larger proportion of responders compared to thewarfarin group (67.9% versus 53.8% respectively p=0.0676). A responder isdefined as a patient who is in range for more than 65% of the time during thetreatment period. In addition, about one-third of the CLN-505 patients who werein the tecarfarin treatment arm and were stable on the drug at the end of thetrial period continued to be treated with tecarfarin in a safety follow-upextension, allowing treatment on the agent for at least one year. During thisextension phase, tecarfarin patients were monitored an average of once everyfour weeks. This group’s average time in therapeutic range of INR was 78.4% ofthe time treated during the extension phase.

 

Based upon feedback from the FDA subsequent to thecompletion of the CLN-505 clinical trial, we believe one additionalPhase 3 trial needs to be conducted to potentially seek regulatoryapproval of tecarfarin. This trial would also directly compare tecarfarin’sability to maintain patients in a targeted therapeutic range of INR compared towarfarin but in a “real-world” setting in which monitoring and dosing decisionswould be made at the trial sites, which would be similar to how warfarin istypically dosed and titrated in clinical practice. We believe tecarfarin shouldcompare favorably against warfarin in a real-world setting due to its inherentproperties and based upon the clinical results we have collected to date. Webelieve this favorable result will be in contrast to the well-establishedpublished data reporting the typical time in therapeutic range of INR expectedin patients treated with warfarin in similar historical trials. In our mostrecent discussions, the FDA confirmed that the ability to maintain patientswithin the targeted INR will likely be an acceptable surrogate and primary endpointfor tecarfarin’s clinical development, and that the data collected in theCLN-505 clinical trial could be used to support the registration of tecarfarin.Using INR as a surrogate measure for the primary endpoint should reduce thesize of our planned second Phase 3 clinical trial compared to clinicaltrials measuring survival rates or other outcomes. We have submitted, inwriting under a Special Protocol Assessment, or SPA, our proposed design of thesecond Phase 3 clinical trial. The process to negotiate a final studydesign with the FDA is ongoing. Through the Strategic Process, we are seekingto identify the best path to maximize the value of tecarfarin and lead to itsfull development and eventual commercialization, in the event requisite regulatoryapproval is obtained.

 

***Budiodarone***

 

Budiodarone is an oral antiarrhythmic agent inPhase 2 clinical development for the treatment of patients with atrialfibrillation. Budiodarone was designed to have the efficacy of amiodarone, adrug that has been used for many years, despite its adverse side effects,because physicians believe based on their own experience, as well as extensiveclinical trial results, that amiodarone is the most effective drug for treatingpatients with atrial fibrillation. Amiodarone accumulates in many differentorgans and can only be metabolized and subsequently cleared from the body byCYP450. This accumulation can lead to serious side effects that are notimmediately reversible upon withdrawal of the drug. Since budiodarone is predominantlymetabolized through the esterases found extensively in the organs, it shouldavoid safety issues associated with accumulation and have fewer drug-druginteractions. We have completed a Phase 2 pilot trial (CLN-208) withbudiodarone involving six atrial fibrillation patients with implantedrecordable pacemakers who did not respond to previous drug therapy. This pilottrial suggested that the effect of budiodarone improved as the dose increased.Based upon the results of this pilot trial, we conducted an additionalPhase 2b clinical trial to further demonstrate the efficacy of budiodaronein patients with atrial fibrillation. The clinical trial, which enrolled72 patients, was a multi-centered, randomized, double blind,placebo-controlled trial of the efficacy and safety of budiodarone in patientswith paroxysmal atrial fibrillation, or PAF. All patients entering this trialhad previously implanted dual chamber pacemakers with diagnostic and recordingcapability. In December 2008, we announced successful top-line efficacyresults from this Phase 2b clinical trial. By achieving statisticalsignificance at the two highest doses of the three tested, the resultsessentially mirrored the findings of the earlier Phase 2 pilot trial alsoconducted in paroxysmal atrial fibrillation patients. The Phase 2b trialalso demonstrated that patients in the trial quickly returned to theirpre-treatment level of atrial fibrillation once the treatment ended. We havealso announced the complete safety results from this Phase 2b clinicaltrial that indicate that budiodarone is generally safe and well-tolerated, andappears to avoid the tissue accumulation evident with amiodarone. Through theStrategic Process, we are seeking to identify the best path to maximize the valueof budiodarone and lead to its full development and eventual commercialization,in the event requisite regulatory approval is obtained.

 

***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.

 

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***Restructuring of Operations***

 

On October 29, 2009, we announced a restructuringof operations which included a reduction in personnel from 73 employees to 56employees. The staff reduction affected all functions within the company andwas accompanied by changes within the organizational structure to improve theefficiency of our operations. We recognized a charge of approximately $375,000related to the restructuring during the fourth quarter of 2009 which includedcosts for severance pay, extended healthcare benefits and outplacement servicesfor the exiting employees. Additionally, we made an assessment to determine ifthere had been any material impairment of assets resulting from therestructuring and concluded that no material impairment had occurred.

 

On February 18, 2010 we announced an additionalrestructuring of operations which included a substantial reduction in forcefrom 56 employees to 17 employees, and further reduced to 16 employeesfollowing the departure of Peter G. Milner, M.D., our former President ofResearch and Development, effective June 15, 2010. The positions impactedwere across all business functions, including the research and development,clinical, operations and general and administrative departments. Therestructuring plan was primarily designed to reduce operating expenses andconserve cash resources as we explore various strategic options. Therestructuring was substantially completed during the first quarter of 2010.Additionally, we announced the shift of our primary focus to the exploration ofstrategic alternatives available to us to realize optimal value for ourlate-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% common stockin order to minimize the associated cash expense, with an aggregate 460,940shares of common stock issued under our equity incentive plan as a severancepayout.

 

As a result of the February 2010 restructuring ofoperations, we incurred an aggregate restructuring charge of approximately$1.6 million less a credit of approximately $0.3 million due to stockoption cancellations in the first six months of 2010. Of this amount,approximately $0.1 million was recognized as expense during the second quarter of2010. The restructuring charge includes costs for severance pay, employeebenefits and outplacement services. The aggregate restructuring charge includedapproximately $1.0 million of cash expenditures and approximately$0.3 million of non-cash charges, net of adjustments related to stockcompensation expense. As part of the restructuring effort and during the courseof our continuing operations, we will be assessing on a quarterly basis anypossible impairment of assets related to idle facilities and equipmentresulting from the February 2010 restructuring and may incur additionalexpense related to any such impairment. During the first and second quarters of2010 we made an assessment in accordance with ASC 360 to determine if there hadbeen any material impairment of assets resulting from the February 2010restructuring and concluded that given the range of possible outcomes relatedto our exploration of strategic alternatives, no material impairment hadoccurred. As a result of our restructuring activities, we anticipate asubstantial reduction in our operating expenses in 2010 as compared to ourspending levels in 2009.

 

As of June 30, 2010, we had cash, cashequivalents and marketable securities on hand in the amount of$1.4 million, current payables and accrued liabilities of approximately$1.4 million and approximately $4.7 million in current notes andrelated interest payable. As of June 30, 2010, we had outstandingnon-current liabilities of $4.8 million. Since our inception, we haveincurred significant net operating losses and, as of June 30, 2010, we hadan accumulated deficit of $197.1 million. We have not achieved sustainedprofitability and anticipate that we will continue to incur significant netlosses for the foreseeable future. There can be no assurances that we willachieve positive cash flow in the foreseeable future or at all. Additionally,we do not anticipate that our cash on hand as of June 30, 2010 will besufficient to fund our operations for the following twelve months. However, webelieve that our cash on hand along with proceeds from the Bridge Financingwill provide us with sufficient funds to operate through the end of 2010. Forthe year ended December 31, 2009 our auditor, Ernst & Young LLP,issued an audit opinion which included an explanatory paragraph raisingsubstantial doubt about our ability to continue as a going concern.

 

***Research andDevelopment Expense***

 

Our research and development expense consistsof expenses incurred in identifying, testing and developing our product candidates.These expenses consist primarily of fees paid to contract researchorganizations and other third parties to assist us in managing, monitoring andanalyzing our clinical trials, clinical trial costs paid to sites andinvestigators’ fees, costs of nonclinical studies including toxicity studies inanimals, costs of contract manufacturing services, costs of materials used inclinical trials and nonclinical studies, laboratory related expenses, researchand development support costs including certain regulatory, quality assurance,project management and administration, allocated expenses such as facilitiesand 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 significantcomponent of our research and development expense. Currently, we conduct ourclinical trials primarily through coordination with contract research organizationsand other third-party service providers. We recognize research and developmentexpense for these activities based upon a variety of factors, including actualand estimated patient enrollment, clinical site initiation activities, directpass-through costs and other activity-based factors.

 

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The following table summarizes our research anddevelopment, or R&D, expense for the three and six months ended June 30,2010 and 2009:

 
| ** **                                           | ** ** | **Three Months Ended********June 30,** | ** ** | **Six Months Ended********June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2010**                                    | ** ** | **2009**                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                          | ** ** |
| Direct  R&D expense by product candidate:        |       |                                        |       |                                      |       |   |   |   |   |
| Budiodarone                                          |       | $                                           | —     |                                      | $          | 69 |   | $ | 40 |   | $ | 707 |   |
| Tecarfarin                                           |       | 17                                          |       | 2,665                                     |       | 271 |   | 5,491 |   |
| Naronapride (ATI-7505)                               |       | 30                                          |       | 64                                        |       | 47 |   | 116 |   |
| ATI-9242                                             |       | (5                                          | )          | 51                                        |       | 107 |   | (56 | ) |
| Other research programs                              |       | 1                                           |       | 56                                        |       | 57 |   | 100 |   |
| Total direct R&D  expense                        |       | 43                                          |       | 2,905                                     |       | 522 |   | 6,358 |   |
| R&D personnel,  administrative and other expense |       | 961                                         |       | 3,366                                     |       | 2,724 |   | 6,702 |   |
| Total R&D expense                                |       | $                                           | 1,004      |                                      | $          | 6,271 |   | $ | 3,246 |   | $ | 13,060 |   |

 

From our inception through June 30, 2010,we estimate that approximately $40.5 million of expense was incurred forour tecarfarin product candidate, approximately $25.2 million was incurredfor our budiodarone product candidate, approximately $22.7 million wasincurred for our naronapride (ATI-7505) product candidate, approximately$5.2 million was incurred for our ATI-9242 product candidate, andapproximately $72.9 million was incurred for costs related to our researchand development personnel, administrative and other research programs.

 

The expenditures summarized in the above tablereflect costs directly attributable to each product candidate and to our otherresearch programs. We do not allocate salaries, employee benefits, or otherindirect costs to our product candidates or other research programs and haveincluded those expenses in “personnel, administrative and other expense” in theabove table.

 

At this time, due to the risks inherent in ourbusiness and given the various stages of development of our product candidates,we are unable to estimate with any certainty the costs we will incur in supportof our product candidates. Clinical development timelines, the probability ofsuccess and development costs can differ materially from expectations. Inaddition, we cannot forecast with any degree of certainty which productcandidates may be subject to future collaborations, when such arrangements maybe secured, if at all, and to what degree such arrangements would affect ourcurrent operating plans and capital requirements.

 

The process of developing and obtaining FDAapproval of products is costly and time consuming. Development activities andclinical trials can take years to complete, and failure can occur at any timeduring the development and clinical trial process. In addition, the resultsfrom early clinical trials may not be predictive of results obtained insubsequent and larger clinical trials, and product candidates in later stagesof clinical trials may fail to show the desired safety and efficacy despitehaving progressed successfully through initial clinical testing. Although ourapproach to identifying and developing new product candidates is designed to mitigaterisk, the successful development of our product candidates is highly uncertain.Further, even if our product candidates are approved for sale, they may not besuccessfully commercialized and therefore the future revenue we anticipate maynot materialize.

 

If we fail to complete the development of any of ourproduct candidates in a timely manner, it could have a material effect on ouroperations, financial position and liquidity. In addition, any failure by us orour partners 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 expendminimal efforts or resources towards further development of our productcandidates. A further discussion of the risks and uncertainties associated withcompleting our programs on schedule, or at all, and certain consequences offailing to do so are discussed in Part II—Item 1A. “Risk Factors”section of this report.

 

**Critical Accounting Policies andSignificant Estimates**

 

We have prepared our consolidated financialstatements in accordance with U.S. generally accepted accounting principles.Accordingly, we have had to make estimates, assumptions and judgments that affectthe amounts reported in our consolidated financial statements. These estimates,assumptions and judgments about future events and their effects on our resultscannot be determined with certainty, and are made based upon our historicalexperience and on other assumptions that are believed to be reasonable underthe circumstances. These estimates may change as new events occur or additionalinformation is obtained, and we may periodically be faced with uncertainties,the outcomes of which are not within our control and may not be known for aprolonged period of time.

 

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Our critical accounting policies are more fullydescribed in Note 1 of the audited consolidated financial statements for theyear ended December 31, 2009, which are included in our annual report onForm 10-K filed with the Securities and Exchange Commission. There havebeen no material changes in our critical accounting policies and significantestimates during the three and six months ended June 30, 2010.

 

**Results of Operations**

 

***Comparison of Threeand Six Months Ended June 30, 2010 and 2009***

 

***Revenue***

 

No revenue was recorded for the three and six monthsended June 30, 2010 or 2009.

 

***Research andDevelopment Expense***

 
|                              |   | **Three Months Ended**       | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** |       |
|-----------------------------------|--------|------------------------------|------------|------------|------------|-------------------|------------|----------------------|------------|------------|------------|------------|------------|
|                              |   | **June 30,**            | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**           |       |
|                              |   | **2010**                     | ** ** | **2009**   | ** ** | **$**             | ** ** | **%**                | ** ** | **2010**   | ** ** | **2009**   | ** ** | **$** | ** ** | **%** |   |
|                              |   | **(In thousands, except %)** |       |
| Research and development  expense |   | $                            | 1,004      |       | $          | 6,271             |       | $                    | (5,267     | )          | (84        | )%         | $          | 3,246 |   | $ | 13,060 |   | $ | (9,814 | ) | (75 | )% |
|                                   |        |                              |            |            |            |                   |            |                      |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

For the three months ended June 30, 2010, ascompared to the same period in 2009, our research and development expensedecreased by $5.3 million, or 84%. The decrease was due to:

 

·                  a $2.7 million reduction in expenses related to our tecarfarinproduct candidate due to the substantial completion of our Phase 2/3 EmbraceACclinical study in the second quarter of 2009;

 

·                  a $2.4 million reduction in personnel and administrative costs resultingprimarily from our restructuring of operations in October 2009 and February 2010;

 

·                  a $0.1 million reduction in expenditures related to the completion of a Phase 2b clinical study for ourbudiodarone product candidate in the first half of 2009; and

 

·                  a $0.1 million reduction in R&D costs related to our other R&Dactivities.

 

For the six months ended June 30, 2010, ascompared to the same period in 2009, our research and development expensedecreased by $9.8 million, or 75%. The decrease was due to:

 

·                  a $5.2 million reduction in expenses related to our tecarfarinproduct candidate due to the substantial completion of our Phase 2/3 EmbraceACclinical study in the second quarter of 2009;

 

·                  a $3.9 million reduction in personnel and administrative costs resultingprimarily from our restructuring of operations in October 2009 and February 2010;and

 

·                  a $0.7 million reduction in expenditures related to the completion of a Phase 2b clinical study for ourbudiodarone product candidate in the first half of 2009.

 

***Selling,General and Administrative Expense***

*** ***
| ** **                                   | ** ** | **Three Months Ended**       | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------|------------|----------------------|------------|------------|------------|------------|------------|
| ** **                                   | ** ** | **June 30,**            | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**           | ** ** |
| ** **                                   | ** ** | **2010**                     | ** ** | **2009**   | ** ** | **$**             | ** ** | **%**                | ** ** | **2010**   | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                   | ** ** | **(In thousands, except %)** | ** ** |
| Selling, general and  administrative expense |       | $                            | 2,238      |       | $          | 2,622             |       | $                    | (384       | )          | (15        | )%         | $          | 6,015 |   | $ | 5,225 |   | $ | 790 |   | 15 | % |
|                                              |            |                              |            |            |            |                   |            |                      |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

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The decrease in selling, general and administrativeexpense for the three months ended June 30, 2010 as compared to the sameperiod in 2009 was primarily due to reduced operating expenses resulting fromour our October 2009 and February 2010 restructuring of operations,partially offset by severance costs related to the departure of Peter Milner,our former President of Research and Development, and costs related to the atmarket financing arrangement incurred during the second quarter of 2010. Theincrease in selling, general and administrative expense for the six monthsended June 30, 2010 as compared to the same period in 2009 was primarilydue to our recognition of a $1.6 million restructuring charge resulting fromour February 2010 restructuring of operations, costs related to thedeparture of Peter Milner and costs related to the at market financingarrangement, partially offset by a reduction in our on-going operating costs asa result of our restructuring efforts.

 

***Interest andOther Income (Expense)***

 
| ** **                      | ** ** | **Three Months Ended**       | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------|------------|------------------------------|------------|------------|------------|-------------------|------------|----------------------|------------|------------|------------|------------|------------|
| ** **                      | ** ** | **June 30,**            | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**           | ** ** |
| ** **                      | ** ** | **2010**                     | ** ** | **2009**   | ** ** | **$**             | ** ** | **%**                | ** ** | **2010**   | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                      | ** ** | **(In thousands, except %)** | ** ** |
| Interest and other income,  net |       | $                            | (5         | )          | $          | 11                |       | $                    | (16        | )          | (145       | )%         | $          | 58 |   | $ | 65 |   | $ | (7 | ) | (11 | )% |
|                                 |            |                              |            |            |            |                   |            |                      |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Interestand other income, net of other expenses, consist primarily of interest incomefrom our investments in money market funds and marketable securities, realizedgains or losses from the sale of marketable securities and certain expensessuch as state franchise tax. The decrease in interest and other income for thethree months ended June 30, 2010 as compared to the same period in 2009was primarily due to lower interest income resulting from lower cash balanceswhich was offset by state franchise tax expense that exceeded our interestincome. The decrease in interest and other income for the six months ended June 30,2010 as compared to the same period in 2009 wasprimarily due to lower interest income resulting from lower cash balances,partially offset by a state franchise tax rebate recognized in the firstquarter of 2010 and a realized gain of approximately $18,000 related to thesale of our auction rate security instrument.

 

***InterestExpense***

 
| ** **       | ** ** | **Three Months Ended**       | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------|------------|------------------------------|------------|------------|------------|-------------------|------------|----------------------|------------|------------|------------|------------|------------|
| ** **       | ** ** | **June 30,**            | ** ** | **Change** | ** ** | **June 30,** | ** ** | **Change**           | ** ** |
| ** **       | ** ** | **2010**                     | ** ** | **2009**   | ** ** | **$**             | ** ** | **%**                | ** ** | **2010**   | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest expense |       | $                            | 390        |       | $          | 496               |       | $                    | 106        |       | (21        | )%         | $          | 824 |   | $ | 996 |   | $ | 172 |   | (17 | )% |
|                  |            |                              |            |            |            |                   |            |                      |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

Thedecrease in interest expense for the three and six month periods ended June 30,2010 as compared to the same periods in 2009 was primarily due to a reductionof our debt balances outstanding resulting from the contractual pay down of ourlong-term debt obligations.

 

**Liquidity and Capital Resources**

** **
| ** **                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **June 30,**    | ** ** |
| ** **                   | ** ** | **2010**             | ** ** | **2009** | ** ** |
| ** **                   | ** ** | **(In thousands)**   | ** ** |
| Cash (used in) provided  by: |       |                 |       |   |   |
| Operating activities         |       | $                    | (9,938     | ) | $ | (22,091 | ) |
| Investing activities         |       | 574                  |       | (1,931 | ) |
| Financing activities         |       | 3,359                |       | (44 | ) |
| Total cash (used) provided   |       | $                    | (6,005     | ) | $ | (24,066 | ) |

 

As of June 30, 2010, the Company had cash,cash equivalents and marketable securities on hand in the amount of$1.4 million, current payables and accrued liabilities of approximately$1.4 million and approximately $4.7 million in current notes andrelated interest payable. As of June 30, 2010, the Company had outstandingnon-current liabilities of $4.8 million. Since our inception, we haveincurred significant net operating losses and, as of June 30, 2010, we hadan accumulated deficit of $197.1 million. We have not achieved sustainedprofitability and anticipate that we will continue to incur significant netlosses for the foreseeable

 

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future. There can be no assurances that we will achievepositive cash flow in the foreseeable future or at all. Additionally, we do notanticipate that our cash on hand as of June 30, 2010 will be sufficient tofund our operations for the following twelve months. However, we believe thatour cash on hand along with proceeds from the Bridge Financing will provide uswith sufficient funds to operate through the end of 2010.

 

Net cash used in operating activities was$9.9 million and $22.1 million for the six months ended June 30,2010 and 2009, respectively. Net cash consumed in each of these periods wasprimarily used towards the funding of our operating costs and expenses inconnection with the conduct of our research, development and administrativeactivities. Additionally, the six month period ended June 30, 2010included approximately $1.0 million of cash expenditures related to ourFebruary 2010 restructuring of operations.

 

Cash used in, or provided by, investingactivities primarily related to purchases, sales and maturities of marketablesecurities, as well as changes in our restricted cash balances and levels ofcapital expenditure. For the six months ended June 30, 2010, net sales ofmarketable securities was $0.4  million as compared to purchases ofmarketable securities, net of maturities, of $1.8 million for the sameperiod in 2009. During the six months ended June 30, 2010, we receivedfunds from the contractual release of approximately $0.2 million of restrictedcash related to our facility lease agreement. Purchases of property andequipment were zero and $89,000 for the six months ended June 30, 2010 and2009, respectively.

 

Net cash provided by financing activities forthe six months ended June 30, 2010 was $3.4 million and was related toproceeds from the sale of common stock pursuant to the Commerce Court equityline agreement, partially offset by principal payments on our long-term debt.For the six months ended June 30, 2009, net cash used in financingactivities was $44,000 and consisted of principal payments on our long-termdebt and equity issuance costs, partially offset by proceeds from employeepurchases of our common stock pursuant to our employee stock purchase plan.

 

As of June 30, 2010, we had loancommitments outstanding with Lighthouse Capital Partners V, L.P., orLighthouse, and Oxford Finance Corporation, or Oxford.  Prior to June 30, 2010 we also had loancommitments outstanding with General Electric Commercial Finance, or GE. Thetotal principal amount borrowed under the Lighthouse agreements was$19.0 million and the total unpaid principal balance outstanding as of June 30,2010, was $6.4 million. Additionally, in accordance with the agreements,we had an obligation to pay Lighthouse a $1.4 million interest balloon paymenton July 1, 2010. We recorded interest expense related to the Lighthouseloan agreement, including amortization of expense related to the terminalpayment and the warrants issued under the agreement, of $369,000 and $461,000for the three months ended June 30, 2010 and 2009, respectively, and$779,000 and $921,000 for the six months ended June 30, 2010 and 2009,respectively. Subsequent to June 30, 2010, we entered into a restructuredloan agreement with Lighthouse. The total principal amount borrowed under theGE agreements was $1.9 million and as of June 30, 2010 the loans hadbeen fully repaid. We recorded interest expense related to the GE loanagreements of $650 and $6,000 for the three months ended June 30, 2010 and2009, respectively, and $2,250 and $15,000 for the six months ended June 30,2010 and 2009, respectively.  The totalprincipal amount borrowed under the Oxford loan agreement was $1.0 millionand the total unpaid principal balance outstanding as of June 30, 2010,was $543,000. We recorded interest expense related to the Oxford loanagreement, including amortization of expense related to the terminal paymentand the warrant issued under the agreement, of $20,200 and $29,000 for thethree months ended June 30, 2010 and 2009, respectively, and $42,700 and$60,000 for the six months ended June 30, 2010 and 2009, respectively.

 

On August 13, 2010, we entered into the Agreement with certainexisting accredited investors (the “Investors”), pursuant to which we agreed toissue and sell in a private placement Notes in the aggregate principal amountof up to $4.0 million, and warrants to purchase up to an aggregate of 2,000,000shares of our common stock (the “Warrants”), subject to the terms andconditions set forth in the Agreement. The Notes are secured by a security interest in all of the assets of theCompany, including our intellectual property.

 

OnAugust 13, 2010, we closed on the initial tranche of $2.0 million of Notespursuant to the terms and conditions set forth in the Agreement and, as aresult, issued Warrants to the Investors to purchase 1,000,000 shares of ourcommon stock.  The Agreement provides forthe sale of a second tranche of $2.0 million of Notes on September 30,2010 (together with the issuance of Warrants to purchase an additional1,000,000 shares of our common stock), at our option, subject to thesatisfaction of certain conditions set forth in the Agreement.  We must deliver notice of our election tocomplete the second tranche to the Investors no later than September 15,2010.

 

The Notes accrue interest at a continuously compounding rate of 12.0%per annum.  Unless earlier paid pursuantto the terms of the Agreement or accelerated in connection with an event ofdefault, we will make interest only payments through December 31, 2010,followed by 24 equal monthly payments of principal and interest through January 1,2013 (the “Maturity Date”).  In the eventwe sell any or all of our assets or enter into certain strategic transactions,we may be required to repay the Notes at an earlier date under the terms of theBridge Financing.

 

TheWarrants have a purchase price of $0.0125 per underlying share of common stockand are exercisable for a term of five years from the date of issuance at anexercise price of $0.50 per share.  Weare required to file, within 60 days after August 13, 2010 (or, in theevent we are required to file the registration statement on a Form S-1,within 90 days after August 13, 2010), a registration statementregistering for resale the shares of common stock issuable upon the exercise ofthe Warrants pursuant to a Registration Rights Agreement we entered into withthe Investors.

 

Weanticipate net proceeds of approximately $1.8 million in connection with theinitial tranche of the Bridge Financing, after deducting certain expensespayable by us. The net proceeds from the initial tranche of the BridgeFinancing were used by us to make an approximately $2.0 million repayment onour existing loan obligation with Lighthouse pursuant to the terms of our loanarrangement with Lighthouse, as more fully described below. We currentlyanticipate the proceeds from the second tranche of the Bridge Financing, to theextent such closing occurs, to be used for working capital and other corporateand operational purposes, including permitted payments to our lenders.

 

Concurrentlywith the Bridge Financing, we and Lighthouse entered into Amendment No. 8(the “Amendment”) to that certain Loan and Security Agreement No. 4521dated March 28, 2005, as amended (the “Loan Agreement”). The Amendmentprovides for the conversion of up to approximately $2.3 million of loanpayments scheduled for the third quarter of 2010 into the New Commitment. Uponthe closing of the initial tranche of the Bridge Financing, we used the netproceeds from such closing to make an approximately $2.0 million repayment ofour loan obligation to Lighthouse and, pursuant to the terms of the Amendment,Lighthouse promptly loaned approximately the same amount to us as part of theNew Commitment. We are required to make a subsequent payment of approximately$300,000 to Lighthouse on or about September 1, 2010, which amountLighthouse has agreed to promptly loan to us upon receipt of such payment asthe balance of the New Commitment.

 

                TheNew Commitment is due and payable on December 31, 2010 in one lump sum paymentequal to the aggregate principal amount plus accrued interest through the duedate at a stated interest rate of 13.0% per annum. However, if the secondtranche of the Bridge Financing does not occur, the New Commitment becomes dueand payable on September 30, 2010. In the event we enter into certain strategictransactions with proceeds of at least $40.0 million prior to the applicabledue date, the New Commitment will be amortized and payable in equal monthlyinstallments of principal and interest over the 18 months following the closingof such strategic transaction. Upon the occurrence of an event of default orliquidation event, all outstanding amounts under the New Commitment shall beimmediately due and payable.

 

The Amendment further provides that (i) any assignment of theNotes without Lighthouse’s consent or (ii) the failure of the secondtranche of the Bridge Financing to occur would each now constitute an event ofdefault under the Loan Agreement.  Wealso granted Lighthouse a security interest in our intellectual property inconnection with the Amendment and New Commitment.

 

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***Equity LineFinancing Facility***

 

On October 6, 2009, we entered into acommon stock purchase agreement, or the Purchase Agreement, with Commerce CourtSmall Cap Value Fund, Ltd., or Commerce Court, providing for a financingarrangement that is sometimes referred to as a committed equity line financingfacility. The Purchase Agreement provided that, upon the terms and subject tothe conditions set forth in the Purchase Agreement, Commerce Court would becommitted to purchase up to $35.0 million of shares of our common stockover the 24-month term of the Purchase Agreement under certain specifiedconditions. Under the terms of the Purchase Agreement, in no event could wesell more than 5,380,090 shares of common stock, which is equal to one shareless than 20% of our outstanding shares of common stock on October 6,2009, the closing date of the Purchase 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 be obligatedto purchase any shares of our common stock which, when aggregated with allother shares of our common stock then beneficially owned by Commerce Court,would result in the beneficial ownership by Commerce Court of more than 9.9% ofthe then outstanding shares of our common stock. We issued to Commerce Court,upon execution of the Purchase Agreement, 114,200 shares of our common stock,or the Commitment Shares.

 

On December 11, 2009, we delivered noticeto Commerce Court to effect a draw down of up to $1.0 million. The firsttrading day of the 10-day pricing period for this draw down wasDecember 14, 2009. In connection with this draw down, we issued anaggregate of 413,896 shares of our common stock to Commerce Court, at a pershare purchase price of approximately $2.42 and an aggregate purchase price of$1.0 million. The settlement date for this draw down was December 30,2009. The per share price at which Commerce Court purchased these shares fromus was 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 7.0% per share. We received net proceedsfrom the sale of these shares of approximately $781,000 after deducting ouroffering expenses of approximately $219,000 including a placement agent fee of$10,000 paid to Reedland Capital Partners, an Institutional Division ofFinancial West Group, member FINRA/SIPC. Of the total offering cost,approximately $180,000 was incurred as one time expenses related to the filingof a registration statement on Form S-1 covering the resale of the sharesof Common Stock sold to Commerce Court and legal fees incurred upon enteringinto the Purchase Agreement with Commerce Court.

 

On January 4, 2010, we delivered notice toCommerce Court, as subsequently amended, to effect a draw down of up to$1.4 million. The first trading day of the 10-day pricing period for thisdraw down was January 5, 2010. In connection with this draw down, weissued an aggregate of 490,864 shares of our common stock to Commerce Court, ata purchase price of approximately $2.85 per share and an aggregate purchaseprice of $1.4 million. The settlement date for this draw down wasJanuary 20, 2010. The share price at which Commerce Court purchased theseshares from us was established under the Purchase Agreement by reference to thevolume weighted average prices of our common stock on The NASDAQ Global Marketduring the 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 noticeto Commerce Court, to effect a draw down under the Purchase Agreement. Thefirst trading day of the 10-day pricing period for this draw down wasFebruary 22, 2010. In connection with this draw down, we issued an aggregateof 2,764,546 shares of our common stock to Commerce Court, at a purchase priceof approximately $1.19 per share and an aggregate purchase price ofapproximately $3.29 million. The settlement date for this draw down wasMarch 8, 2010. The share price at which Commerce Court purchased theseshares from us was established under the Purchase Agreement by reference to thevolume weighted average price of our common stock on The NASDAQ Global Marketduring the pricing period, net a discount of approximately 7.0% per share. Wereceived 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 toCommerce Court, to effect a draw down under the Purchase Agreement. The firsttrading day of the 10-day pricing period for this draw down was March 12,2010. In connection with this draw down, we issued an aggregate of 1,710,784shares of our common stock to Commerce Court, at a purchase price ofapproximately $1.07 per share and an aggregate purchase price of approximately$1.83 million. The settlement date for this draw down was March 26,2010. The share price at which Commerce Court purchased these shares from uswas established under the Purchase Agreement by reference to the volumeweighted average price of our common stock on The NASDAQ Global Market duringthe pricing period, net a discount of approximately 7.0% per share. We receivednet proceeds from the sale of these shares of approximately $1.8 millionafter deducting our estimated offering expenses of approximately $30,000,including a placement agent fee of $18,311 payable to Reedland Capital Partnersin connection with this draw down.

 

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As of March 26, 2010, we had issued the maximumamount of common stock available under the Commerce Court Purchase Agreementand therefore will no longer be able to utilize the facility.

 

***At Market Issuance Facility***

 

On May 20, 2010, we entered into an at marketissuance sales agreement, or Sales Agreement, with McNicoll, Lewis &Vlak LLC, or MLV, and Wm Smith & Co., or Wm Smith, pursuant to whichwe may issue and sell shares of our common stock having an aggregate offeringprice of up to $6.0 million from time to time through MLV and Wm Smith as oursales agents. Sales of our common stock through MLV and Wm Smith, if any,will be made on The NASDAQ Global Market by means of ordinary brokers’transactions at market prices, in block transactions or as otherwise agreed byus and these sales agents. Subject to the terms and conditions of the SalesAgreement, MLV and Wm Smith will use commercially reasonable efforts to sellour common stock from time to time, based upon our instructions (including anyprice, time or size limits or other customary parameters or conditions we mayimpose). We will pay these sales agents an aggregate commission rate of 3.0% ofthe gross proceeds of the sales price per share of any common stock soldthrough the sales agents under the Sales Agreement. The number of shares we areable to sell under this arrangement will be limited in practice based on thetrading volume of our common stock. As of August 11, 2010 we had notissued or sold any shares of our common stock pursuant to the Sales Agreement.In connection with this financing arrangement, we incurred costs ofapproximately $150,000 that were expensed during the second quarter of 2010 andare included within our selling, general and administrative expense.

 

***Future Funding Requirements***

 

Our future funding requirements will dependupon many factors, including:

 

·                  theextent of our success in monetizing the value of our current product candidateportfolio;

 

·                  thesize, complexity and cost of our remaining business operations;

 

·                  theterms and timing of any collaborative, licensing and other arrangements that wemay establish;

 

·                  thecost, timing and outcomes of regulatory approvals;

 

·                  thetiming, receipt and amount of sales or royalties generated, if any, from ourproduct candidates; and

 

·                  thecost of preparing, filing, prosecuting, defending and enforcing any patentclaims and other intellectual property rights.

 

Our ability to continue operations will bedependent on our ability to obtain additional funding and such funding may notbe available to us on acceptable terms, or at all. We may seek to raisenecessary additional funds through public or private equity, debt financings,collaborative arrangements with corporate partners or other sources. 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, including sales under our Sales Agreement with MLV and Wm Smith,dilution to our existing stockholders may result. In addition, if we raiseadditional funds through the sale of equity securities, new investors couldhave rights superior to our existing stockholders. To the extent that we raiseadditional capital through licensing or other arrangements, we may be requiredto relinquish, on terms that are not favorable to us, rights to some of ourtechnologies or product candidates that we would otherwise seek to develop orcommercialize ourselves for a higher profit margin. The terms of futurefinancings may restrict our ability to raise additional capital, which coulddelay 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.

 

**Recent Accounting Pronouncements**

 

See Note 1 of the Notes to our Condensed ConsolidatedFinancial Statements included elsewhere in this report for recent accountingpronouncements that could have an effect on us.

 

**Off-Balance Sheet Arrangements**

 

Since inception, except for standard operating leases,we have not engaged in any off-balance sheet arrangements, including the use ofstructured finance, special purpose entities or variable interest entities.

 

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**ITEM 3. QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

There were no materialchanges to our market risk from those disclosed in our annual report onForm 10-K filed with the Securities and Exchange Commission onMarch 30, 2010.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

***Evaluationof Disclosure Controls and Procedures***

 

As of June 30, 2010, an evaluation was performedby management, with the participation of our Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15-d and15(e) under the Securities Exchange Act of 1934, as amended). Disclosurecontrols and procedures are controls and procedures that are designed to ensurethat information required to be disclosed in our reports filed or submittedunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms. Based on that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that, subject tothe limitations described below, our disclosure controls and procedures wereeffective as of June 30, 2010.

 

***Limitationson the Effectiveness of Controls***

 

Our management, including our Chief Executive Officerand Chief Financial Officer, does not expect that our disclosure controls andprocedures or our internal controls will prevent all error and all fraud. Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Over time, control may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand may not be detected.

 

***Changes inInternal Control over Financial Reporting***

 

No change was made in our internal control overfinancial reporting during the quarter ended June 30, 2010 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

From time to time we are involved in legal proceedingsarising in the ordinary course of our business. We believe there is nolitigation pending that could have, individually or in the aggregate, amaterial adverse effect on our results of operations or financial condition.

 

**ITEM 1A. RISK FACTORS**

 

*We have identified thefollowing risks and uncertainties that may have a material adverse effect onour business, financial condition or results of operations. The risks describedbelow are not the only ones we face. Additional risks not presently known to usor that we currently believe are immaterial may also significantly impair ourbusiness operations. Our business could 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 risksdescribed below that reflect substantive changes from the risks described inour Annual Report on Form 10-K for the year ended December 31, 2009,filed with the Securities and Exchange Commission on March 30, 2010. 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 needsubstantial additional funding and may be unable to raise capital when needed,which would force us to limit or cease our operations and related productdevelopment programs.****

 

As of June 30, 2010, we had$1.4 million in cash, cash equivalents and marketable securities on hand,which are only sufficient to fund our current operations into the third quarterof 2010. As of June 30, 2010, we had current payables and accrued liabilitiesof $1.4 million, current notes and related interest payable of$4.7 million and outstanding non-current liabilities of $4.8 million.Our ability to continue operations as a going concern, to evaluate strategicalternatives and potentially resume development activities with respect to ourproduct candidates is dependent upon our ability to obtain substantialadditional capital. Our 

 

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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:

 

·                  theterms and timing of any collaborative, licensing and other arrangements that wemay establish, if any;

 

·                  theextent of our success in monetizing the value of our current product candidateportfolio;

 

·                  thecost, timing and outcomes of regulatory approvals;

 

·                  thesize, complexity and cost of our remaining business operations;

 

·                  thetiming, receipt and amount of sales or royalties, if any, from our potentialproducts; and

 

·                  thecost of preparing, filing, prosecuting, defending and enforcing any patentclaims and other intellectual property rights.

 

Until we can generate a sufficient amount ofcollaboration or product revenue to finance our cash requirements, which we maynever do, we expect to finance future cash needs primarily through public orprivate equity offerings, debt arrangements, including the Bridge Financing,and/or a possible sale, collaboration or license of development and/orcommercialization rights to one or more of our product candidates. We do notknow whether additional funding will be available to us on acceptable terms, orat all.

 

If we raise additional funds by issuing equitysecurities, including under our Sales Agreement with MLV and Wm Smith, ourstockholders will experience dilution, which may be significant. Any debt financingor additional equity that we raise may contain terms that are not favorable toour stockholders or us. If we raise additional funds through collaboration,sales or licensing arrangements with third parties, we may be required torelinquish some rights to our technologies or our product candidates, grantlicenses on terms that are not favorable to us or enter into a collaborationarrangement for a product candidate at an earlier stage of development or for alesser amount than we might otherwise choose.

 

Our existing capital resources are notsufficient to enable us to continue 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:

 

·                  terminateor delay future clinical trials for one or more of our product candidates; or

 

·                  furtherreduce our headcount and capital or operating expenditures.

 

As we explore strategic options, no significantdevelopment activity is currently underway on any of our product candidates,and therefore we are not able to advance their development.

 

***We haveincurred significant operating losses since inception and expect to continue toincur substantial and increasing losses for the foreseeable future. We maynever achieve or sustain profitability.***

 

We have a limited operating history and haveincurred significant losses since our inception. As of June 30, 2010, wehad an accumulated deficit of approximately $197.1 million. We expect tocontinue to incur net losses for the foreseeable future as we explore strategicoptions available to us. These losses have had and will continue to have anadverse effect on our stockholders’ equity and working capital.

 

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Because of the numerous risks and uncertaintiesassociated with drug development, we are unable to predict with certainty thecosts we will incur in support of our product candidates as we pursue strategicoptions, including potential collaboration arrangements. Currently, we have noproducts approved for commercial sale, and, to date, we have not generated anyproduct revenue. We have financed our operations primarily through the sale ofequity securities, capital lease and equipment financings, debt financings anda single corporate partnership with Procter & GamblePharmaceuticals, Inc., or P&G, that was terminated in July 2008.We have devoted substantially all of our efforts to research and development,including clinical trials. If we are unable to develop and commercialize any ofour product 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 loanagreements impose restrictions on us that may adversely affect our ability tooperate our business.***

 

Certain of our loan agreements with our lenders,including our debt arrangements with Lighthouse, Oxford and the Investors inthe Bridge Financing, contain covenants that restrict or limit, among otherthings, our ability to create liens supporting indebtedness, sell assets, makecertain distributions, and incur additional debt. In addition, our debtagreements contain, and those we enter into in the future may contain,financial covenants and other limitations with which we will need to comply.Our ability to comply with these covenants may be affected by many events beyondour control, and we cannot assure you that our future operating results will besufficient to comply with the covenants or, in the event of a default under anyof our debt agreements, to remedy that default.

 

Our failure to comply with the covenants in ourloan agreements and other related transactional documents could result inevents of default. Upon the occurrence of such an event of default, the lenderscould elect to declare all amounts outstanding under a particular facility tobe immediately due and payable and terminate all commitments, if any, to extendfurther credit. An event of default or an acceleration under one loan agreementcould cause a cross-default or cross-acceleration of another loan agreement.Such cross- default or cross-acceleration could have a wider impact on ourliquidity than might otherwise arise from a default or acceleration of a singleloan facility. 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 ourexisting debt obligations and to obtain future credit will depend primarily onour operating performance and ability to raise additional capital to continueour operations, which will be affected by general economic, financial,regulatory, business and other factors, many of which are beyond our control.Our ability to refinance existing debt obligations will also depend upon thecurrent conditions in the credit markets and the availability of creditgenerally. If we are unable to meet our debt service obligations or are unableto obtain future credit on acceptable terms, if at all, we could be forced torestructure or refinance our indebtedness, seek additional equity capital orsell or liquidate our assets. In such an event, we may be unable to obtainfinancing or sell our assets on acceptable terms, or at all.

 

***Unfavorableeconomic and market conditions may negatively impact our business, results ofoperations, and financial condition, and may make it difficult or costly toraise additional capital.****

 

The deterioration in worldwide economicconditions and the disruption to the credit and financial markets in the UnitedStates and worldwide have led to, among other things, extreme volatility insecurity prices, declining valuations of certain investments, and reducedliquidity and credit availability. As a company having no commercialoperations, a protracted downturn may hurt our business in a number of ways,including the impact on our ability to access capital and credit markets tomeet our financing objectives to allow us to continue our operations, and onour ability to manage our cash balance, current portfolio of cash equivalentsor investments in marketable securities. While we are unable to predict thelikely duration and severity of these unfavorable economic conditions in theUnited States and other countries, any of the circumstances mentioned abovecould adversely affect our business, financial condition, operating results,cash flow or cash position, and our ability to raise capital.

 

***Our successdepends substantially on our most advanced product candidates, which are stillunder development. If we are unable to bring any or all of these productcandidates to market, or experience significant delays in doing so, our abilityto generate product revenue and our likelihood of success will be harmed.***

 

We have three product candidates in late stageclinical development, with tecarfarin in Phase 3, and budiodarone andnaronapride (ATI-7505) in Phase 2b. A fourth product candidate, ATI-9242,entered into a Phase 1 clinical trial in April 2008. Our ability togenerate product revenue in the future will depend heavily on the successfuldevelopment and commercialization of these product candidates. Our otherproduct candidates are in the discovery stage. Any of our product candidatescould be unsuccessful for a variety of reasons, including that they:

 

·                  maynot demonstrate acceptable safety and efficacy in preclinical trials orclinical trials or otherwise may not meet applicable regulatory standards forapproval;

 

·                  maynot offer therapeutic, safety or other improvements over existing or futuredrugs used to treat the same conditions;

 

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·                  maynot be capable of being produced in commercial quantities at acceptable costs;or

 

·                  maynot be accepted in the medical community or by third-party payors.

 

We do not expect any of our current productcandidates to be commercially available in the next several years, if at all.If we are unable to make our product candidates commercially available, we willnot generate product revenues and we will not be successful. The results of ourclinical trials to date do not provide assurance that acceptable efficacy orsafety will be shown upon completion of Phase 3 clinical trials.

 

***We expect todepend on collaborative arrangements to complete the development andcommercialization of each of our product candidates. Potential collaborativearrangements will likely place the development of our product candidatesoutside of our control and will likely require us to relinquish importantrights or may otherwise be on terms unfavorable to us.***

 

The strategic options we are currently pursuinginclude potential collaborative arrangements with third parties to develop andcommercialize each of our lead product candidates. Dependence on collaborativearrangements for development and commercialization of our product candidateswill subject us to a number of risks, including:

 

·                  wemay not complete a collaborative arrangement in time to avoid delays inclinical development, if at all, and if no collaborative arrangement isachieved, product development may be halted altogether. Currently, there are noclinical activities underway on any of our product candidates;

 

·                  wemay not be able to control the amount and timing of resources that ourcollaborators may devote to the development or commercialization of productcandidates or to their marketing and distribution;

 

·                  collaboratorsmay delay clinical trials, provide insufficient funding for a clinical trialprogram, stop a clinical trial or abandon a product candidate, repeat orconduct new clinical trials or require a new formulation of a product candidatefor clinical testing;

 

·                  wemay have limited control over our clinical trial design;

 

·                  disputesmay arise between us and our collaborators that result in the delay ortermination of the research, development or commercialization of our productcandidates or that result in costly litigation or arbitration that divertsmanagement’s attention and resources;

 

·                  ourcollaborators may experience financial difficulties;

 

·                  collaboratorsmay not properly maintain or defend our intellectual property rights or may useour proprietary information in such a way as to invite litigation that couldjeopardize or invalidate our proprietary information or expose us to potentiallitigation;

 

·                  businesscombinations or significant changes in a collaborator’s business strategy mayadversely affect a collaborator’s willingness or ability to fulfill itsobligations under any arrangement;

 

·                  acollaborator could independently move forward with a competing productcandidate developed either independently or in collaboration with others,including our competitors; and

 

·                  anycollaborative arrangement may be terminated or allowed to expire, which woulddelay the development and may increase the cost of developing our productcandidates.

 

***Collaborativearrangements do not currently exist for any of our product candidates. If we donot establish collaborations for each of our budiodarone, tecarfarin,naronapride (ATI-7505) and ATI-9242 product candidates or future productcandidates, we may have to alter our development and commercialization plans.***

 

The strategic options we are currently pursuinginclude potential collaborations with leading pharmaceutical and biotechnologycompanies to assist us in furthering the development and potentialcommercialization of some of our product candidates, including budiodarone,tecarfarin, naronapride (ATI-7505) and ATI-9242. We are seeking partnersbecause the

 

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commercialization of each of our first four productcandidates involves a large, primary care market that must be served by largesales and marketing organizations and because we do not currently have thecapabilities to perform Phase 3 clinical trials. We face significant competitionin seeking appropriate collaborators, and these collaborations are complex andtime-consuming to negotiate and document. We may not be able to negotiatecollaborations on acceptable terms, if at all. We are unable to predict when,if ever, we will enter into any collaborations because of the numerous risksand uncertainties associated with establishing collaborations. If we are unableto negotiate an acceptable collaboration, we may have to curtail thedevelopment of a particular product candidate, reduce or delay its developmentprogram or one or more of our other development programs, delay its potentialcommercialization or reduce the scope of our sales or marketing activities orincrease our expenditures and undertake development or commercializationactivities at our own expense. If we elect to increase our expenditures to funddevelopment or commercialization activities on our own, we may need to obtainadditional capital, which may not be available to us on acceptable terms, if atall. If we do not have sufficient funds, we will not be able to bring ourproduct candidates to market and generate product revenues.

 

***Thecommercial success of our potential collaborations will depend in part on thedevelopment and marketing efforts of our potential partners, over which we willhave limited control. If our collaborations are unsuccessful, our ability todevelop and commercialize and to generate future revenue from the sale of ourproducts will be significantly reduced.***

 

Our dependence on future collaborationarrangements will subject our company to a number of risks. Our ability todevelop and commercialize each of our product candidates will depend on our andour potential collaboration partner(s)’ ability to establish the safety andefficacy of each respective product candidate, obtain and maintain regulatoryapprovals and achieve market acceptance of the product candidate(s) oncecommercialized. Our potential collaboration partner(s) may elect to delayor terminate development of our product candidates, independently developproducts that compete with ours, or fail to commit sufficient resources to themarketing and distribution of our product candidates. The termination of acollaboration agreement may cause us to incur additional and unanticipated coststhat may be material to our operations.

 

Business combinations, significant changes inbusiness strategy, litigation and/or financial difficulties may also adverselyaffect the willingness or ability of our potential collaboration partners tofulfill their obligations to us. If a partner fails to perform in the manner weexpect, our potential to develop and commercialize the respective productcandidate(s) through other collaborations and to generate future revenuefrom the sale of the product candidate(s) may be significantly reduced. Ifa conflict of interest arises between us and our collaboration partner(s), theymay act in their own self-interest and not in the interest of our company orour stockholders. 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 naronapride (ATI-7505), and we mayexperience a similar result with potential collaboration partners in the futurewith respect to any of our product candidates.

 

***If we arenot able to obtain required regulatory approvals, we will not be able tocommercialize our product candidates, our ability to generate revenue will bematerially impaired and our business will not be successful.***

 

Our product candidates and the activitiesassociated with their development and commercialization are subject tocomprehensive regulation by the FDA and other federal and state regulatoryagencies in the United States and by comparable authorities in other countries.The inability to obtain FDA approval or approval from comparable authorities inother countries would prevent us and our collaborative partners fromcommercializing our product candidates in the United States or other countries.Future collaborative agreements will likely cause us to give up control ofinteractions and regulatory approval processes with the FDA and otherregulatory bodies. We or our partners may never receive regulatory approval forthe commercial sale of any of our product candidates. We have only limited experiencein preparing and filing the applications necessary to gain regulatory approvalsand have not received regulatory approval to market any of our productcandidates in any jurisdiction. The process of applying for regulatory approvalis expensive and time-consuming, and can vary substantially based upon thetype, complexity and novelty of the product candidates involved.

 

Because our product candidates are modeledafter drugs which are known to have safety problems, the FDA and otherregulatory agencies may require additional safety testing which may delay ourclinical progress, increase our expected costs or make further developmentunfeasible. For instance, because of known problems with the drug after whichit was modeled, we were required to conduct significant monitoring for cardiactoxicity in our clinical trials of naronapride (ATI-7505).

 

Changes in regulatory approval policies duringthe development period, changes in, or the enactment of, additional regulationsor statutes or changes in the regulatory review team for each submitted productapplication may cause delays in the approval or rejection of an application.Even if the FDA or a foreign regulatory agency approves a product candidate,the approval may impose significant restrictions on the indicated uses,conditions for use, labeling, advertising, promotion, marketing and/orproduction of such product and may impose requirements for post-approvaltrials, including additional research and development and clinical trials. TheFDA and other agencies also may impose various civil or criminal sanctions forfailure to comply with regulatory requirements, including substantial monetarypenalties and withdrawal of product approval.

 

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The FDA has substantial discretion in theapproval process and may refuse to accept any application or decide that ourdata are insufficient for approval and require additional preclinical, clinicalor other trials. For example, varying interpretations of the data obtained frompreclinical and clinical testing could delay, limit or prevent regulatoryapproval of a product candidate. Moreover, the FDA may not agree that certaintarget indications are approvable. For instance, the FDA has never approved adrug for postprandial distress syndrome, or PDS, and we cannot be certain thatthe FDA will recognize PDS as an indication for which naronapride (ATI-7505) orother drugs can be approved. As another example, while we believe we have cleardirection from the FDA as to the development path for our tecarfarin productcandidate based on our various discussions, the FDA may change its judgment onthe appropriate development pathway for tecarfarin at any time. Similarly, theclinical trials to be required by the FDA for approval of new anti-arrythmictherapies may change as the FDA considers the approval of similar therapiessubmitted by competing pharmaceutical companies.

 

We will need to obtain regulatory approval fromauthorities in foreign countries to market our product candidates in thosecountries. We have not yet initiated the regulatory process in any foreignjurisdictions. Approval by one regulatory authority does not ensure approval byregulatory authorities in other jurisdictions. If we fail to obtain approvalsfrom foreign jurisdictions, the geographic market for our product candidateswould be limited.

 

***Safetyissues relating to our product candidates or the original drugs upon which ourproduct candidates have been modeled, or relating to approved products of thirdparties that are similar to our product candidates, could give rise to delaysin the regulatory approval process.***

 

Discovery of previously unknown problems withan approved product may result in restrictions on its permissible uses,including withdrawal of the medicine from the market. Each of the opportunitiesupon which we have chosen to focus is based upon our belief that ourRetroMetabolic Drug Design technology can be used to create a new product basedupon an existing product which is efficacious in treating a specific condition,but which has a known safety problem. Each of our four lead product candidatesis modeled on drugs which have significant safety problems. Budiodarone ismodeled on amiodarone which is used, but not approved, for atrial fibrillationin spite of known safety problems due to its accumulation in the body andinteraction with other drugs. Both amiodarone and budiodarone contain iodinewhich can accumulate in the thyroid and must be monitored for safety purposes.In addition, budiodarone is partially metabolized by CYP450 and, at certainlevels has caused drug-drug interactions with warfarin, which increased INR andcould increase the risk of hemorrhage complications. Tecarfarin is modeled onwarfarin which is known to have safety risks because of its potential forbleeding and for interactions with numerous other drugs as listed on thepackage insert for the product. Naronapride (ATI-7505) is modeled on cisapridewhich was withdrawn from the market due to fatal cardiac problems. ATI-9242 ismodeled to retain certain of the positive features of the class of atypicalantipsychotic drugs while lessening certain of the safety issues that vary butexist within the class. The receptor profile which yields the positive andavoids the negative features of this class of drugs is a matter of greatdebate. While we have designed ATI-9242 to have an appropriate balance across avery complex set of receptors, we may have targeted an inappropriate profile orthe profile attained may result in an unanticipated lack of efficacy or safetyproblems. Although we have designed our drugs to largely address each of theoriginal drugs’ key safety problems, we will need to continue to demonstratethis through continued clinical testing. It is possible that the FDA may imposeadditional requirements on the development or approval of our products becauseof its concern about the original drug’s safety problems. These potentialadditional barriers could delay, increase the cost of, or prevent thecommercialization of our product candidates.

 

Our product candidates are engineered to bebroken down by the body’s natural metabolic processes in a manner we believe tobe safer than that of the original drug. There can be no assurance that theproducts we develop will actually be metabolized as we expect. While we havedesigned the breakdown products to be safe, it is possible that there will beunexpected toxicity associated with these breakdown products that could causeour products to be poorly tolerated by, or toxic to, humans. Additionally,while we believe we have addressed the key safety problem of each of theoriginal drugs, it is possible that our change to the chemical structure mayresult in new unforeseen safety issues. Any unexpected toxicity or suboptimaltolerance of our products would delay or prevent commercialization of theseproduct candidates. Additionally, problems with approved products marketed bythird parties that utilize the same therapeutic target as our productcandidates could adversely affect the development of our product candidates.For example, the product withdrawals of Vioxx byMerck & Co., Inc. and Bextra by Pfizer because of safetyissues 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. Although in our end of Phase 2 meeting withthe FDA, they did not indicate any special tests would be required, it is possiblethat we or a future collaboration partner may be required by regulatoryagencies to perform tests, in addition to those we have planned, in order todemonstrate that naronapride (ATI-7505) does not have the safety problemsassociated with Zelnorm. Any failure or delay in commencing or completingclinical trials or obtaining regulatory approvals for our product candidateswould delay commercialization of our product candidates and severely harm ourbusiness and financial condition.

 

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*** ***

***Any failureor delay in commencing or completing clinical trials for our product candidatescould severely harm our business.***

 

To date, we have not completed the clinicaltrial program of any product candidate. The commencement and completion ofclinical trials for our product candidates may be delayed or terminated as aresult of many factors, including:

 

·                  ourinability or the inability of our collaborators or licensees to manufacture orobtain from third parties materials sufficient for use in preclinical andclinical trials;

 

·                  delaysin patient enrollment, which we previously experienced in certain trials, andvariability in the number and types of patients available for clinical trials;

 

·                  difficultyin maintaining contact with patients after treatment, resulting in incompletedata;

 

·                  pooreffectiveness of product candidates during clinical trials;

 

·                  poorpatient compliance while participating in one of our clinical trials;

 

·                  unforeseensafety issues or side effects; and

 

·                  governmentalor regulatory delays and changes in regulatory requirements, policies andguidelines.

 

Any delay in commencing or completing clinicaltrials for our product candidates would delay commercialization of our productcandidates and severely harm our business and financial condition. It is alsopossible that none of our product candidates will complete clinical trials inany of the markets in which our collaborators or we intend to sell thoseproduct candidates. Accordingly, our collaborators or we would not receive theregulatory approvals needed to market our product candidates, which wouldseverely harm our business and financial condition.

 

***We rely onthird parties to conduct our clinical trials. If these third parties do notperform as contractually required or expected, we may not be able to obtainregulatory approval for or commercialize our product candidates.***

 

We do not have the ability to independentlyconduct clinical trials for our product candidates, and thus for each of ourproduct candidates we must rely on third parties such as contract researchorganizations, medical institutions, clinical investigators and contractlaboratories, to conduct our clinical trials. We have, in the ordinary courseof business, entered into agreements with these third parties. To date, we haveutilized numerous vendors to provide clinical trial management, data collectionand analysis and laboratory and safety analysis services in the conduct of ourclinical trials. In addition, to date we have conducted our clinical trials atnumerous sites in North America and Europe. Nonetheless, we are responsible forconfirming that each of our clinical trials is conducted in accordance with itsgeneral investigational plan and protocol. Moreover, the FDA requires us tocomply with regulations and standards, commonly referred to as good clinicalpractices, for conducting and recording and reporting the results of clinical trialsto assure that data and reported results are credible and accurate and that thetrial participants are adequately protected. Our reliance on third parties thatwe do not control does not relieve us of these responsibilities andrequirements. If these third parties do not successfully carry out theircontractual duties or regulatory obligations or meet expected deadlines, if thethird parties need to be replaced or if the quality or accuracy of the datathey obtain is compromised owing to the failure to adhere to our clinicalprotocols or regulatory requirements or for other reasons, our clinical trialsmay be extended, delayed, suspended or terminated, and we may not be able toobtain regulatory approval for, or successfully commercialize, our productcandidates.

 

***If some orall of our patents expire, are invalidated or are unenforceable, or if some orall of our patent applications do not yield issued patents or yield patentswith narrow claims, competitors may develop competing products using our intellectualproperty and our business will suffer.****

 

Our success will depend in part on our abilityto obtain and maintain patent and trade secret protection for our technologiesand product candidates both in the United States and other countries. When referringto “our” patents and other intellectual property in this section, we arereferring both to patents and other intellectual property that we own. We relyon composition of matter patents for the compounds we develop. We cannotguarantee that 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.

 

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The degree of future protection for ourproprietary technologies and product candidates is uncertain because legalmeans afford only limited protection and may not adequately protect our rights orpermit us to gain or keep our competitive advantage. For example, as applied toboth existing and future patents and other intellectual property:

 

·                  wemight not have been the first to make the inventions covered by each of ourpending patent applications and issued patents;

 

·                  wemight not have been the first to file patent applications for the disclosedinventions;

 

·                  othersmay independently develop similar or alternative technologies or duplicate ourtechnologies;

 

·                  itis possible that none of our pending patent applications will result in issuedpatents;

 

·                  anypatents issued to us or our collaborators may not provide protection forcommercially viable products or may be successfully challenged by thirdparties;

 

·                  thepatents of others may have an adverse effect on our ability to do business;

 

·                  regulatorsor courts may retroactively diminish the value of our intellectual property;or,

 

·                  dueto financial constraints, we may choose to not maintain or further prosecutecertain patents in certain geographies and thereby lose patent protection inthose geographies.

 

Even if valid and enforceable patents cover ourproduct candidates and technologies, the patents will provide protection onlyfor a limited amount of time. As our product candidates are based on a parentdrug where much research has been conducted, we may encounter many competitivepatents from covered analogs of the parent drug. Our know-how and trade secretsmay only provide a competitive advantage for a short amount of time, if at all.Furthermore, we cannot guarantee that our patents, present or future, will havescope sufficient to prevent competing products.

 

Our ability and our potential collaborators’ability to obtain and enforce patents is highly uncertain because of thecomplexity of the scientific and legal issues involved and the subjectivenature of issues upon which reasonable minds may differ. Legislative, judicial,and administrative bodies, both foreign and domestic, may issue laws,decisions, and regulations, respectively, that (a) detrimentally affectour ability to obtain protection for our technologies, (b) increase ourcosts of obtaining and maintaining patents, (c) detrimentally affect ourability to enforce our existing patents, (d) narrow the scope of ourpatent protection, and/or (e) otherwise diminish the value of ourintellectual property in at least the following ways: 1) U.S. FederalCourts and foreign judicial authorities may render decisions that alter theapplication of the patent laws and detrimentally affect our ability to enforceour patents and obtain patent protection for our technologies; 2) the U.S.Patent and Trademark Office, or USPTO, and foreign counterparts may change thenature of how patent applications are examined and issue regulations that detrimentallyaffect our ability to obtain patent protection for our technologies and/orincrease the costs for obtaining and maintaining protection; and/or3) Congress and other foreign legislative bodies may make changes to theirrespective patent laws that may make obtaining and enforcing patents moredifficult and/or costly, and/or otherwise diminish the value of ourintellectual property or narrow the scope of our patent protection.

 

Even if patents are issued regarding ourproduct candidates or methods of using them, those patents can be challenged byour competitors who can argue that such patents are invalid and/orunenforceable. Defending against such challenges could be costly, and theoutcome is inherently uncertain and may result in the loss of some or all ofour rights. Patents also may not protect our product candidates if competitorsdevise ways of making these or similar product candidates without legallyinfringing our patents. The Federal Food, Drug and Cosmetic Act and FDAregulations and policies provide incentives to manufacturers to challengepatent validity or create modified, non-infringing versions of a drug in orderto facilitate the approval of generic substitutes. These same types ofincentives encourage manufacturers to submit new drug applications that rely onliterature and clinical data not prepared for or by the drug sponsor.

 

Similarly, we may choose to challenge thepatents and other rights alleged or asserted by third parties. Such challenges,whether judicial or administrative in nature, could be costly and the outcomeuncertain. A negative outcome could detrimentally affect our ability to dobusiness.

 

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While at present we have no such agreements inplace, we may enter into agreements to license technologies and patent rights.Should we fail to comply with the terms of those license agreements, includingpayment of any required maintenance fees or royalties, or should the licensorsfail to maintain their licensed interest in the licensed patents, we could losethe rights to those technologies and patents, which may have a detrimentalaffect on our ability to do business.

 

As of June 30, 2010, we held 44 issued orallowed U.S. patents and had 14 patent applications pending before the USPTO.For some of our inventions, corresponding foreign patent protection is pending.Of the 44 U.S. patents that we hold, 39 patents are compound and compositionrelated, having expiration dates from 2013 to 2025. Our composition of matterpatent for budiodarone, our compound for the treatment of atrial fibrillation,issued in April 2002 and has an expiration date in 2020. The composition ofmatter patent for tecarfarin, our compound for anticoagulation, issued inAugust 2007 and has an expiration date in 2025. The composition of matterpatent for naronapride (ATI-7505), our compound for the treatment ofgastrointestinal disorders, issued in February 2007 and has an expiration datein 2025. Our composition of matter patent applications for ATI-9242, ourproduct candidate for the treatment of schizophrenia and other psychiatricdisorders, are currently pending, one in the United States and 15 in foreignjurisdictions. Although third parties may challenge our rights to, or the scopeor validity of, our patents, to date we have not received any communicationsfrom third parties challenging our patents or patent applications covering ourclinical candidates.

 

While budiodarone, tecarfarin and naronapride(ATI-7505) are all covered in the United States by issued composition of matterpatents, additional patent applications would be required to extend patentprotection beyond 2020, 2025 and 2025, respectively (assuming the validity andenforceability of the current composition of matter patents). We cannotguarantee that any patents will be issued from our pending or future patentapplications, and any patents that issue from such pending or future patentapplications would be subject to the same risks described herein for currentlyissued patents.

 

Our research and development collaborators mayhave rights to publish data and other information in which we have rights. Inaddition, we sometimes engage individuals or entities to conduct research thatmay be relevant to our business. The ability of these individuals or entitiesto publish or otherwise publicly disclose data and other information generatedduring the course of their research is subject to certain contractuallimitations. In most cases, these individuals or entities are at the leastprecluded from publicly disclosing our confidential information and are onlyallowed to disclose other data or information generated during the course ofthe research after we have been afforded an opportunity to consider whetherpatent and/or other proprietary protection should be sought. If we do not applyfor patent protection prior to such publication or if we cannot otherwisemaintain the confidentiality of our technology and other confidentialinformation, then our ability to receive patent protection or protect ourproprietary information may be jeopardized.

 

***Failure toadequately protect our trade secrets and other intellectual property couldsubstantially harm our business and results of operations.***

 

We also rely on trade secrets to protect ourtechnology, especially where we do not believe that patent protection isappropriate or obtainable. This is particularly true for our RetroMetabolicDrug Design technology. However, trade secrets are difficult to protect. Ouremployees, consultants, contractors, outside scientific collaborators and otheradvisors are required to sign confidential disclosure agreements but they mayunintentionally or willfully disclose our confidential information tocompetitors. Enforcing a claim that a third party illegally obtained and isusing our trade secrets is expensive and time-consuming, and the outcome isunpredictable. Failure to obtain or maintain trade secret protection couldadversely affect our competitive business position.

 

***Third-partyclaims of intellectual property infringement would require us to spendsignificant time and money and could prevent us from developing orcommercializing our products.***

 

Our commercial success depends in part on notinfringing the patents and proprietary rights of other parties and notbreaching any licenses that we have entered into with regard to ourtechnologies and products. Because others may have filed, and in the future arelikely to file, patent applications covering products or other technologiesthat are similar or identical to ours, patent applications or issued patents ofothers may have priority over or dominate our patent applications or issuedpatents or otherwise prevent us from commercializing our technologies. Thereare numerous issued and pending applications related to the original moleculesand analogs from which our products are engineered. If such pending patents issuingfrom such pending applications are determined to be valid and construed tocover our products, the development and commercialization of any or all couldbe negatively affected and even prevented. We do not believe that ouractivities infringe the patents of others or that the patents of others inhibitour freedom to operate, but we cannot guarantee that we have identified allUnited States and foreign patents and patent applications that pose a risk ofinfringement. We may be forced to litigate if an intellectual property disputearises, and it is possible that others may choose to challenge our position andthat a judge or jury will disagree with our conclusions. We could incursubstantial costs in litigation if we are required to defend against patentsuits brought by third parties. If we do not successfully defend aninfringement action, are unable to have infringed patents declared invalid, anddo not obtain a license to the patented technology, we may,

 

·                  incursubstantial monetary damages;

 

·                  encountersignificant delays in marketing our products; and

 

·                  beunable to conduct or participate in the manufacture, use or sale of ourproducts or methods of treatment.

 

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Similarly, if we initiate suits to defend ourpatents, such litigation could be costly and there is no assurance we wouldhave the resources to defend our patents or that we would be successful in suchprocesses. Any legal action against our collaborators or us claiming damagesand seeking to enjoin commercial activities relating to the affected productsand processes could, in addition to subjecting us to potential liability fordamages, require our collaborators or us to obtain a license to continue tomanufacture or market the affected products and processes. Licenses requiredunder any of these patents may not be available on commercially acceptableterms, if at all. Failure to obtain such licenses could materially andadversely affect our ability to develop, commercialize and sell our productcandidates. We believe that there may continue to be significant litigation inthe biotechnology and pharmaceutical industry regarding patent and other intellectualproperty rights. If we become involved in litigation, it could consume asubstantial portion of our management and financial resources and we may notprevail in any such litigation.

 

Furthermore, our commercial success willdepend, in part, on our ability to continue to conduct research to identifyadditional product candidates in current indications of interest oropportunities in other indications. Some of these activities may involve theuse of genes, gene products, screening technologies and other research toolsthat are covered by third-party patents. In some instances, we may be requiredto obtain licenses to such third-party patents to conduct our research anddevelopment activities, including activities that may have already occurred. Itis not known whether any license required under any of these patents would bemade available on commercially acceptable terms, if at all. Failure to obtainsuch licenses could materially and adversely affect our ability to maintain apipeline of potential product candidates and to bring new products to market.If we are required to defend against patent suits brought by third partiesrelating to third-party patents that may be relevant to our researchactivities, or if we initiate such suits, we could incur substantial costs inlitigation. Moreover, the results of any such litigation are uncertain, and anadverse result from any legal action in which we are involved could subject usto damages and/or prevent us from conducting some or potentially all of ourresearch and development activities.

 

***If thirdparties do not manufacture our product candidates in sufficient quantities orat an acceptable cost, clinical development and commercialization of ourproduct candidates would be delayed.***

 

We presently do not have sufficient quantitiesof our product candidates to complete clinical trials of any of our leadproduct candidates. We do not currently own or operate manufacturingfacilities, and we rely and expect to continue to rely on a small number ofthird-party manufacturers and active pharmaceutical ingredient formulators forthe production of clinical and commercial quantities of our product candidates.We do not have long-term agreements with any of these third parties, and ouragreements with these parties are generally terminable at will by either partyat any time. If for any reason, these third parties are unable or unwilling toperform under our agreements or enter into new agreements, we may not be ableto locate alternative manufacturers or formulators or enter into favorableagreements with them. Any inability to acquire sufficient quantities of ourproduct candidates in a timely manner from these third parties could delayclinical trials and prevent us from developing and commercializing our productcandidates in a cost-effective manner or on a timely basis.

 

The starting materials for the production ofbudiodarone are provided by the following vendors: SCI Pharmtech, Inc.,Lexen Inc., Panchim, Julich GmbH and Weylchem Inc. To date,Ricerca, Biosciences, LLC, ScinoPharm Ltd. and SCI Pharmtech haveproduced all of budiodarone’s active pharmaceutical ingredient. Historically,we have relied on Ricerca, ScinoPharm and SCI Pharmtech as single-sourcesuppliers for budiodarone’s active pharmaceutical ingredients. In the eventthat Ricerca, Biosciences, LLC, ScinoPharm Ltd. or SCI Pharmtech isunable or unwilling to serve as the supplier of budiodarone, we might not beable to manufacture budiodarone’s active pharmaceutical ingredient. This coulddelay the development of, and impair our ability to, commercialize budiodarone.To produce budiodarone drug product, drug substance is processed into 50milligram or 200 milligram capsule forms by Patheon Inc. of Mississauga,Ontario.

 

The starting materials for the production oftecarfarin are provided by Synquest Labs, Inc. and ChemUetikon, GmbH. To date, the active pharmaceutical ingredient fortecarfarin has been produced by ChemShop BV of the Netherlands andCorum Inc. of Taiwan on an ongoing purchase order basis. ShouldChemShop BV or Corum Inc. be unable or unwilling to serve as thesupplier of tecarfarin, a delay in the development of tecarfarin could occur,impairing our ability to commercialize tecarfarin on our existing timeline.Tecarfarin’s active pharmaceutical ingredient is processed into 1 milligram,2 milligram, 5 milligram or 10 milligram tablets by QS Pharma of Boothwyn,PA.

 

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The starting materials for the production ofnaronapride (ATI-7505) are provided by the following vendors: SCIPharmtech, Inc., Corum, Inc. and Lexen Inc. To producenaronapride drug products, drug substance is processed into 20 milligram or 40milligram tablet form by Pharmaceutics International, Inc. of Hunt Valley,MD (PII). In the event that any of these vendors are unable or unwilling toproduce sufficient quantities of material for the manufacture of naronapride,the development and/or commercialization of naronapride could be delayed orimpaired. A 500 kg quantity of naronapride active pharmaceutical ingredient(API) is currently in storage at PII. This drug supply is owned byProcter & Gamble and is being stored at our expense. Procter &Gamble has informally agreed that they will maintain this API untilapproximately September 30, 2010 at which time we must purchase the API forapproximately $3.5 million or they may destroy it. We believe this issufficient supply to conduct the required Phase 3 program forregistration. However, Procter & Gamble may terminate this arrangementat any time subsequent to the date they have agreed and dispose of the APImaterial, or it may prove not to be adequate for the entire Phase 3program.

 

The starting materials for the production ofATI-9242 are provided by the following vendors: Corum Inc., Alfa Aesar,Apollo Scientific 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 ATI-9242, we would not be able to manufacture ATI-9242’s activepharmaceutical ingredient. This could delay the development of, and impair ourability to, commercialize ATI-9242. To produce ATI-9242 drug product, drugsubstance is processed into 20 milligram capsule form by Xcelience LLC ofTampa, FL.

 

All of our current arrangements withthird-party manufacturers and suppliers for the production of our productcandidates are on a purchase order basis. We currently do not have long-termsupply contracts with any of the third-party manufacturers and suppliers forour product candidates, and they are not required to supply us with productsfor any specified periods, in any specified quantities or at any set price,except as may be specified in a particular purchase order. We have no reason tobelieve that any of the current manufacturers and suppliers for our productcandidates is the sole source for the materials they supply us. However, if wewere to lose one of these vendors and were unable to obtain an alternativesource on a timely basis or on terms acceptable to us, our clinical andproduction schedules could be delayed. In addition, to the extent that any ofthese vendors uses technology or manufacturing processes that are proprietary,we may be unable to obtain comparable materials from alternative sources.

 

***If we arerequired to obtain alternate third-party manufacturers, it could delay orprevent the clinical development and commercialization of our productcandidates.***

 

We may not be able to maintain or renew ourexisting or any other third-party manufacturing arrangements on acceptableterms, if at all. If we are unable to continue relationships with our currentsuppliers, or to do so at acceptable costs, or if these suppliers fail to meetour requirements for these product candidates for any reason, we would berequired to obtain alternative suppliers. Any inability to obtain qualifiedalternative suppliers, including an inability to obtain or delay in obtainingapproval of an alternative supplier from the FDA, would delay or prevent theclinical development and commercialization of these product candidates.

 

Changes in manufacturing site, process or scalecan trigger additional regulatory requirements that could delay our ability toperform certain clinical trials or obtain product approval.

 

The manufacturing and formulation of each ofour lead product candidates that have been tested in humans to date has beenperformed by entities other than those that will likely manufacture theproducts for future clinical trials or commercial use. There is a possibilitythat analysis of future clinical trials will show that the results from ourearlier clinical trials have not been replicated. The failure to replicatethese earlier clinical trials would delay our clinical development timelines.New impurity profiles that occur as a result of changing manufacturers may leadto delays in clinical trial testing and approvals.

 

***Use of third-partymanufacturers may increase the risk that we will not have adequate supplies ofour product candidates.***

 

Our current and anticipated future reliance onthird-party manufacturers will expose us and our future collaborative partnersto risks that could delay or prevent the initiation or completion of ourclinical trials, the submission of applications for regulatory approvals, theapproval of our product by the FDA or the commercialization of our products,and may result in higher costs or lost product revenues. In particular, ourcontract manufacturers could:

 

·                  encounterdifficulties in achieving volume production, quality control and qualityassurance or suffer shortages of qualified personnel, which could result intheir inability to manufacture sufficient quantities of drugs to meet ourclinical schedules or to commercialize our product candidates;

 

·                  terminateor choose not to renew manufacturing agreements, based on their own businesspriorities, at a time that is costly or inconvenient for us;

 

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·                  failto establish and follow FDA-mandated current good manufacturing practices, orcGMPs, which are required for FDA approval of our product candidates, or failto document their adherence to cGMPs, either of which could lead to significantdelays in the availability of material for clinical trials and delay or preventmarketing approval for our product candidates; and

 

·                  breachor fail to perform as agreed under manufacturing agreements.

 

If we are not able to obtain adequate suppliesof our product candidates, it will be more difficult for us to develop ourproduct candidates and compete effectively. Our product candidates and anyproducts that we may develop may compete with other product candidates andproducts for access to manufacturing facilities.

 

In addition, Lexen, SCI Pharmtech, Scinopharm,Corum Inc. and ChemShop BV are located outside of the United States.This may give rise to difficulties in importing our product candidates or theircomponents into the United States as a result of, among other things, FDAimport inspections, incomplete or inaccurate import documentation, or defectivepackaging.

 

***If ourpreclinical trials do not produce successful results or our clinical trials donot demonstrate safety and efficacy in humans, we will not be able tocommercialize our product candidates.***

 

To obtain the requisite regulatory approvals tomarket and sell any of our product candidates, we must demonstrate, throughextensive preclinical and clinical trials that the product candidate is safeand effective in humans. To date, we have not completed all required clinicaltrials of any product candidate. Preclinical and clinical testing is expensive,can take many years and has an uncertain outcome. A failure of one or more ofour clinical trials could occur at any stage of testing. In addition, successin preclinical testing and early clinical trials does not ensure that laterclinical trials will be successful, and interim results of a clinical trial donot necessarily predict final results. We may experience numerous unforeseenevents during, or as a result of, preclinical testing and the clinical trialprocess, which could delay or prevent our ability to commercialize our productcandidates, including:

 

·                  regulatorsor institutional review boards may not authorize us to commence a clinicaltrial at a prospective trial site;

 

·                  ourpreclinical or clinical trials may produce negative or inconclusive results,which may require us to conduct additional preclinical or clinical testing orto abandon development projects;

 

·                  wemay suspend or terminate our clinical trials if the participating patients arebeing exposed to unacceptable health risks;

 

·                  regulatorsor institutional review boards may suspend or terminate clinical research forvarious reasons, including noncompliance with regulatory requirements;

 

·                  theeffects of our product candidates may not be the desired effects or may includeundesirable side effects; and

 

·                  ourpreclinical or clinical trials may show that our product candidates are notsuperior to the original drugs on which our product candidates are modeled.

 

For instance, our preclinical and clinicaltrials may indicate that our product candidates cause unexpected drug-druginteractions and result in adverse events. For example, budiodarone’spreclinical trials contain results that have led to our decision to monitor forsuch effect in the clinic and may continue to be monitored in the clinic in thefuture. Inhibition of testicular function was observed in one animal species aspart of these trials. No such effect has been observed to date in the clinicand monitoring continues. In published trials, a similar effect is thought tobe correlated with the accumulation of amiodarone in tissues. A possible renaleffect was also observed at high doses in our rat and dog toxicology trials forbudiodarone. While we have and will continue to monitor patients for these effects,there is no assurance these effects will not occur in patients as part of ourclinical trials for budiodarone, and have a resulting adverse effect on ourability to obtain requisite regulatory approval to market and sell budiodarone.Similarly, in the clinical testing of budiodarone in patients whose conditionalso required treatment with warfarin, dose adjustments of warfarin weresometimes required. As is common to most clinical trials, the potential fordrug-drug interactions will be monitored. As another example, due to the resultof our Phase 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 naronapride (ATI-7505)performed by our former collaboration partner, P&G, six deaths occurred atdoses that were 10 and 20 times greater than doses currently being used inclinical trials. Our clinical trials to date have indicated only mild tomoderate side effects in humans. However, further observation is warranted.

 

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Even when our product candidates do not causeany adverse effects, clinical trials of efficacy may show that our productcandidates do not have significant effects on target symptoms or may beinconclusive. For example, in the EmbraceAC trial, tecarfarin demonstratedefficacy essentially the same as in earlier Phase 2 trials but did notachieve the primary endpoint of superiority over warfarin, as measured by timein therapeutic range. Naronapride (ATI-7505) was tested in two Phase 2clinical trials in which the primary endpoints were not met in comparison toplacebo. Although these trials did support naronapride’s efficacy againstcertain symptoms as secondary endpoints, if future trials show that naronaprideis not sufficiently efficacious to justify its use as a therapy, our businessand prospects may be materially adversely affected. In addition, we may need toreformulate the ATI-9242 drug product should we find in our on-goingPhase 1 testing that adequate blood levels are not achieved with ourcurrent formulation.

 

Unforeseen events could cause us to experiencesignificant delays in, or the termination of, clinical trials. Any such eventswould increase our costs and could delay or prevent our ability tocommercialize our product candidates, which would adversely impact ourfinancial results.

 

***Our productcandidates will remain subject to ongoing regulatory review even if theyreceive marketing approval. If we fail to comply with continuing regulations,we could lose these approvals and the sale of our products could be suspended.***

 

Even if we receive regulatory approval tomarket a particular product candidate, the approval could be conditioned on ourconducting additional costly post-approval trials, implementing a RiskEvaluation and Mitigation Strategy, or REMS, if the FDA determines that a REMSis necessary to ensure the benefits of the drug outweigh the risks, or couldlimit the indicated uses included in our labeling. Moreover, the product maylater cause adverse effects that limit or prevent its widespread use, force usto withdraw it from the market or impede or delay our ability to obtainregulatory approvals in additional countries. In addition, the manufacturer ofthe product and its facilities will continue to be subject to FDA review andperiodic inspections to ensure adherence to applicable GMP regulations. Afterreceiving marketing approval, the manufacturing, labeling, packaging, adverseevent reporting, storage, advertising, promotion and record keeping related tothe product will remain subject to extensive regulatory requirements.

 

If we fail to comply with the regulatoryrequirements of the FDA and other applicable U.S. and foreign regulatoryauthorities or previously unknown problems with our products, manufacturers ormanufacturing processes are discovered, we could be subject to administrativeor judicially imposed sanctions, including:

 

·                  restrictionson the products, manufacturers or manufacturing processes;

 

·                  warningletters;

 

·                  civilor criminal penalties or fines;

 

·                  injunctions;

 

·                  productseizures, detentions or import bans;

 

·                  voluntaryor mandatory product recalls and publicity requirements which could vary inforeign jurisdictions;

 

·                  suspensionor withdrawal of regulatory approvals;

 

·                  totalor partial suspension of production; and

 

·                  refusalto approve pending applications for marketing approval of new drugs orsupplements to approved applications.

 

***We are notcurrently pursuing additional research candidates using our RetroMetabolic DrugDesign technology.***

 

Because we have limited financial andmanagerial resources, we must focus on pursuing our strategic alternativesrelated to our later-stage programs and are not pursuing product candidates forthe opportunities that we believe remain amenable to our RetroMetabolic DrugDesign. We are not currently pursuing additional research candidates using ourRetrometabolic Drug Design technology. As a result, we may forego or delaypursuit of opportunities with other product candidates or other indicationsthat later prove to have greater commercial potential. Our resource allocationdecisions may cause us to fail to capitalize on viable commercial products orprofitable market opportunities. During our recent restructuring, a significantportion of our research and development capability was dismantled. It wouldrequire significant time and effort to reestablish these capabilities if discoveringor developing earlier-stage programs becomes part of our strategic focus in thefuture.

 

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***Thecommercial success of any products that we may develop will depend upon thedegree of market acceptance among physicians, patients, healthcare payors andthe medical community.***

 

Any products that we may develop may not gainmarket acceptance among physicians, patients, healthcare payors and the medicalcommunity. If these products do not achieve an adequate level of acceptance, wemay not generate material product revenues and we may not become profitable.The degree of market acceptance of any of our product candidates, if approvedfor commercial sale, will depend on a number of factors, including:

 

·                  demonstrationof efficacy and safety in clinical trials;

 

·                  demonstrationthat we have adequately addressed the specific safety problem of the originalmolecule;

 

·                  theprevalence and severity of any side effects;

 

·                  potentialor perceived advantages over alternative treatments;

 

·                  perceptionsabout the relationship or similarity between our product candidates and theoriginal drug upon which each RetroMetabolic Drug Design candidate was based;

 

·                  advantageover other drugs may not be sufficiently great enough to obtain premiumpricing;

 

·                  thetiming of market entry relative to competitive treatments;

 

·                  theability to offer our product candidates for sale at competitive prices;

 

·                  relativeconvenience and ease of administration;

 

·                  thestrength of marketing and distribution support;

 

·                  sufficientthird-party coverage or reimbursement; and

 

·                  theproduct labeling or product insert required by the FDA or regulatoryauthorities in other countries.

 

***If we areunable to enter into agreements with third parties to market and sell ourproduct candidates, we may be unable to generate product revenue.***

 

We do not have a sales and marketingorganization and have no experience in the sales, marketing and distribution ofpharmaceutical products. It is our intention to use collaborative arrangementsto gain access to large sales and marketing organizations in order tocommercialize our product candidates. If we do not enter into a collaborativeagreement with partners which give us access to a large sales and marketing organization,we may decide to engage contract sales organizations, pharmaceutical or otherhealthcare companies with an existing sales and marketing organization, anddistribution system, to sell, market and distribute our products. If we enterinto arrangements with third parties to perform sales, marketing anddistribution services, our product revenues are likely to be lower than if wemarket and sell any products that we develop ourselves. We may not be able toestablish these sales and distribution relationships on acceptable terms, or atall. If we 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 abilityto generate revenue from any products that we may develop will depend onreimbursement and drug pricing policies and regulations.***

 

Many patients may be unable to pay for anyproducts that we may develop. In the United States, many patients will rely onMedicare, Medicaid, private health insurers and other third-party payors to payfor their medical needs. Our ability to achieve acceptable levels ofreimbursement for drug treatments by governmental authorities, private healthinsurers and other organizations will have an effect on our ability tosuccessfully commercialize, and attract collaborative partners to invest in thedevelopment of, our product candidates. We cannot be sure that reimbursement inthe United States, Europe or elsewhere will be available for any products thatwe may develop, and any reimbursement that may become available may bedecreased or eliminated in the future. Third- party payors increasingly arechallenging prices charged for medical products and services, and manythird-party payors may refuse to provide reimbursement for particular drugswhen an equivalent generic drug is available. Although we believe that thesafety profile of any products that we may develop will be sufficientlydifferent from the original drugs from which they are modeled to be 

 

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considered unique and not subject to substitution by ageneric of the original drug in the case of budiodarone and tecarfarin, it ispossible that a third- party payor may consider our product candidate and thegeneric original drug as equivalents and only offer to reimburse patients forthe generic drug. In the case of naronapride (ATI-7505), the original molecule,cisapride, was withdrawn from the market and no generic version exists, butthere are many competitive products which may limit the amount we can chargefor this product candidate. There are five atypical antipsychotics whichcurrently dominate an estimated $16.0 billion market for such drugs. Mostwill be generic competitors of ATI-9242 if it ever reaches the marketplace.While we have designed ATI-9242 to have the improved efficacy and safetyfeatures over the existing atypical antipsychotics, these desired features maynot be proven in clinical testing or payors may be unwilling to pay a higherprice for improved features when generic alternatives are available. Even if weshow improved safety with our product candidates, pricing of the existing originaldrug may limit the amount we will be able to charge for each of our productcandidates. If reimbursement is not available or is available only at limitedlevels, we may not be able to successfully commercialize our productcandidates, and may not be able to obtain a satisfactory financial return onproducts that we may develop.

 

The trend toward managed healthcare in theUnited States and the changes in health insurance programs, as well aslegislative proposals to reform healthcare or reduce government insuranceprograms, may result in lower prices for pharmaceutical products, including anyproducts that may be offered by us. In addition, any future regulatory changesregarding the healthcare industry or third-party coverage and reimbursement mayaffect demand for any products that we may develop and could harm our sales andprofitability.

 

***If ourcompetitors are able to develop and market products that are more effective,safer or less costly than any products that we may develop, our commercialopportunity will be reduced or eliminated.***

 

The pharmaceutical industry is highlycompetitive, with a number of established, large pharmaceutical companies, aswell as smaller companies. Many of these companies have greater financialresources, marketing capabilities and experience in obtaining regulatoryapprovals for product candidates than we currently do. There are manypharmaceutical companies, biotechnology companies, public and privateuniversities, government agencies and research organizations actively engagedin research and development of products which may target the same markets asour product candidates. We expect any of the potential products we develop tocompete on the basis of, among other things, product efficacy and safety, timeto market, price, extent of adverse side effects experienced and convenience ofadministration and drug delivery. One or more of our competitors may developproducts based upon the principles underlying our proprietary technologiesearlier than us, obtain approvals for such products from the FDA more rapidlythan us or develop alternative products or therapies that are safer, moreeffective and/or more cost effective than any future products developed by us.We also expect to face competition in our efforts to identity appropriatecollaborators or partners to help commercialize our product candidates in ourtarget commercial areas.

 

Competition for tecarfarin for use as an oralanticoagulant will continue to come from generic coumadin due to its pricingand the years of experience physicians and patients have with the drug. Otheroral anticoagulants 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 thatJohnson & Johnson in collaboration with Bayer AG has a factor Xabefore the FDA for approval, and that Bristol- Myers Squibb Company incollaboration with Pfizer, Inc., and Merck/PortolaPharmaceuticals, Inc. each have factor Xa programs in Phase 2 orPhase 3 testing. We are aware of a direct thrombin inhibitor, dabigitranfrom Boehringer-Ingelheim GmbH, that produced Phase 3 results inSeptember 2009 in a clinical trial treating atrial fibrillation patients in whichdabigatran was shown to be superior to warfarin at one of its two doses tested.The first direct thrombin inhibitor presented to the FDA for approval,ximelagatran, previously marketed as Exanta by AstraZeneca plc, has notbeen recommended for approval due to idiosyncratic liver toxicity problems.Although we believe tecarfarin’s mechanism of action (VKOR inhibition as withwarfarin) and broadly available inexpensive monitoring methodology (INR)provide an advantage, these factor Xa and direct thrombin inhibitor programs willlikely provide major competition in this market. In addition, there may beother compounds of which we are not aware that are at an earlier stage ofdevelopment and may compete with our product candidates. If any of thosecompounds are successfully developed and approved, they could compete directlywith our product candidates.

 

We believe generic amiodarone will continue toprovide competition to budiodarone for the treatment of atrial fibrillation,even though it is not labeled for use in atrial fibrillation in the UnitedStates. Amiodarone will continue to be used off-label in spite of its safetyproblems because of its generic pricing. Sanofi-Aventis has been grantedapproval and launched in the United States its antiarrhythmic therapy Multaq® (dronedarone). Approval was alsogranted by the European Union in November 2009 and launch is underway. Webelieve Multaq® 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. Vernakalant is inPhase 3 testing and 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.

 

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Competition for ATI-9242 will likely come fromthe five largest selling atypical antipsychotics: Risperdal by JanssenPharmaceutica, Seroquel by AstraZeneca Pharmaceuticals LP, Zyprexa by EliLilly and Company, Abilify by Bristol-Myers Squibb/Otsuka AmericaPharmaceutical, Inc., and Geodon by Pfizer Inc., which sold acollective $15.7 billion in 2007. It is likely that virtually all of thesewould be sold as generic versions by the time ATI-9242 could come to market.Other antipsychotics are in development which may also be competitive toATI-9242.

 

Naronapride (ATI-7505) has potential use infive indications: chronic constipation, functional dyspepsia, GERD,gastroparesis and IBS with constipation. Some of these indications may not berecognized by the FDA as sufficiently defined to enable regulatory approval ofa drug for treatment. Naronapride is a prokinetic agent which has been shown toincrease motility in the upper and lower gastrointestinal tract, including theability to improve gastric emptying and colonic motility. Products which affectthe gastrointestinal system’s motility could be useful in the treatment of eachof these disorders. Other prokinetics are on the market or in development whichwill also be competitive to naronapride, including tegaserod, marketed byNovartis Pharmaceuticals Corporation as Zelnorm, which was withdrawn from themarket and is currently available through an investigational new drug (IND)process, TD-5108 being developed by Theravance, and erythromycin. Anotherprokinetic compound in development in Europe, with the potential forcommercialization in the United States and Asia, is prucalopride from Movetis.Prucalopride has been approved for commercialization in certain Europeancountries for the treatment of chronic constipation in women but has not yetbeen launched. Trials are on-going in Europe testing prucalopride in thetreatment of chronic constipation in men. Johnson & Johnson has rightsto prucalopride in North American and certain European countries and we expectprucalopride to provide competition in markets around the world. IronwoodPharmaceuticals and Forest Laboratories are jointly developing linaclotide, aguanylate cyclase C agonist, in North America for the treatment of chronicconstipation and irritable bowel syndrome. They have completed two Phase 3trials in North America with positive efficacy results. Ironwood has licenseddevelopment and commercialization rights to linaclotide in both Europe andAsia, and we expect linaclotide to provide competition in specific lower GItract indications. We believe the most significant competition to naronapridefor the treatment of GERD is proton pump inhibitors and H2 blockers, which arecurrently on the market in both prescription formulations and strengths as wellas in over-the-counter forms. Many major pharmaceutical companies currentlymarket proton pump inhibitors and H2 blockers generating worldwide sales ofover $17.0 billion in 2006. Naronapride is targeted at the approximately20-25% of GERD patients who do not receive adequate relief from proton pumpinhibitors, which reduce the creation of acid in the stomach. Naronapride willface competition from the prokinetics as well as many inexpensiveover-the-counter indications for the treatment of these gastrointestinaldisorders.

 

***If we failto attract and keep senior management and key scientific personnel, we may beunable to successfully develop or commercialize our product candidates if wechoose to do so.****

 

Our success depends on our ability to attract,retain and motivate highly qualified management, clinical and scientificpersonnel and on our ability to develop and maintain important relationshipswith leading clinicians. If we are not able to retain Dr. Goddard, ourChairman and Chief Executive Officer, Mr. Varian, our Chief OperatingOfficer and Chief Financial Officer, and Dr. Druzgala, our Senior VicePresident and Chief Scientific Officer, we may not be able to successfullycomplete our ongoing effort to explore strategic options or develop orcommercialize our product candidates, if we choose to do so. Our ability toretain and incentivize our senior management and key scientific personnel maybe impaired by the October 2009 and February 2010 terminations of a substantialportion of our workforce, including Dr. Daniel Canafax, our former VicePresident and Chief Development Officer, and this recent primary focus toexplore strategic options to optimize the value of our assets. Competition forexperienced scientists may limit our ability to hire and retain highlyqualified personnel on acceptable terms, if we choose to do so. In addition,none of our employees have employment commitments for any fixed period of timeand could leave our employment at will. In June 2010, Peter Milner, our formerPresident of Research and Development, resigned from the company. We carry “keyperson” insurance in the amount of $1.0 million for Dr. Druzgala, butdo not carry “key person” insurance covering any other members of seniormanagement or key scientific personnel. If we fail to retain qualifiedpersonnel, we may be unable to continue our ongoing strategic process.

 

***Ourworkforce reductions in October 2009 and February 2010 and any future workforceand expense reductions may have an adverse impact on our internal programs, ourability to retain key personnel and may be distracting to management.***

 

In October 2009, our board of directorscommitted to a restructuring plan that resulted in a reduction in forceaffecting 17 employees in order to improve operational efficiencies. InFebruary 2010, our board committed to a further reduction in force affecting 37employees in order to further reduce operating expenses and conserve cashresources as we explore various strategic options. In light of our continuedneed for funding and expense control, we may be required to implement furtherworkforce and expense reductions in the future. Further workforce and expensereductions could result in reduced progress on our internal programs. Inaddition, employees, whether or not directly affected by a reduction, may seekfuture employment with our business partners or competitors. Although ouremployees are required to sign a confidentiality agreement at the time of hire,the confidential nature of 

 

 

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certain proprietary information may not be maintainedin the course of any such future employment. Further, we believe that ourfuture success will depend in large part upon our ability to retain highlyskilled personnel. We may have difficulty retaining such personnel as a resultof a perceived risk of future workforce and expense reductions. In addition,the implementation of the restructuring program may result in the diversion ofefforts of our executive management team and other key employees, which couldadversely affect our business.

 

***While we arenot currently planning to commercialize our product candidates using our ownresources, we may need to hire additional employees in order to continue todevelop or commercialize our product candidates, if we choose to do so. Anyinability to manage future growth could harm our ability to develop orcommercialize our product candidates, increase our costs and adversely impactour ability to compete effectively.***

 

In order to further develop or commercializeour product candidates, we will need to expand the number of our managerial,operational, financial and other employees since our recent restructuringsseverely reduced our development capabilities. Because the projected time framefor hiring these additional employees depends on access to additional financialresources and on the development status of our product candidates and becauseof the numerous risks and uncertainties associated with drug development andour existing capital resources, we are unable to project if and when we willhire these additional employees. While to date we have not experienceddifficulties in recruiting, hiring and retaining qualified individuals, thecompetition for qualified personnel in the pharmaceutical and biotechnologyfield is intense.

 

Future growth will impose significant addedresponsibilities on members of management, including the need to identify,recruit, maintain and integrate additional employees. Our future financialperformance and our ability to further develop and commercialize our productcandidates and compete effectively will depend, in part, on our ability tomanage any future growth effectively.

 

***If productliability lawsuits are brought against us, we may incur substantial liabilitiesand may be required to limit commercialization of any products that we maydevelop.***

 

We face an inherent risk of product liabilityexposure related to the testing of our product candidates in human clinicaltrials and will face an even greater risk if we commercially sell any productsthat we may develop. If we cannot successfully defend ourselves against claimsthat our product candidates or products that we may develop caused injuries, wewill incur substantial liabilities. Regardless of merit or eventual outcome,liability claims may result in:

 

·                  decreaseddemand for any product candidates or products that we may develop;

 

·                  injuryto our reputation;

 

·                  withdrawalof clinical trial participants;

 

·                  coststo defend the related litigation;

 

·                  increaseddemands on management’s attention in defending the related litigation;

 

·                  substantialmonetary awards to clinical trial participants or patients;

 

·                  lossof revenue; and

 

·                  theinability to commercialize any products that we may develop.

 

We have product liability insurance that coversour clinical trials up to an aggregate $10.0 million annual limit. Weintend to expand our insurance coverage to include the sale of commercialproducts if marketing approval is obtained for any products that we maydevelop. Insurance coverage is increasingly expensive, and we may not be ableto maintain insurance coverage at a reasonable cost or obtain insurancecoverage that will be adequate to satisfy any liability that may arise.

 

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***If we usebiological and hazardous materials in a manner that causes contamination,injury or violates laws, we may be liable for damages.***

 

Our research and development activities involvethe use of potentially harmful biological materials as well as hazardousmaterials, chemicals and various radioactive compounds. We cannot completelyeliminate the risk of accidental contamination or injury from the use, storage,handling or disposal of these materials. In the event of contamination orinjury, we could be held liable for damages that result, and any liabilitycould exceed our resources. We, the third parties that conduct clinical trialson our behalf and the third parties that manufacture our product candidates aresubject to federal, state and local laws and regulations governing the use,storage, handling and disposal of these materials and waste products. The costof compliance with these laws and regulations could be significant. The failureto comply with these laws and regulations could result in significant fines andwork stoppages and may harm our business.

 

Our principal facility is located in California’sSilicon Valley, in an area with a long history of industrial activity and useof hazardous substances, including chlorinated solvents. Certain environmentallaws, including the U.S. Comprehensive, Environmental Response, Compensationand Liability Act of 1980, impose strict, joint and several liabilities oncurrent operators of real property for the cost of removal or remediation ofhazardous substances. These laws often impose liability even if the owner oroperator did not know of, or was not responsible for, the release of suchhazardous substances. As a result, while we have not been notified of any claimagainst us, we are not aware of any such release, nor have we been held liablefor costs to address contamination at the property beneath our facility in thepast, we cannot rule out the possibility that this may occur in the future. Wedo not carry specific insurance against such a claim.

 

***Failure tomaintain effective internal controls in accordance with Section 404 of theSarbanes-Oxley Act of 2002 could have a material adverse effect on ourbusiness, stock price and ability to raise additional capital.****

 

Section 404 of the Sarbanes-Oxley Act of2002 requires management’s annual review and evaluation of our internalcontrols and, to the extent required, an attestation of the effectiveness ofinternal controls by our independent auditor. While the company believes thatall material information about the company’s finances is known to managementand that we are able to continue to provide reasonable assurance about thereliability of our financial reporting to stockholders including that the preparationof financial statements for external purposes are in accordance with generallyaccepted accounting principles, due to the company’s recent restructuring,management may determine that we no longer have sufficient personnel orinternal procedures to allow us to certify that we are in compliance withSection 404 of the Sarbanes-Oxley Act as of December 31, 2010. Due torecent legislative changes, we are no longer required to have an auditorattestation regarding our compliance in the first quarter of 2011. However, ifmanagement is unable to certify as to the effectiveness of internal controls asof December 31, 2010, then it is possible that we will receive an adverseopinion from our auditor. Similarly, if we conclude at anytime that our internalcontrols are no longer sufficient to provide reasonable assurance regarding thereliability of our external financial reporting to stockholders, we may berequired to make such a disclosure to our stockholders. Either of these eventscould have a material adverse effect on our business. We could lose investorconfidence in the accuracy and completeness of our financial reports, whichcould have an adverse effect on our stock price and our ability to raiseadditional capital.

 

***Ourprincipal facility is located near known earthquake fault zones, and theoccurrence of an earthquake, extremist attack or other catastrophic disastercould cause damage to our facilities and equipment, which could require us tocease or curtail operations.***

 

Our principal facility is located in California’sSilicon Valley near known earthquake fault zones and, therefore, is vulnerableto damage from earthquakes. In October 1989, a major earthquake struck thisarea and caused significant property damage and a number of fatalities. We arealso vulnerable 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.

 

**Risks Related to Ownership of Our Common Stock**

 

***Our stockprice may be extremely volatile, and your investment in our common stock couldsuffer a decline in value.****

 

You should consider an investment in our commonstock risky and invest only if you can withstand a significant loss and widefluctuations in the market value of your investment. Investors who purchase ourcommon stock may not be able to sell their shares at or above the purchaseprice. Securities market prices for securities of biopharmaceutical companieshave been highly volatile. In addition, the volatility of biopharmaceutical companystocks often does not correlate to the operating performance of the companiesrepresented by such stocks. Some of the factors that may cause the market priceof our common stock to fluctuate include:

 

·                  announcementsregarding the sufficiency of our cash resources and the ongoing exploration ofthe strategic alternatives available to us;

 

·                  adverseresults or delays in our clinical trials;

 

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·                  thetiming or delay of achievement of our clinical, regulatory, partnering andother milestones, such as the commencement of clinical development, thecompletion of a clinical trial, the receipt of regulatory approval or theestablishment or termination of a commercial partnership for one or more of ourproduct candidates;

 

·                  announcementof FDA approval or non-approval of our product candidates or delays in the FDAreview process;

 

·                  actionstaken by regulatory agencies with respect to our product candidates, ourclinical trials or our sales and marketing activities;

 

·                  thecommercial success of any product approved by the FDA or its foreigncounterparts;

 

·                  regulatorydevelopments in the United States and foreign countries;

 

·                  changesin the structure of healthcare payment systems;

 

·                  anyintellectual property infringement lawsuit involving us;

 

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

 

·                  marketconditions for the biotechnology or pharmaceutical industries in general;

 

·                  changesin financial estimates or recommendations by securities analysts;

 

·                  salesof large blocks of our common stock;

 

·                  salesof our common stock by our executive officers, directors and significantstockholders;

 

·                  directsales of our common stock through our Sales Agreement with MLV and Wm Smith orother financing arrangements;

 

·                  Borrowingof funds under new or existing loan facilities;

 

·                  restatementsof our financial results and/or material weaknesses in our internal controls;and

 

·                  theloss of any of our key scientific or management personnel.

 

The stock markets in general, and the marketsfor biotechnology stocks in particular, have experienced extreme volatility andprice and volume fluctuations that have often been unrelated ordisproportionate to the operating performance of particular companies. Thesebroad market and industry factors may seriously harm the market price of ourcommon stock, regardless of our operating performance. In the past, classaction litigation has often been instituted against companies whose securitieshave experienced periods of volatility in market price. Any such litigationbrought against us could result in substantial costs, which would hurt ourfinancial condition and results of operations, divert management’s attentionand resources, and possibly delay our clinical trials or commercializationefforts.

 

***Fluctuationsin our operating results could cause our stock price to decline.***

 

The following factors are likely to result influctuations of our operating results from quarter to quarter and year to year:

 

·                  fluctuationsin our expenses based on adjustments in light of our limited cash resources;

 

·                  adverseresults or delays in our clinical trials;

 

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·                  thetiming or delay of achievement of our clinical, regulatory, partnering andother milestones, such as the commencement of clinical development, thecompletion of a clinical trial, the receipt of regulatory approval or theestablishment or termination of a commercial partnership for one or more of ourproduct candidates;

 

·                  announcementof FDA approval or non-approval of our product candidates or delays in the FDAreview process;

 

·                  actionstaken by regulatory agencies with respect to our product candidates, ourclinical trials or our sales and marketing activities;

 

·                  thecommercial success of any product approved by the FDA or its foreigncounterparts;

 

·                  regulatorydevelopments in the United States and foreign countries;

 

·                  changesin the structure of healthcare payment systems;

 

·                  anyintellectual property infringement lawsuit involving us; and

 

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

 

Because of these potential fluctuations in ouroperating results, a period-to-period comparison of our results of operationsmay not be a good indication of our future performance. In any particularfinancial period the actual or anticipated fluctuations could be below theexpectations of securities analysts or investors and our stock price coulddecline.

 

***If we failto regain compliance with the listing requirements of The NASDAQ Global Market,our common stock may be delisted and the price of our common stock and ourability to access the capital markets could be negatively impacted.****

 

Our common stock is currently listed on TheNASDAQ Global Market. We announced on April 9, 2010 that we had received aletter, dated April 5, 2010, from the Listing Qualifications Department ofThe NASDAQ Stock Market notifying us that, for the last 30 consecutive businessdays, the market value of our listed securities had been below the minimum$50.0 million requirement for continued inclusion on The NASDAQ GlobalMarket pursuant to NASDAQ Listing Rules. In accordance with NASDAQ ListingRules, we have been given 180 calendar days, or until October 4, 2010, toregain compliance. To regain compliance, the market value of our listedsecurities must close at $50.0 million or more for a minimum of 10 consecutivebusiness days at any time prior to October 4, 2010. If we do notdemonstrate compliance by October 4, 2010, the NASDAQ ListingQualifications Department will provide written notification to us that ourcommon stock may be delisted. At that time, we may either apply for listing onThe NASDAQ Capital Market, provided we meet the continued listing requirementsof that market in accordance with NASDAQ Listing Rules, or appeal the decisionto a NASDAQ Listing Qualifications Panel, or Panel. In the event of an appeal,our securities would remain listed on The NASDAQ Global market pending adecision by the Panel following a hearing. There can be no assurance that, ifwe do appeal a delisting determination to the Panel, that such appeal would besuccessful.

 

We announced on June 1, 2010 that we hadreceived a letter, dated May 25, 2010, from the Listing QualificationsDepartment of The NASDAQ Stock Market notifying us that, for the last 30consecutive business days, the bid price of our common stock had closed below theminimum $1.00 per share requirement for continued inclusion on The NASDAQGlobal Market pursuant to NASDAQ Listing Rules. In accordance with NASDAQListing Rules, we have been given 180 calendar days, or until November 22,2010, to regain compliance. To regain compliance, the bid price for our commonstock must close at $1.00 or more for a minimum of 10 consecutive business daysat any time prior to November 22, 2010. If we do not demonstratecompliance by November 22, 2010, the NASDAQ Listing QualificationsDepartment will provide written notification to us that our common stock may bedelisted. At that time, we may either apply for listing on The NASDAQ CapitalMarket, provided we meet the continued listing requirements of that market inaccordance with NASDAQ Listing Rules, or appeal the decision to the Panel. Inthe event of an appeal, our securities would remain listed on The NASDAQ GlobalMarket pending a decision by the Panel following a hearing. There can be noassurance that, if we do appeal a delisting determination to the Panel, thatsuch appeal would be successful.

 

We announced on July 8, 2010 that we hadreceived a letter, dated July 2, 2010, from the Listing QualificationsDepartment of The NASDAQ Stock Market notifying us that, for the last 30consecutive business days, the market value of our publicly held shares hasbeen below the minimum $15.0 million requirement for continued inclusion on TheNASDAQ Global Market pursuant to NASDAQ Listing Rules.  In accordance with NASDAQ Listing Rules, wehave been given 180 calendar days, or until December 28, 2010, to regaincompliance. To regain compliance, the market value of our publicly held sharesmust close at $15.0 million or more for a minimum of 10 consecutive businessdays at any time prior to December 28, 2010. If we do not demonstrate compliance by December 28, 2010, the NASDAQListing Qualifications Department will provide written notification to us thatour common stock

 

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may be delisted. At that time, we may either apply for listing on The NASDAQ CapitalMarket, provided we meet the continued listing requirements of that market inaccordance with NASDAQ Listing Rules, or appeal the decision to the 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 an appeal would be successful.

 

If we fail to regain compliance with thelisting standards of The NASDAQ Global Market, we may consider transferring toThe NASDAQ Capital Market, provided we meet the transfer criteria, which is alower tier market, or our common stock may be delisted and traded on theover-the-counter bulletin board network. Moving our listing to The NASDAQCapital Market could adversely affect the liquidity of our common stock. If ourcommon stock were to be delisted by NASDAQ, we could face significant materialadverse consequences, including:

 

·      alimited availability of market quotations for our common stock;

 

·      areduced amount of news and analyst coverage for us;

 

·      adecreased ability to issue additional securities or obtain additional financingin the future;

 

·      reducedliquidity for our stockholders;

 

·      potentialloss of confidence by collaboration partners and employees; and

 

·      lossof institutional investor interest and fewer business developmentopportunities.

 

***Because asmall number of existing stockholders own a large percentage of our votingstock, they may be able to control our management and operations, acting intheir best interests and not necessarily those of other stockholders.****

 

Based on our outstanding shares as ofJuly 31, 2010 (which excludes any shares of common stock issuable uponexercise of warrants and options outstanding on such date), our executiveofficers, directors and holders of 5% or more of our outstanding common stockbeneficially owned approximately 42% of our common stock. As a result, thesestockholders, acting together, may be able to significantly influence anymatters requiring approval by our stockholders, including the election of directorsand the approval of mergers or other business combination transactions. Theinterests of this group of stockholders may not always coincide with ourinterests or the interests of other stockholders. The significant concentrationof stock ownership may adversely affect the trading price of our common stockdue to the perception that conflicts of interest may exist or arise.

 

***Anti-takeoverprovisions in our charter documents and under Delaware law could make anacquisition of us, which may be beneficial to our stockholders, more difficultand may prevent attempts by our stockholders to replace or remove our currentmanagement.***

 

Provisions in our certificate of incorporationand our bylaws may delay or prevent an acquisition of us, a change in ourmanagement or other changes that stockholders may consider favorable. Theseprovisions include:

 

·      aclassified board of directors;

 

·      aprohibition on actions by our stockholders by written consent;

 

·      theability of our board of directors to issue preferred stock without stockholderapproval, which could be used to adopt a stockholders’ rights plan that wouldmake it difficult for a third party to acquire us;

 

·      noticerequirements for nominations for election to the board of directors; and

 

·      limitationson the removal of directors.

 

Moreover, we are governed by the provisions ofSection 203 of the Delaware General Corporation Law, which prohibits aperson who owns in excess of 15% of our outstanding voting stock from mergingor combining with us for a period of three years after the date of thetransaction in which the person acquired in excess of 15% of our outstandingvoting stock, unless the merger or combination is approved in a prescribedmanner.

 

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***Future salesof our common stock in the public market could cause our stock price to dropsubstantially.***

 

Sales of a substantial number of shares of ourcommon stock in the public market, or the perception that these sales mightoccur, could depress the market price of our common stock and could impair ourability to raise capital through the sale of additional equity securities.

 

As of July 31, 2010, we had 33,461,975 sharesof common stock outstanding, which excludes any shares of common stock issuableupon exercise of warrants and options outstanding as of such date. The sharesoutstanding are freely tradable without restriction in the public market unlessheld by an affiliate of ours. Shares held by our affiliates are eligible forsale in the public market either in accordance with an effective resaleregistration statement with the Securities and Exchange Commission or pursuantto the volume limitations and manner of sale requirements under Rule 144.Any common stock that is either subject to outstanding options or warrants orreserved for future issuance under our 2001 Equity Incentive Plan, 2007 EquityIncentive Plan, 2007 Non-Employee Directors’ Stock Option Plan and 2007Employee Stock Purchase Plan could also become eligible for sale in the publicmarket to the extent permitted by the provisions of various vesting agreements,and Rules 144 and 701 under the Securities Act. If these additional sharesare sold, or if it is perceived that they will be sold, in the public market,the trading price of our common stock could decline.

 

Certain of our affiliates have rights with respect toregistration of a significant number of our shares of common stock under theSecurities Act. If such holders, by exercising their registration rights, causea large number of securities to be sold in the public market, these sales couldhave an adverse effect on the market price for our common stock and may impairour ability to raise additional capital. In addition, as of December 31,2009, we have filed three registration statements on Form S-8 under theSecurities Act to register up to an aggregate of 5,005,132 shares of our commonstock for issuance under our stock option and employee stock purchase plans,and intend to file additional registration statements on Form S-8 toregister the shares automatically added each year to the share reserves underthese plans.

 

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

 

None.

 

**ITEM 3. DEFAULTS UPON SENIORSECURITIES**

 

None.

 

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

 

None.

 

**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.

 

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**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

Dated: August 16, 2010

 

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

 

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**EXHIBIT INDEX**

 
| **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.                                                     |
|                |       |                                                                                                                                                                             |
| 10.1(6)             |       | At Market Issuance Sales Agreement, dated May 20,  2010, by and among ARYx, McNicoll, Lewis & Vlak LLC and Wm Smith &  Co.                                               |
|                |       |                                                                                                                                                                             |
| 10.2(7)*            |       | Separation and Consulting Agreement, dated June 2,  2010, by and between ARYx and Peter G. Milner, M.D.                                                                          |
|                |       |                                                                                                                                                                             |
| 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. |

 

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*      Indicatesmanagement contract, compensatory plan or arrangement.

 

(1)   Previouslyfiled as the like numbered exhibit to registrant’s Registration Statement onForm S-1 (No. 333-145813), initially filed with the Securities andExchange Commission on August 30, 2007, as amended, and incorporated byreference herein.

 

(2)   Previouslyfiled as the like-numbered exhibit to registrant’s Current Report onForm 8-K (File No. 001-33782), filed with the SEC on October 23,2008 and incorporated herein by reference.

 

(3)   Previouslyfiled as the like-numbered exhibit to registrant’s Current Report onForm 8-K (File No. 001-33782), filed with the SEC onNovember 12, 2008 and incorporated herein by reference.

 

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

 

(5)   Previouslyfiled as the like-numbered exhibit to registrant’s Current Report onForm 8-K (File No. 001-33782), filed with the SEC on October 8,2009 and incorporated herein by reference.

 

(6)   Previouslyfiled as the like-numbered exhibit to registrant’s Current Report on Form 8-K(File No. 001-33782), filed with the SEC on May 20, 2010 and incorporatedherein by reference.

 

(7)   Previouslyfiled as Exhibit 10.1 to registrant’s Current Report on Form 8-K (File No.001-33782), filed with the SEC on June 3, 2010 and incorporated herein byreference.

 

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