SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

                                    Form 10-Q

(Mark One)
            [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                For the quarterly period ended September 30, 2006
                                       or

            [ ] 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 0-13634

                              MACROCHEM CORPORATION
             (Exact name of registrant as specified in its charter)

           Delaware                                         04-2744744
  (State or Other Jurisdiction                           (I.R.S. Employer
of Incorporation or Organization)                       Identification No.)

      40 Washington Street, Suite 220, Wellesley Hills, Massachusetts 02481
               (Address of principal executive offices, Zip Code)

                                  781-489-7310
              (Registrant's telephone number, including area code)

     Indicate  by check mark  whether the  Registrant  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
Registrant  was required to file such  reports) and (2) has been subject to such
filing requirements for the past 90 days.
 Yes X     No
------   ------

     Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large  accelerated  filer" in Rule 12b-2 of the  Exchange  Act.
Large accelerated filer        Accelerated filer        Non-accelerated filer X


     Indicate  by check mark  whether  the  Registrant  is a shell  company  (as
defined in Rule 12b-2 of the Exchange Act).
  Yes     No X
------   ------

     Indicate the number of shares  outstanding of each of the issuer's  classes
of common stock, as of the latest practicable date.

           Class                                Outstanding at November 6, 2006:
----------------------------                    --------------------------------
Common Stock, $.01 par value                               2,115,927

                                       1
<PAGE>


                              MACROCHEM CORPORATION

                               INDEX TO FORM 10-Q


                                                                     Page Number
PART I            FINANCIAL INFORMATION

Item 1          Financial Statements

                Condensed Balance Sheets
                September 30, 2006 (Unaudited) and December 31, 2005           3

                Condensed Statements of Operations for the
                Three and Nine Months Ended September 30, 2006
                and 2005 (Unaudited)                                           4

                Condensed Statements of Cash Flows for the
                Nine Months Ended September 30, 2006
                and 2005 (Unaudited)                                         5-6

                Notes to Unaudited Condensed Financial
                Statements                                                  7-15

Item 2          Management's Discussion and Analysis of
                Financial Condition and Results of Operations              16-23

Item 3          Quantitative and Qualitative Disclosures About Market Risk    24

Item 4          Controls and Procedures                                       24


PART II         OTHER INFORMATION

Item 1A         Risk Factors                                               25-26

Item 6          Exhibits                                                      27

SIGNATURES                                                                    28

EXHIBIT INDEX                                                                 29

                                       2
<PAGE>


Item 1.  Financial Statements
<TABLE>
<CAPTION>
                                           MACROCHEM CORPORATION
                                          CONDENSED BALANCE SHEETS




                                                                                SEPTEMBER 30,        DECEMBER 31,
                                                                                    2006                 2005
<S>                                                                             <C>                  <C>
                                                                                 (Unaudited)
ASSETS                                                                          ------------       ------------
Current assets:
      Cash and cash equivalents                                                 $    589,574       $ 3,023,436
      Short-term investments                                                       5,150,263               ---
      Prepaid expenses and other current assets                                      256,041           106,761
                                                                                ------------       ------------
          Total current assets                                                     5,995,878         3,130,197

Property and equipment, net                                                           42,074            72,203

Patents, net                                                                         579,920           579,053
                                                                                ------------       ------------
Total assets                                                                    $  6,617,872       $ 3,781,453
                                                                                ============       ============
LIABILITIES
Current liabilities:
      Accounts payable                                                          $    302,610       $   125,478
      Accrued expenses and other liabilities                                         163,040           249,552
                                                                                ------------       ------------
          Total current liabilities                                                  465,650           375,030

Warrants liability (Note 5)                                                          554,397         1,620,778
                                                                                ------------       ------------
Total liabilities                                                                  1,020,047         1,995,808

Commitments and contingencies (Note 3)

Preferred stock, $.01 par value, 6,000,000 shares authorized, 809 and
     250 shares Series C Convertible issued and outstanding at
     September 30, 2006 and December 31, 2005, respectively (Note 5)                 335,441           330,243
                                                                                ------------       ------------
                                                                                     335,441           330,243

STOCKHOLDERS' EQUITY
Common stock, $.01 par value, 100,000,000 shares authorized;  2,116,456
      and 997,438 shares issued at September 30, 2006 and
      December 31, 2005, respectively
                                                                                      21,165             9,974
Additional paid-in capital                                                        85,769,015        84,089,530
Accumulated deficit                                                             (80,468,686)       (82,584,992)
Less treasury stock, at cost, 529 shares at September 30, 2006 and
      December 31, 2005                                                             (59,110)           (59,110)
                                                                                ------------       ------------
Total stockholders' equity                                                         5,262,384         1,455,402
                                                                                ------------       ------------
Total liabilities and stockholders' equity                                      $  6,617,872       $ 3,781,453
                                                                                ============       ============
</TABLE>

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

                                       3
<PAGE>

<TABLE>
<CAPTION>
                                                       MACROCHEM CORPORATION
                                                CONDENSED STATEMENTS OF OPERATIONS
                                 For the three and nine months ended September 30, 2006 and 2005
                                                            (Unaudited)


                                                    FOR THE THREE MONTHS ENDED                          FOR THE NINE MONTHS ENDED
                                                          SEPTEMBER 30,                                       SEPTEMBER 30,
                                                            2006                 2005                  2006                2005
                                                        ------------         ------------         -------------        -------------
<S>                                                     <C>                  <C>                  <C>                  <C>
OPERATING EXPENSES:
     Research and development                           $    332,295         $    380,881         $     488,520        $  2,149,949
     Marketing, general and administrative                   828,472              703,098             2,946,159           2,347,376
     Costs associated with staff reduction and
     transition agreements (Note 7)                                -              751,277                  -                751,277
                                                        ------------         ------------         -------------        -------------
         TOTAL OPERATING EXPENSES                          1,160,767            1,835,256             3,434,679           5,248,602
                                                        ------------         ------------         -------------        -------------
LOSS FROM OPERATIONS                                      (1,160,767)          (1,835,256)           (3,434,679)         (5,248,602)
                                                        ------------         ------------         -------------        -------------
OTHER INCOME:
     Interest income                                          69,929               14,264               189,081              59,724
     Gain on change in value of warrant liability          1,597,911                    -             5,910,979                   -
                                                        ------------         ------------         -------------        -------------
              TOTAL OTHER INCOME
             (NOTE 5)                                      1,667,840               14,264             6,100,060              59,724
                                                        ------------         ------------         -------------        -------------

NET INCOME (LOSS)                                       $    507,073         $ (1,820,992)        $   2,665,381        $ (5,188,878)
                                                        ============         ============         =============        =============

BENEFICIAL CONVERSION FEATURE (NOTE 5)                             -                    -               (11,895)                  -

DIVIDEND ON SERIES C CUMULATIVE PREFERRED STOCK             (203,999)                   -              (549,075)                  -
                                                        ============         ============         =============        =============

NET INCOME (LOSS) ATTRIBUTABLE TO COMMON
     STOCKHOLDERS                                       $    303,074         $ (1,820,992)  $         2,104,411        $ (5,188,878)
                                                        ============         ============         =============        =============

BASIC NET INCOME (LOSS) PER COMMON SHARE                $       0.21         $      (1.83)  $              1.78        $      (5.37)
                                                        ============         ============         =============        =============

DILUTED NET INCOME (LOSS)
     PER COMMON SHARE                                   $       0.06         $      (1.83)  $              0.33        $      (5.37)
                                                        ============         ============         =============        =============

WEIGHTED AVERAGE SHARES USED TO COMPUTE BASIC NET
     INCOME (LOSS) PER COMMON SHARE                        1,461,192              996,749             1,184,572             966,610
                                                        ============         ============         =============        =============

WEIGHTED AVERAGE SHARES USED
     TO COMPUTE DILUTED NET
       INCOME (LOSS) PER COMMON
       SHARE                                               9,169,190              996,749             8,053,511             966,610
                                                        ============         ============         =============        =============
</TABLE>

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

                                       4
<PAGE>

<TABLE>
<CAPTION>
                                        MACROCHEM CORPORATION
                                 CONDENSED STATEMENTS OF CASH FLOWS
                          For the nine months ended September 30, 2006 and 2005
                                            (Unaudited)


                                                                           FOR THE NINE MONTHS ENDED SEPTEMBER 30,
<S>                                                                          <C>                  <C>
                                                                                 2006                 2005

CASH FLOWS FROM OPERATING ACTIVITIES
     Net income (loss)                                                       $  2,665,381         $  (5,188,878)
     Adjustments to reconcile net income or loss to net cash
       used by operating activities:
         Depreciation and amortization                                             70,032               149,582
         Stock-based compensation                                                 804,489                   ---
         401(k) contributions in Company common stock                                 ---                15,610
         Deferred rent                                                                ---                (5,509)
         (Gain) on change in value of warrant liability                        (5,910,979)                  ---
     Change in assets and liabilities:
         Prepaid expenses and other current assets                               (149,281)              104,661
         Accounts payable and accrued expenses                                     90,621              (448,453)
                                                                              -------------          ------------
Net cash used in operating activities                                          (2,429,737)           (5,372,987)
                                                                              -------------          ------------

CASH FLOWS FROM INVESTING ACTIVITIES:
     Sale of short-term investments                                                   ---             1,185,406
     Purchases of short-term investments                                       (5,150,263)                  ---
     Expenditures for property and equipment                                         (436)              (14,519)
     Additions to patents                                                         (40,334)             (105,439)
                                                                              -------------          ------------
Net cash (used in) provided by investing activities                            (5,191,033)            1,065,448
                                                                              -------------          ------------

CASH FLOWS FROM FINANCING ACTIVITIES:
     Net proceeds from issuance of Series C Cumulative
       Convertible Preferred Stock and Warrants                                 5,186,908                   ---
     Proceeds from sale of common stock (net of legal and
        financial costs)                                                              ---               601,341
     Proceeds from exercise of warrants                                               ---                87,500
                                                                              -------------          ------------
Net cash provided by financing activities                                       5,186,908               688,841
                                                                              -------------          ------------


Net change in cash and cash equivalents                                        (2,433,862)           (3,618,698)
Cash and cash equivalents at beginning of period                                3,023,436             4,888,868
                                                                              -------------          ------------

Cash and cash equivalents at end of period                                   $    589,574         $   1,270,170
                                                                             ==============          ============
</TABLE>

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


                                                                     (Continued)
                                       5
<PAGE>



                              MACROCHEM CORPORATION
                      STATEMENTS OF CASH FLOWS (Continued)


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

The  Company  did not pay any cash for  interest  expense  or income  taxes
during the nine-month periods ended September 30, 2006 and 2005.

In  February of 2006,  the  Company  issued  warrants  for the  purchase of
approximately  548,095  shares  of its  Common  Stock  to the  designees  of the
placement agent in connection  with the sale of Series C Cumulative  Convertible
Preferred  Stock.  The  warrants  were valued using the Black  Scholes  model at
$330,415 and are recorded as a non-cash issuance cost.

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


                                       6
<PAGE>


                              MACROCHEM CORPORATION
                NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS

All  references  to share  amounts,  share prices and per share data in the
Unaudited  Condensed  Financial  Statements and these accompanying Notes reflect
both the  1-for-7  reverse  stock split  effected  on December  30, 2005 and the
1-for-6  reverse stock split  effected on February 9, 2006.  Accordingly,  where
appropriate,  share amounts,  share prices and per share data have been adjusted
to give retroactive effect to the reverse splits.

(1)      BASIS OF PRESENTATION AND OPERATIONS




         The  financial   statements  included  herein  have  been  prepared  by
         MacroChem  Corporation  ("MacroChem"  or the "Company")  without audit,
         pursuant to the rules and  regulations  of the  Securities and Exchange
         Commission.  Certain  information  and  footnote  disclosures  normally
         included in financial statements prepared in accordance with accounting
         principles generally accepted in the United States of America have been
         condensed  or omitted  pursuant to such rules and  regulations.  In the
         opinion of management,  the accompanying  unaudited condensed financial
         statements include all adjustments (consisting only of normal recurring
         adjustments)  necessary  to  present  fairly  the  financial  position,
         results of  operations  and cash flows of the  Company at the dates and
         for the periods indicated. The unaudited condensed financial statements
         included  herein  should  be  read  in  conjunction  with  the  audited
         financial  statements  and the notes thereto  included in the Company's
         Annual Report on Form 10-K for the fiscal year ended December 31, 2005.



         The Company has been  engaged  primarily  in research  and  development
         since its inception in 1981 and has derived  limited  revenues from the
         commercial  sale of its products,  licensing of certain  technology and
         feasibility  studies.  The Company has had no revenues  relating to the
         sale of any  products  currently  under  development.  The  Company has
         incurred net losses from operations  every year since its inception and
         the Company  anticipates  that losses from operations will continue for
         the   foreseeable   future.   At  September  30,  2006,  the  Company's
         accumulated deficit was $80,468,686. At September 30, 2006, the Company
         believes that its existing cash and cash  equivalents are sufficient to
         fund operations under the Company's current operating plan for at least
         the next twelve months.  The Company's  ability to continue  operations
         after its  current  capital  resources  are  exhausted  depends  on its
         ability  to  obtain   additional   financing  and  achieve   profitable
         operations,  as to which no assurances can be given. The Company's cash
         requirements  may vary  materially  from those now  planned  because of
         changes in the focus and  direction  of its  research  and  development
         programs,  competitive and technical  advances,  patent developments or
         other developments.



         The  Company  organizes  itself as one segment  reporting  to the chief
         executive officer.  Products and services consist primarily of research
         and development activities in the pharmaceutical  industry. The results
         disclosed  in the  Statement  of  Operations  for the nine months ended
         September 30, 2006 are not necessarily  indicative of the results to be
         expected for the full year.



                                       7
<PAGE>

(2)      STOCK BASED COMPENSATION

         Stock Incentive Plans

         The Company has granted options to purchase the Company's  common stock
         to employees and directors under various stock incentive  plans.  Under
         the plans, employees and non-employee directors are eligible to receive
         awards  of  various  forms  of  equity-based  incentive   compensation,
         including stock options,  restricted  stock,  and  performance  awards,
         among others.  The plans are  administered by the Board of Directors or
         the Compensation  Committee of the Board of Directors,  which determine
         the terms of the awards  granted.  Stock options are generally  granted
         with an exercise  price equal to the market  value of a share of common
         stock on the date of grant,  have a term of ten years or less, and vest
         over terms of two to three years from the date of grant.

         Adoption of SFAS 123(R)

         Prior to  January  1,  2006,  the  Company  accounted  for  stock-based
         compensation  issued to employees  using the  intrinsic  value  method,
         which follows the recognition and measurement  principles of Accounting
         Principles  Board ("APB") Opinion No. 25,  "Accounting for Stock Issued
         to  Employees,"  and  Financial  Accounting  Standards  Board  ("FASB")
         Interpretation  ("FIN") No. 44,  "Accounting  for Certain  Transactions
         Involving  Stock  Compensation."  Generally,  no  stock-based  employee
         compensation cost related to stock options was reflected in net income,
         as all options  granted  under  stock-based  compensation  plans had an
         exercise price equal to the market value of the underlying common stock
         on the grant date.  Compensation cost related to restricted stock units
         granted  to  non-employee  directors  and  certain  key  employees  was
         reflected as an expense as services were rendered.

         On  January  1,  2006,  the  Company  adopted  Statement  of  Financial
         Accounting Standards ("SFAS") No. 123(R),  "Share-Based Payment," using
         the  modified   prospective  method,   which  requires  measurement  of
         compensation  cost for all stock  awards  at fair  value on the date of
         grant and recognition of compensation over the requisite service period
         for  awards  expected  to vest.  The fair  value  of stock  options  is
         estimated using the  Black-Scholes  valuation model, and the fair value
         of restricted  stock units is determined  based on the number of shares
         granted and the quoted price of the Company's  common stock on the date
         of grant.  Such  value is  recognized  as  expense  over the  requisite
         service period, net of estimated  forfeitures,  using the straight-line
         attribution  method.  The estimate of awards that will  ultimately vest
         requires  significant  judgment,  and to the extent  actual  results or
         updated  estimates differ from the Company's  current  estimates,  such
         amounts  will be  recorded  as a  cumulative  adjustment  in the period
         estimates  are  revised.   The  Company  considers  many  factors  when
         estimating expected  forfeitures,  including types of awards,  employee
         class and historical  employee  attrition  rates.  Actual results,  and
         future  changes  in  estimates,   may  differ  substantially  from  the
         Company's current estimates.

         On March 29,  2005,  the  Securities  and Exchange  Commission  ("SEC")
         published Staff Accounting Bulletin ("SAB") No. 107, which provides the
         Staff's views on a
                                       8
<PAGE>

         variety  of  matters  relating  to  stock-based  payments.  SAB No. 107
         requires  that  stock-based  compensation  be  classified  in the  same
         expense  line items as cash  compensation.  The Company has  classified
         stock-based  compensation  during the nine months ended  September  30,
         2006 within the same operating  expense line items as cash compensation
         paid to employees.

         Stock-based compensation expense under SFAS No. 123(R) was $129,894 and
         $804,489  during the three and nine months  ended  September  30, 2006,
         respectively.  The  incremental  impact of SFAS No.  123(R)  during the
         three and nine months ended September 30, 2006  represents  stock-based
         compensation expense related to stock options.

         Valuation Assumptions for Stock Options

         The fair  value of stock  options  granted  during  the  three and nine
         months  ended  September  30,  2006 and 2005 was  estimated  using  the
         Black-Scholes option-pricing model with the following assumptions:

                                                     THREE AND NINE MONTHS ENDED
                                                            SEPTEMBER 30,
                                                          2006              2005
Risk-free interest rate                                  4.72%             4.25%
Expected life of option grants                         6 years           6 years
Expected volatility of underlying stock                   102%               93%
Expected dividend payment rate, as a percentage of
the stock price on the date of grant                       ---               ---

         The dividend  yield  assumption is based on the  Company's  history and
         expectation  of future  dividend  payouts.  The expected  volatility is
         based on a  combination  of the  Company's  historical  stock price and
         implied  volatility.  The risk-free  interest rate  assumption is based
         upon the U.S.  Treasury  yield curve in effect at the time of grant for
         periods  corresponding  with  the  expected  life  of the  option.  The
         expected life of employee stock options represents the weighted-average
         period the stock options are expected to remain outstanding.
                                       9
<PAGE>


         Pro Forma Information for Period Prior to SFAS 123(R) Adoption

         In accordance  with FAS 123(R),  the Company  adopted the provisions of
         FAS 123(R) at January 1, 2006 using the modified prospective  approach.
         Under this  method,  prior  periods are not  restated.  Had the Company
         previously  recognized  compensation  costs as  prescribed  by FAS 123,
         previously  reported  net loss,  basic  earnings  per share and diluted
         earnings per share would have changed to the pro forma amounts shown as
         follows:

<TABLE>
<CAPTION>
                                                               THREE MONTHS ENDED   NINE MONTHS ENDED
                                                               SEPTEMBER 30, 2005   SEPTEMBER 30, 2005
<S>                                                             <C>                  <C>

        Net loss as reported                                    $ (1,820,992)        $ (5,188,878)
        Deduct: Total stock-based employee compensation
                measured using the fair value method                 (67,226)            (680,413)
                                                                -------------        -------------
        Pro forma net loss                                      $ (1,888,218)        $ (5,869,291)
                                                                =============        =============
        Basic and diluted net loss per share - as reported      $      (1.83)        $      (5.37)
                                                                =============        =============
        Basic and diluted net loss per share - pro forma        $      (1.89)        $      (6.07)
                                                                =============        =============
</TABLE>

         Stock option  activity for the nine months ended September 30, 2006 was
         as follows:
<TABLE>
<CAPTION>

                                                        WEIGHTED           WEIGHTED         AGGREGATE
                                        NUMBER OF       AVERAGE            AVERAGE          INTRINSIC
                                        OPTIONS      EXERCISE PRICE     REMAINING LIFE        VALUE
<S>                                    <C>            <C>               <C>               <C>

Outstanding, December 31, 2005           108,600      $  132.24
  Granted                                945,000      $    1.62
  Exercised                                  ---            ---
  Canceled or Expired                    (38,884)
                                       ----------     ----------        ----------        ----------
Outstanding, September 30, 2006        1,014,716      $   10.63             9.63          $        0
                                       ==========     ==========        ==========        ==========
Exercisable, September 30, 2006          382,363      $   24.81             6.01          $        0
                                       ==========     ==========        ==========        ==========
</TABLE>

         The weighted  average grant date fair value of options  granted  during
         the nine months ended September 30, 2006 was $1,250,910.  The remaining
         unrecognized  compensation cost related to unvested awards at September
         30, 2006 was approximately  $451,720 and the weighted average period of
         time over which this cost will be recognized is 1.25 years.


(3)      COMMITMENTS AND CONTINGENCIES

         LEASE  COMMITMENTS - In accordance with certain lease contracts related
         to office space and  equipment,  in the event that they are  terminated
         early,  we  would  owe  approximately  $132,400  as  early  termination
         payments.
                                       10
<PAGE>

 (4)     BASIC AND DILUTED INCOME OR (LOSS) PER SHARE

         The  following is a  reconciliation  of net income  (loss) and weighted
         average common shares outstanding for purposes of calculating basic and
         diluted income (loss) per share:
<TABLE>
<CAPTION>

                                                        THREE MONTHS ENDED                                 NINE MONTHS ENDED
                                                           SEPTEMBER 30,                                      SEPTEMBER 30,
                                                            2006                 2005                 2006                 2005
<S>                                                     <C>                  <C>                  <C>                  <C>

                                                        ------------         ------------         -------------        ------------
Basic income (loss) per common share
   computation:
   Numerator:
Net income (loss) available to common
stockholders used for basic income                      $    303,074         $ (1,820,992)        $   2,104,411        $ (5,188,878)
                                                        ============         ============         =============        ============
  Denominator:
Weighted average shares used for basic
  income (loss) per common share                           1,461,192              996,749             1,184,572             966,610
                                                        ============         ============         =============        ============

   Basic income (loss) per common share                 $       0.21         $      (1.83)        $        1.78        $      (5.37)
                                                        ============         ============         =============        ============


 Diluted income (loss) per common share
   Computation:
   Numerator:
 Net income (loss) used for basic income
   (loss) per common share                              $    303,074         $ (1,820,992)        $   2,104,411        $ (5,188,878)
 Dividend on convertible preferred                           203,999                  ---               549,075                 ---
                                                        ------------         ------------         -------------        ------------
 Net income (loss) used for diluted income
   (loss) per common share                              $    507,073         $ (1,820,992)        $   2,653,486        $ (5,188,878)
                                                        ============         ============         =============        ============
   Denominator:
 Weighted average shares used for basic
   income (loss) per common share                          1,461,192              996,749             1,184,572             966,610
 Effect of dilutive securities:
 Conversion of convertible preferred stock                 7,707,998                  ---             6,868,939                 ---
 Weighted average shares used for diluted
   income (loss) per common share                          9,169,190              996,749             8,053,511             966,610
                                                        ============         ============         =============        ============

 Diluted income (loss) per common share                 $       0.06            $   (1.83)        $        0.33        $      (5.37)
                                                        ------------         ------------         -------------        ------------
</TABLE>


         Potential common shares are not included in the per share  calculations
         for diluted loss per share where the effect of their inclusion would be
         anti-dilutive. Anti-dilutive potential shares not included in per share
         calculations  for the three and nine months  ended  September  30, 2005
         were 233,011 and 198,603, respectively. Dilutive shares not included in
         the  income  per share  calculation  for both the three and nine  month
         periods ended September 30, 2006 were 9,716,289.  These shares were not
         included as the closing  average price of the  Company's  common shares
         for the three and nine months  ended  September  30, 2006 was below the
         exercise price of the warrants and stock options.
                                       11
<PAGE>

(5)      STOCKHOLDER'S EQUITY

         AUTHORIZED  CAPITAL  STOCK  -  Authorized  capital  stock  consists  of
         100,000,000  shares of $.01 par value common  stock of which  2,116,456
         shares  are issued  (2,115,927  are  outstanding)  and  17,499,289  are
         reserved  for  issuance  upon  exercise  of common  stock  options  and
         warrants and  conversion of Series C Cumulative  Convertible  Preferred
         Stock  at  September  30,  2006.   Authorized  preferred  stock  totals
         6,000,000 shares, of which 500,000 shares have been designated Series A
         Preferred Stock, 600,000 shares have been designated Series B Preferred
         Stock  and  1,500  shares  have  been  designated  Series C  Cumulative
         Convertible   Preferred  Stock  (809  shares  of  Series  C  Cumulative
         Convertible  Preferred  Stock were  outstanding at September 30, 2006).
         The Series C Cumulative  Convertible  Preferred Stock has a liquidation
         value of $10,000 per share, is entitled to a dividend of 10% per annum,
         payable  in cash or shares of our  common  stock at our  option,  which
         dividend  rate is subject to  increase  to 14% upon the  occurrence  of
         certain events. The Series C Cumulative  Convertible Preferred Stock is
         redeemable  at the holder's  election in the event the Company fails or
         refuses  to  convert  any  shares  of Series C  Cumulative  Convertible
         Preferred  Stock in  accordance  with the terms of the  Certificate  of
         Designation,   Rights  and  Preferences  of  the  Series  C  Cumulative
         Convertible  Preferred Stock. The number of shares of common stock into
         which each share of Series C Cumulative  Convertible Preferred Stock is
         convertible is determined by dividing the  liquidation  value per share
         plus all accrued and unpaid dividends thereon by $1.05.

         During 1998, the Company's Board of Directors authorized the repurchase
         of up to 23,809  shares of common  stock at market  price.  The Company
         repurchased  no shares in 2004,  2005 and 2006.  At September 30, 2006,
         529  repurchased  shares  remain  available  for  future use and 16,180
         shares are available to be repurchased.

         STOCK SALES - In September  2003,  the Company  sold 108,420  shares of
         common stock and warrants to purchase  21,684 shares of common stock to
         primarily  institutional  investors.  Gross  proceeds  were  $3,246,000
         ($2,971,505  net of  issuance  costs) and were  allocated  between  the
         common stock and the warrants  based on the relative  fair value of the
         warrants  and common  stock.  In March 2004,  the Company  sold 128,619
         shares of common stock and warrants to purchase 25,723 shares of common
         stock  to  primarily  institutional  investors.   Gross  proceeds  were
         $7,292,700  ($6,681,274  net of  issuance  costs)  and  were  allocated
         between the common  stock and the warrants  based on the relative  fair
         value of the warrants and common stock. In April 2005, the Company sold
         approximately  65,040  shares of common  stock and warrants to purchase
         32,520 shares of common stock to institutional investors and to certain
         executive  officers and directors of the Company.  Gross  proceeds were
         $815,000  ($601,342  net of cash  issuance  costs)  and were  allocated
         between the common  stock and the warrants  based on the relative  fair
         value of the warrants and common stock.  In December  2005, the Company
         sold 250 shares of Series C Cumulative  Convertible Preferred Stock and
         warrants to purchase  2,380,951 shares of common stock to institutional
         investors.  Gross  proceeds  were  $2,500,000  ($2,125,943  net of cash
         issuance  costs) and were  allocated  between  the Series C  Cumulative
         Convertible Preferred Stock and the warrants based on the fair value of
         the warrants. In February 2006, the Company sold 575.5 shares of Series
         C Cumulative Convertible Preferred
                                       12
<PAGE>

         Stock and  warrants to  purchase  5,480,961  shares of common  stock to
         institutional investors. Gross proceeds were $5,755,000 ($5,186,908 net
         of cash  issuance  costs)  and  were  allocated  between  the  Series C
         Cumulative  Convertible  Preferred  Stock and the warrants based on the
         fair value of the warrants.

         WARRANTS - On February 13, 2006, the Company closed a private placement
         in which institutional investors received six-year warrants to purchase
         5,480,961  shares of the Company's common stock at an exercise price of
         $1.26 per share. As of September 30, 2006, none of these $1.26 investor
         warrants had been  exercised.  The placement  agent in the  transaction
         received a warrant to purchase  approximately  548,095 shares of common
         stock at a  purchase  price of $1.05 for a period of six  years.  As of
         September 30, 2006,  none of these $1.05  placement  agent warrants had
         been  exercised.  On December  23, 2005,  the Company  closed a private
         placement  in  which  institutional   investors  received  warrants  to
         purchase 2,380,951 shares of common stock at an exercise price of $1.26
         per share for a period of six years.  As of September 30, 2006, none of
         these $1.26 investor warrants had been exercised.  The designees of the
         placement  agent in this  transaction  received  warrants  to  purchase
         approximately  238,095  shares of common  stock at a purchase  price of
         $1.05 for a period of five years. As of September 30, 2006, none of the
         $1.05 placement  agent warrants had been exercised.  In accordance with
         EITF 00-19,  "Accounting for Derivative  Financial  Instruments Indexed
         to, and  Potentially  Settled in, a Company's  Own Stock," the investor
         warrants  are  included as a liability  and valued at fair market value
         each  reporting  period,  with the  changes in fair value  recorded  in
         earnings,  until the Company  meets the  criteria  under EITF 00-19 for
         permanent equity.  The Company valued the investor warrants at $554,397
         on September 30, 2006 using the Black-Scholes method with the following
         assumptions:  a risk-free  interest rate of 4.82%,  volatility of 100%,
         and a dividend yield of 0%.

         On April 19,  2005,  the Company  closed a private  placement  in which
         institutional investors and certain executive officers and directors of
         the Company received warrants to purchase  approximately  32,520 shares
         of common stock for a period of five years.  The exercise  price of the
         warrants is $14.70 per share for the institutional investors and $21.84
         for the participating executive officers and directors. As of September
         30,  2006,  approximately  6,012 of the $14.70  warrants  issued to the
         institutional  investors  had been  exercised  and  none of the  $21.84
         warrants issued to participating  executive  officers and directors had
         been  exercised.  The placement  agent in this  transaction  received a
         warrant to purchase  approximately  1,190  shares of common  stock at a
         purchase  price of $14.70 for a period of five years.  As of  September
         30, 2006, none of the $14.70 warrants issued to the placement agent had
         been exercised.

         During  2004,  the  Company  conducted  a  private  placement  in which
         primarily  institutional  investors  received  warrants  to purchase an
         aggregate  of  25,723  shares of common  stock at a  purchase  price of
         $87.78 per share for a period of five years.  As of September 30, 2006,
         none of the $87.78 warrants had been exercised.

         During  2003,  the  Company  conducted  a  private  placement  in which
         primarily  institutional  investors  received  warrants  to purchase an
         aggregate  of  21,684  shares of common  stock at a  purchase  price of
         $49.266 per share for a period of
                                       13
<PAGE>

         three years.  As of September 30, 2006,  9,011 of the $49.266  warrants
         issued to the institutional investors had been exercised. The placement
         agent in this  transaction  received a warrant to purchase 3,571 shares
         of common  stock at a purchase  price of $49.266  for a period of three
         years. As of September 30, 2006, none of the $49.266 warrants issued to
         the placement agent had been exercised.

         STOCK OPTION PLANS - The Company has two stock option  plans,  the 1994
         Equity Incentive Plan (1994 Plan) and the 2001 Incentive Plan (the 2001
         Plan).

         Under the terms of the 1994 Plan,  the Company may no longer  award any
         options.  All  options  previously  granted  under the 1994 Plan may be
         exercised  at any time up to ten years  from the date of award.  During
         the three and nine-month  periods ended  September 30, 2006, no options
         were  granted or  exercised  under the 1994 Plan.  During the three and
         nine-month  periods ended September 30, 2006, 6,214 and 23,756 options,
         respectively, were cancelled under the 1994 Plan.

         Under the terms of the 2001  Plan,  the  Company  may grant  options to
         purchase up to a maximum of 1,373,809 shares of common stock to certain
         employees,  directors and consultants.  During the three and nine month
         periods ended  September 30, 2006, no options were granted,  no options
         were exercised and 15,128 options were cancelled under the 2001 Plan.

         STOCK AND STOCK  OPTION  ISSUANCES  OUTSIDE  THE STOCK  OPTION  PLANS -
         During the three  months  ended  September  30,  2006,  no options were
         granted  outside the Stock Option  Plans.  During the nine months ended
         September 30, 2006,  options to purchase an aggregate of 945,000 shares
         of common stock were granted to executive officers and directors of the
         Company.  One third of the options  vested on the date of grant and the
         remaining options vest over a two year period with an exercise price of
         $1.62.

         During the nine months  ended  September  30,  2006,  75,000  shares of
         restricted  stock were  granted to Robert J.  DeLuccia,  the  Company's
         Chief  Executive  Officer.  The restricted  stock vests if and when the
         Company's  common  stock  trades at or above $4.00 per share for thirty
         consecutive trading days.

(6)      COMPREHENSIVE LOSS

         Comprehensive  loss is  equal  to the  Company's  net loss for the nine
         months ended September 30, 2006 and 2005.

(7)      COSTS ASSOCIATED WITH STAFF REDUCTION AND TRANSITION AGREEMENTS

         As reported on September 7, 2005, the Company terminated  substantially
         all  its  non-management  personnel  on  August  31,  2005.  The  costs
         associated  with  this  staff  reduction  and  related   expenses  were
         approximately $166,839.

         As reported on September 16, 2005, the Company  entered into transition
         agreements   with  its  executive   officers  in  September  2005.  The
         transition  agreements terminated the existing employment and severance
         agreements  between  the Company  and each  executive.  Pursuant to the
         terms of the transition
                                       14
<PAGE>

         agreements,  the executives  agreed that they would remain  employed by
         the Company until  November 30, 2005. The costs  associated  with these
         transition  agreements were  approximately  $584,438.  These agreements
         also  provide  for  aggregate  payments  of  approximately  $75,000  on
         November 30, 2005. There are no further payments due as a result of the
         staff reduction or under the transition agreements. As disclosed in our
         Annual  Report on Form 10-K for the period ended  December 31, 2005, we
         entered into employment  agreements of indefinite length with our three
         remaining executive officers on February 13, 2006.

(8)      RECENT ACCOUNTING PRONOUNCEMENTS

         In June 2006, the Financial  Accounting Standards Board ("FASB") issued
         Interpretation  No.  48  ("FIN  48"),  "Accounting  for  Uncertain  Tax
         Positions,  an  Interpretation  of Statement  of  Financial  Accounting
         Standards  ("SFAS")  No.  109".  FIN 48 clarifies  the  accounting  for
         uncertain tax  positions  that are more likely than not to be sustained
         upon examination by a relevant taxing authority. This interpretation is
         effective  for fiscal years  beginning  after  December  15, 2006.  The
         adoption  of the  requirements  of FIN 48 is  not  expected  to  have a
         material  impact  on the  Company's  financial  condition,  results  of
         operations, or cash flows.

         In September 2006, the FASB issued SFAS 157, "Fair Value Measurements."
         This standard defines fair value, establishes a framework for measuring
         fair value in accounting  principles  generally  accepted in the United
         States ("GAAP"), and expands disclosures about fair value measurements.
         This standard is effective for financial  statements  issued for fiscal
         years  beginning  after  November  15,  2007.  Management  is currently
         evaluating the  requirements of SFAS 157 and has not yet determined the
         impact on the Company's financial  condition,  results of operations or
         cash flows.


                                       15
<PAGE>


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

NOTE REGARDING FORWARD LOOKING STATEMENTS

     This report and the documents  incorporated in this report by reference may
contain  "forward-looking  statements"  within the meaning of Section 21E of the
Securities  Exchange  Act of  1934,  as  amended  (the  "Exchange  Act").  These
statements may be identified by the use of forward-looking words or phrases such
as "anticipate,"  "believe," "could," "expect," "intend," "look forward," "may,"
"planned,"  "potential,"  "should,"  "will," and "would." These  forward-looking
statements  reflect  our  current  expectations  and are  based  upon  currently
available data. The Private Securities  Litigation Reform Act of 1995 provides a
"safe harbor" for such forward-looking  statements.  In order to comply with the
terms of the safe harbor,  we note that a variety of factors  could cause actual
results and  experience to differ  materially  from the  anticipated  results or
other expectations  expressed in the forward-looking  statements.  These factors
include,  but are not limited to: our history of operating losses,  our decision
to discontinue  research and development  activities and our need for additional
external  financing;  our need for significant  additional  product  development
efforts  and  additional  financing;   technological   uncertainty  relating  to
transdermal  drug  delivery  systems;  the  early  stage of  development  of our
proposed  products;  the  lack of  success  of our  prior  development  efforts;
uncertainties related to clinical trials of our proposed products; uncertainties
relating to government  regulation and regulatory  approvals;  our dependence on
third parties for the FDA application  process;  uncertainties  regarding market
acceptance  of our product  candidates;  uncertainties  regarding  the potential
health  risks of hormone  replacement  therapies;  our ability to  identify  and
obtain  rights to products or  technologies  in order to build our  portfolio of
product candidates; our ability to recruit additional key employees; our limited
personnel  and our  dependence  on continued  access to  scientific  talent;  no
assurance of our  entering  into license  arrangements;  our lack of  laboratory
facilities and scientific personnel and uncertainties  regarding our reliance on
third  parties  to  conduct   research  and   development   activities  for  our
technologies  and product  candidates;  uncertainties  relating to  competition,
patents and proprietary  technology;  our dependence on third parties to conduct
research and development activities; our dependence on third-party suppliers and
manufacturers; uncertainties relating to risks of product liability claims, lack
of product liability insurance, and expense and difficulty of obtaining adequate
insurance coverage;  our majority  shareholders,  who own a large portion of our
voting stock, could control company decisions and could  substantially lower the
market price of our common stock if they were to sell large blocks of our common
stock in the future;  uncertainty of pharmaceutical pricing and related matters;
volatility of our stock price; the effect that our quotation on the OTC Bulletin
Board will have on the liquidity of our common stock; and dilution of our shares
as a result  of our  contractual  obligation  to  issue  shares  in the  future.
Additional  information  on these and  other  factors  which  could  affect  the
Company's  actual results and  experience  are included in the Company's  Annual
Report on Form 10-K for the year ended December 31, 2005 and, in particular, the
section entitled "Risk Factors".

     These or other events or circumstances  could cause our actual  performance
or financial results in future periods to differ materially from those expressed
in the  forward-looking  statements.  We  undertake  no  obligation  to make any
revisions  to the  forward-looking  statements  contained  in this report or the
documents   incorporated  by  reference  in  this  report,   or  to  update  the
forward-looking  statements to reflect events or  circumstances  occurring after
the date of this report.
                                       16
<PAGE>

GENERAL

     On December 30, 2005 we  implemented  a 1-for-7  reverse stock split of our
common stock and on February 9, 2006 we implemented a subsequent 1-for-6 reverse
stock split of our common stock.  Unless otherwise  noted,  data used throughout
this  Quarterly  Report on Form 10-Q has been  adjusted to reflect these reverse
splits.

     We are a  specialty  pharmaceutical  company  that  develops  and  seeks to
commercialize  pharmaceutical  products.  Currently,  our  portfolio  of product
candidates  is based on our  proprietary  drug delivery  technologies:  SEPA(R),
MacroDerm(TM)  and  DermaPass(TM).  Our  patented  SEPA  topical  drug  delivery
technology   (SEPA  is  an  acronym  for  "Soft   Enhancement  of   Percutaneous
Absorption,"  where "soft" refers to the  reversibility of the skin effect,  and
"percutaneous"  means  "through the skin")  enhances the  efficiency and rate of
diffusion  of drugs into and  through  the skin.  Our  patented  MacroDerm  drug
delivery  technology  encompasses a family of low to moderate  molecular  weight
polymers that impede dermal drug or chemical  penetration.  We have also filed a
patent application for our DermaPass family of transdermal  absorption enhancers
that have a different drug delivery profile than SEPA, which we believe could be
used with a wider range of active pharmaceutical ingredients. Currently, we have
two clinical stage investigational new drugs: EcoNail, our lead product, for the
treatment of fungal  infections of the nails and Opterone,  for the treatment of
male  hypogonadism.  We believe that  products  incorporating  our drug delivery
technologies  may allow selected drugs to be administered  more  effectively and
with  improved  patient  compliance  compared  to  alternative  methods  of drug
administration, such as ingestion and injection.

     Since   inception,   we  have  been  engaged   primarily  in  research  and
development.  We have not generated any meaningful  revenues from operations and
we have  sustained  significant  operating  losses.  We anticipate  that we will
continue to incur  significant  operating losses for the foreseeable  future. We
cannot guarantee that we will be successful in commercializing our products,  or
that we will  ever  become  profitable.  As of  September  30,  2006,  we had an
accumulated  deficit of $80,468,686.  Our product candidates are in discovery or
developmental  stages and must undergo a rigorous  regulatory  approval process,
which  includes  costly and  extensive  pre-clinical  and clinical  testing,  to
demonstrate safety and efficacy before we can market any resulting  product.  To
date, neither the FDA nor any of its international  equivalents has approved any
of our product candidates for marketing.

     Our results of operations  can vary  significantly  from  year-to-year  and
quarter-to-quarter, and depend, among other factors, on:

        o  the progress of clinical trials we conduct;

        o  the degree of our research, marketing and administrative efforts;

        o  our ability to raise additional capital; and

        o  the signing of licenses and product development agreements.
                                       17
<PAGE>

     The  timing of our  revenues  may not match  the  timing of our  associated
product  development  expenses.  To date, our research and development  expenses
generally have exceeded our revenues in any particular period or fiscal year.

     We expect to  continue  to spend  significant  amounts  on  developing  and
seeking  regulatory  approval of our lead product,  EcoNail.  Ultimately,  if we
receive regulatory approval for EcoNail, significant expenses may be incurred in
connection with its commercialization. In addition, we also plan to identify and
develop,  internally,  through  in-licensing,  or  through  other  collaborative
arrangements, additional product candidates and technologies that fit within our
growth strategy.  If we identify  potential  product  candidates,  we will incur
additional costs in connection with testing and seeking  regulatory  approval of
those product candidates.

     We  believe  that our  existing  cash and cash  equivalents  and short term
investments  of  $5,739,837  as of September 30, 2006 will be sufficient to meet
our operating  expenses and capital  expenditure  requirements under our current
operating plan for at least the next twelve months.

         Research and Development Expenses.  Research and development expenses
         consist of:

        o  payments to consultants, investigators, contract research
           organizations and manufacturers in connection with our pre-clinical
           and clinical trials;

        o  costs associated with conducting our clinical trials;

        o  costs of developing and obtaining regulatory approvals;

        o  salaries and expenses for our research and development personnel; and

        o  allocable costs, including occupancy and depreciation.

     Because a portion  of our  research  and  development  expenses  (including
employee payroll and related benefits,  laboratory  supplies,  travel,  dues and
subscriptions,  temporary help costs,  consulting costs and allocable costs such
as occupancy and  depreciation)  benefit multiple  projects or our drug delivery
technologies  in general,  we do not track these expenses by project.  On August
31, 2005, we discontinued all research and development activities and terminated
substantially  all of  our  non-management  personnel.  We  resumed  development
activities  in the first  quarter  of 2006.  For the  three-month  period  ended
September 30, 2006,  we spent  $332,295 on research and  development,  including
$271,504 in costs  associated  with a clinical  trial for EcoNail and $60,791 in
costs  not  specifically  tracked  to a  project.  For the  three  months  ended
September 30, 2005, we spent $380,881 on research and development,  all of which
was not specifically  tracked to a particular project. For the nine-month period
ended  September  30,  2006,  we spent  $488,520  on research  and  development,
including  $419,351 in costs  associated  with a clinical  trial for EcoNail and
$69,169 in costs not  specifically  tracked to a  project.  For the nine  months
ended  September  30, 2005,  we spent  $2,149,949  on research and  development,
including  $22,965 and $111,739 in costs associated with our clinical trials for
EcoNail and Opterone,  respectively,  and  $2,015,245 in costs not  specifically
tracked to a particular project.
                                       18
<PAGE>

     Each of our  research  and  development  programs  is  subject to risks and
uncertainties,  including the requirement to seek regulatory approval,  that are
outside of our control.  Moreover,  the product  candidates  identified in these
research and development programs,  which currently are in developmental stages,
must overcome significant technological,  manufacturing and marketing challenges
before they can be successfully  commercialized.  As a result of these risks and
uncertainties,  we are unable to predict with any  certainty the period in which
material net cash inflows from these  projects  could be expected to commence or
the completion date of these programs.  For example, we are seeking a partner to
advance development of our Opterone product candidate. We cannot predict whether
our efforts to find a partner will be  successful  nor can we predict the manner
and timing in which any  eventual  partner  may elect to pursue  development  of
Opterone.  Moreover,  we may elect not to develop  Opterone further if we cannot
find a partner. In addition,  these risks and uncertainties also prevent us from
estimating  with any  certainty  the  specific  timing and  future  costs of our
clinical development programs,  although historical trends at similarly situated
companies  indicate that research and  development  expenses tend to increase in
later  stages  of  clinical   development.   Our  failure  to  obtain  requisite
governmental approvals timely or at all will delay or preclude us from licensing
or marketing our products or limit the  commercial  use of our  products,  which
could  adversely  affect  our  business,  financial  condition  and  results  of
operations.

     MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES.  Marketing,  general and
administrative  expenses  consist  primarily of salaries and other related costs
for personnel, marketing and promotion,  professional fees and facilities costs.
Assuming we are able to raise sufficient  capital, we anticipate that marketing,
general and administrative expenses will increase over the next several years as
we  begin,  when  appropriate,  to  license,  partner,  or  market  our  product
candidates if and when they receive regulatory approval.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our  discussion  and  analysis of our  financial  condition  and results of
operations  are based on our financial  statements,  which have been prepared in
accordance with accounting principles generally accepted in the United States of
America.  The  preparation  of these  financial  statements  requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses.  Note 1 to our financial  statements  included within our
Annual  Report on Form 10-K for the year ended  December  31,  2005,  includes a
summary  of  the  significant  accounting  policies  and  methods  we use in the
preparation of our financial statements.  The following is a brief discussion of
the more significant  accounting  policies and methods that affect the judgments
and estimates used in the preparation of our financial statements.

     PATENT ASSETS.  We defer costs and expenses  incurred in  connection  with
pending  patent  applications.  We amortize  costs related to successful  patent
applications   over  the  estimated  useful  lives  of  the  patents  using  the
straight-line  method.  We charge  accumulated  patent costs and deferred patent
application  costs related to patents that are considered to have limited future
value to operations.  Estimates we use to determine the future value of deferred
patent  costs  include  analysis  of  potential  market  size,  time and cost to
complete  clinical  trials,  anticipated  interest in our products and potential
value for licensing or partnering  opportunities.  We recognize revenues derived
or expected to be derived from the sale,  assignment,  transfer, or licensing of
patents or other  intellectual  property  based  upon the terms of the  relevant
agreement.
                                       19
<PAGE>

     RESEARCH AND DEVELOPMENT.  Research and development  costs are expensed as
incurred.

     WARRANTS AND  LIABILITY.  Based on certain  terms in the  warrants  that we
issued  in  connection  with the sale of our  Series  C  Cumulative  Convertible
Preferred  Stock,  we  determined  that the warrants  should be  classified as a
liability  and valued at fair  market  value  each  reporting  period,  with the
changes in fair value  recorded  in  earnings,  in  accordance  with EITF 00-19,
"Accounting  for Derivative  Financial  Investments  Indexed to, and Potentially
Settled in, a Company's  Own Stock." We will  continue to evaluate  the warrants
under EITF 00-19 to determine  when, if ever,  they meet certain  criteria under
EITF 00-19 for permanent equity.

RESULTS OF OPERATIONS

     We had no  revenues  for the  three-month  and  nine-month  periods  ending
September  30, 2006 and  September  30, 2005.  For the year ending  December 31,
2006, we do not expect to have any revenues.

     For  the  three-month  period  ended  September  30,  2006,   research  and
development  costs decreased by $48,586,  or 12.8%, to $332,295 from $380,881 in
the  three-month  period ended  September  30,  2005.  The decrease is primarily
attributable to the temporary  cessation of research and development  activities
in August  2005,  resulting  in a reduction  in payroll and related  expenses of
$207,468 and a reduction  in  laboratory  operating  expenses of $170,818 in the
three-month  period  ended  September  30,  2006.  The decrease was offset by an
increase in spending of $332,295 on clinical  trials for the three month  period
ending  September 30, 2006. For the nine-month  period ended September 30, 2006,
research and development  costs  decreased by $1,661,429,  or 77.3%, to $488,520
from $2,149,949 in the nine-month  period ended September 30, 2005. The decrease
is primarily attributable to the temporary cessation of research and development
activities  in August  2005,  resulting  in a  reduction  in payroll and related
expenses  of  $684,628  and a  reduction  in  laboratory  operating  expenses of
$580,076 in the nine-month  period ended September 30, 2006 compared to the same
period in 2005.  In  addition,  there was a  reduction  in  spending on clinical
trials of $410,567 in the nine month period ended  September  30, 2006  compared
with the same  period in 2005.  For the next  quarter,  we expect  research  and
development spending to increase  significantly from the level seen in the first
three quarters of 2006 as we continue the ongoing  clinical trial for EcoNail in
the fourth quarter of 2006.

     For the three-month period ended September 30, 2006, marketing, general and
administrative costs increased by $125,374, or 17.8%, to $828,472, from $703,098
in the  three-month  period ended  September 30, 2005. The increase is primarily
attributable  to the Company's  adoption of SFAS No. 123(R),  which requires the
expensing of stock options  granted to employees  based on the fair value on the
date of the grant,  resulting in an expense of $129,894.  In addition,  expenses
relating  to  conferences   and  investor   relations   meetings   increased  by
approximately  $145,255.  The effect of these amounts on marketing,  general and
administrative  expenses for the three-month period ended September 30, 2006 was
partially  offset by a reduction  in legal and audit  expenses of  approximately
$75,775 and patent and search fees by approximately $40,439. In addition,  there
was a savings attributable to a staff reduction in August 2005 which resulted in
a reduction of salary and related expenses of $28,188. For the nine-month period
ended September 30, 2006, marketing,  general and administrative costs increased
                                       20
<PAGE>

by $598,783,  or 25.5%, to $2,946,159,  from $2,347,376 in the nine-month period
ended  September  30,  2005.  The  increase  is  primarily  attributable  to the
Company's  adoption of SFAS No.  123(R),  which  requires the expensing of stock
options  granted to employees  based on the fair value on the date of the grant,
resulting  in  an  expense  of  $804,489.  In  addition,   expenses  related  to
conferences and investor relations meetings increased by approximately $170,061.
The Company also incurred  additional  costs of $14,837  relating to certain SEC
filings and reverse  stock  splits.  The effect of these  amounts on  marketing,
general and  administrative  expenses for the nine-month  period ended September
30, 2006 was partially  offset by savings  attributable  to a staff reduction in
August  2005 which  resulted in a  reduction  of salary and related  expenses of
$280,941 during the nine-month period ended September 30, 2006. In addition,  in
the  nine-month  period  ended  September  30,  2006,  legal and audit  expenses
decreased   by   approximately   $57,495,   insurance   expenses   decreased  by
approximately  $20,156 and patent and search  fees  decreased  by  approximately
$66,277.  For the next quarter, we expect marketing,  general and administrative
spending to approximate the same level as seen in the third quarter of 2006.

     For the three-month period ended September 30, 2006, other income increased
by $1,653,576 to $1,667,840  compared to $14,264 in the three-month period ended
September  30,  2005.  This is  primarily  a non-cash  increase as a result of a
change in the valuation of warrants in accordance  with EITF 00-19,  "Accounting
for Derivative  Financial  Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock" to reflect a decline in price of our common stock for which
the  warrants  are  exercisable.  As a  result,  the fair  value of the  warrant
liability  decreased by $1,597,911.  Interest income for the three-month  period
ended  September 30, 2006  increased by $55,665 to $69,929  compared to interest
income of $14,264 in the  three-month  period  ended  September  30,  2005.  The
increase  in  interest  income is due to higher  amounts of cash  available  for
investing  purposes and higher interest rate returns  available for cash that is
invested.  For the  nine-month  period ended  September  30, 2006,  other income
increased by  $6,040,336  to  $6,100,060  compared to $59,724 in the  nine-month
period ended  September  30, 2005.  The increase is primarily  the result of the
valuation of warrants in accordance with EITF 00-19,  "Accounting for Derivative
Financial  Instruments  Indexed to, and Potentially  Settled in, a Company's Own
Stock."  As a result,  the fair  value of the  warrant  liability  decreased  by
$5,910,979.  Interest income for the nine-month  period ended September 30, 2006
increased by $129,357 to $189,081  compared to interest income of $59,724 in the
nine-month  period ended  September 30, 2005. The increase in interest income is
due to higher  amounts  of cash  available  for  investing  purposes  and higher
interest rate returns available for cash that is invested.

     For the reasons described above, the Company's financial statements reflect
a net income of $507,073 in the  three-month  period  ended  September  30, 2006
compared with a net loss of $1,820,992 in the three-month period ended September
30, 2005.  For the  nine-month  period ended  September 30, 2006,  the Company's
financial statements reflect a net income of $2,665,381 compared with a net loss
of $5,188,878 in the nine-month period ended September 30, 2005.

LIQUIDITY AND CAPITAL RESOURCES

     Since inception,  our primary source of funding for our operations has been
the private  and public sale of our  securities,  and, to a lesser  extent,  the
licensing of our proprietary technology and products,  research  collaborations,
feasibility  studies,  government  grants and the limited  sales of products and
test  materials.  During the first nine months of 2006,  we received no proceeds
                                       21
<PAGE>

from the  exercise of options and  warrants,  and gross  proceeds of  $5,755,000
($5,186,908  net of cash issuance costs) as a result of the sale of our Series C
Cumulative   Convertible  Preferred  Stock  in  a  private  placement  financing
transaction.  During the first nine months of 2005,  we received net proceeds of
$87,500  from the exercise of warrants  and gross  proceeds of $815,000  (before
issuance  costs)  as a result  of the  sale of our  common  stock  in a  private
placement transaction.

     At September  30, 2006,  working  capital was  approximately  $5.5 million,
compared to $1.2  million at  September  30,  2005.  The increase in our working
capital reflects the receipt of private placement proceeds,  partially offset by
the use of funds in  operations  during the year.  On February 13, 2006, we sold
575.5  shares  of our  Series  C  Cumulative  Convertible  Preferred  Stock  for
$5,755,000  in gross  proceeds  ($5,186,908  net of cash  issuance  costs)  in a
private  placement to  institutional  investors.  The  investors  also  received
warrants  to  purchase  5,480,961  shares of the  Company's  common  stock at an
exercise price of $1.26 per share.  Until such time as we obtain agreements with
third-party  licensees  or  partners  to  provide  funding  for our  anticipated
business activities, or otherwise generate revenue from the commercialization of
our products, we will use our working capital to fund our operating activities.

     Pursuant  to a plan  approved  by our Board of  Directors  in 1998,  we are
authorized  to  repurchase  23,809  shares  of our  common  stock  to be held as
treasury shares for future use. During the nine-month period ended September 30,
2006, we did not repurchase  any shares of common stock.  At September 30, 2006,
529 repurchased  shares remain available for future use and 16,180 shares remain
available for repurchase under the plan.

     Capital and patent development expenditures were $40,770 for the first nine
months of 2006.  Capital and patent  development  expenditures were $119,958 for
the nine-month period ended September 30, 2005. We anticipate additional capital
and patent  expenditures will be approximately  $40,000 for the remainder of the
fiscal year ending December 31, 2006.

     On  August  31,  2005,  at the  direction  of our  Board of  Directors,  we
discontinued   all   research  and   development   activities   and   terminated
substantially  all  of  our  non-management   personnel.  We  made  payments  of
approximately  $166,839  in  connection  with this staff  reduction  and related
expenses. In September 2005, the Company entered into transition agreements with
its  executive  officers.  The  transition  agreements  terminated  the existing
employment  and  severance  agreements  between the Company and each  executive.
Pursuant to the terms of the transition  agreements,  the executives agreed that
they would  remain  employed by the  Company  until  November  30,  2005.  Three
executives  executed amendments to their transition  agreements  extending their
employment   through  December  31,  2005  and  beyond.   We  made  payments  of
approximately  $709,646 in connection with all executive transition  agreements.
We also made aggregate  payments of  approximately  $35,000 on November 30, 2005
and $35,000 on December 15, 2005 under a separate  provision  of the  transition
agreements. There are no further payments due as a result of the staff reduction
or under the  transition  agreements.  As disclosed in our Annual Report on Form
10-K for the  period  ended  December  31,  2005,  we  entered  into  employment
agreements of indefinite length with our three remaining  executive  officers on
February 13, 2006.

     As of September 30, 2006, we had $5,739,837 in cash,  cash  equivalents and
short-term  investments.  We believe that our existing cash and cash equivalents
                                       22
<PAGE>

will be  sufficient  to meet our  anticipated  operating  expenses  and  capital
expenditure  requirements under our current operating plan for at least the next
twelve months.  Our cash requirements may vary materially from those now planned
because of changes in the focus and  direction of our  research and  development
programs,  competitive  and technical  advances,  patent  developments  or other
developments.  We will require additional financing to continue operations after
we exhaust our current capital resources and to continue our long-term plans for
clinical trials and new product development. We expect to continue financing our
operations  through  sales  of our  securities,  strategic  alliances  or  other
financing  vehicles,  if any, that might become available to us on terms that we
deem acceptable.

     We do not enter  into  financial  instrument  transactions  for  trading or
speculative  purposes.  We do not intend to establish any special purpose entity
and do not have any material off balance sheet financing transactions. We do not
believe that  inflation will have any  significant  effect on the results of our
operations.

     As described in our current  report on Form 8-K filed on July 25, 2006,  we
entered into a 20-month  sublease of  approximately  4,000 square feet of office
space at, and relocated our principal  executive  offices to, 40 Washington St.,
Suites 220 and 240, Wellesley Hills, Massachusetts,  02481, effective as of June
1, 2006. Our telephone number is (781) 489-7310. At September 30, 2006, with the
exception  of  this   sublease,   the  Company  had  no  long-term   contractual
obligations.

RECENT ACCOUNTING PRONOUNCEMENTS

     In June 2006, the Financial  Accounting  Standards  Board  ("FASB")  issued
Interpretation  No. 48 ("FIN 48"),  "Accounting for Uncertain Tax Positions,  an
Interpretation of Statement of Financial Accounting Standards ("SFAS") No. 109".
FIN 48 clarifies the accounting for uncertain tax positions that are more likely
than not to be sustained upon examination by a relevant taxing  authority.  This
interpretation  is effective for fiscal years beginning after December 15, 2006.
The  adoption of the  requirements  of FIN 48 is not expected to have a material
impact on the Company's  financial  condition,  results of  operations,  or cash
flows.

     In September  2006,  the FASB issued SFAS 157,  "Fair Value  Measurements."
This standard  defines fair value,  establishes  a framework for measuring  fair
value in accounting principles generally accepted in the United States ("GAAP"),
and  expands  disclosures  about  fair  value  measurements.  This  standard  is
effective  for  financial  statements  issued for fiscal years  beginning  after
November 15, 2007.  Management is currently  evaluating the requirements of SFAS
157 and has not yet determined the impact on the Company's financial  condition,
results of operations or cash flows.


                                       23
<PAGE>


Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

     As of September  30, 2006,  we were exposed to market  risks,  which relate
primarily to changes in U.S. interest rates. Our cash equivalents and short-term
investments  are  subject  to  interest  rate risk and will  decline in value if
interest  rates  increase.   Due  to  the  short  duration  of  these  financial
instruments,  generally  one year or less,  changes in interest  rates would not
have a material effect on our financial  position.  A hypothetical 10% change in
interest  rates would not have a material  effect on our Statement of Operations
or Cash Flows for the nine months ending September 30, 2006.

Item 4.  CONTROLS AND PROCEDURES

     As of the end of the  period  covered  by this  report,  we  carried  out a
review,  under the  supervision  and with the  participation  of our management,
including  our Chief  Executive  Officer  and Chief  Financial  Officer,  of the
effectiveness  of our disclosure  controls and procedures (as defined in the SEC
rules promulgated under the Securities Exchange Act of 1934, as amended),  which
are  designed  to  ensure  that  information  required  to be  disclosed  in our
Securities  and Exchange  Commission  reports is properly  and timely  recorded,
processed,  summarized and reported. Based upon that review, our Chief Executive
Officer and Chief Financial Officer concluded that while our disclosure controls
and  procedures  are effective in timely  alerting them to material  information
required to be included in our periodic filings with the Securities and Exchange
Commission,  there is a lack of  segregation of duties at the Company due to the
small number of employees  dealing with  general  administrative  and  financial
matters.  This  constitutes  a significant  deficiency  in financial  reporting.
However,  at this time  management has decided that,  considering  the employees
involved and the control  procedures in place,  the risks  associated  with such
lack of  segregation  are  insignificant,  and the potential  benefits of adding
additional  employees  to clearly  segregate  duties do not justify the expenses
associated  with such  increases.  Management  will  continue to  evaluate  this
segregation of duties.

     There were no changes in our internal control over financial reporting that
occurred  during the  quarter  ended  September  30,  2006 that have  materially
affected,  or are reasonably likely to materially  affect,  our internal control
over financial reporting.

                                       24
<PAGE>


PART II - OTHER INFORMATION

Item 1A.      RISK FACTORS.

The following  updates and supplements  the risk factors  included in Item 1A of
Part I of our Annual  Report on Form 10-K for the year ended  December 31, 2005.
Other than as set forth below,  there have been no material  changes to the risk
factors  included in Item 1A of Part I of our Annual Report on Form 10-K for the
year ended December 31, 2005.

WE HAVE A HISTORY OF  OPERATING  LOSSES,  EXPECT TO CONTINUE TO INCUR LOSSES AND
RELY  EXTENSIVELY  ON EXTERNAL  FINANCING TO MAINTAIN OUR  OPERATIONS. IF WE ARE
UNABLE TO OBTAIN  EXTERNAL  FINANCING,  WE WOULD BE REQUIRED  TO FURTHER  LIMIT,
SCALE BACK OR CEASE OUR OPERATIONS ENTIRELY.

     Since 1981, we have been engaged  primarily in research and development and
have derived limited revenues from feasibility  studies and the licensing of our
technology.  We have not  generated  any material  revenues from the sale of any
products.  In  addition,  we have  incurred net losses every year since we began
doing  business  and we  anticipate  that we will  continue to incur losses from
operations  for the  foreseeable  future.  As of December  31,  2005,  we had an
accumulated  deficit of  approximately  $82,584,992.  For the fiscal years ended
December 31, 2003,  2004 and 2005, we had a net loss of $5,661,694,  $8,274,521,
and $5,760,475, respectively.

     On August 31,  2005,  due to our  financial  condition  at the time and our
inability to raise sufficient  capital to maintain  operations,  we discontinued
all research and development activities and terminated  substantially all of our
non-management  personnel.  In December  2005 and  February  2006,  we raised an
aggregate  of  $8.25  million  in a  private  placement  of  our  securities  to
institutional investors. As a result of this private placement, we have begun to
resume  operations  with a focus on advancing  clinical  development of our lead
product,  EcoNail.  Our ability to continue operations after our current capital
resources are exhausted  depends on our ability to secure  additional  financing
and to become profitable, which we cannot guarantee.

     Before we or any of our  potential  licensees may market any of our product
candidates,  significant  additional development efforts and substantial testing
will be  necessary.  We will require  substantial  additional  financing to fund
clinical  studies  on our  product  candidates.  We may not be  able  to  secure
financing  on  favorable  terms or at all.  If we are unable to obtain  external
financing, we would have to reduce, delay or eliminate our clinical studies.

WE ARE  CONTRACTUALLY  OBLIGATED  TO ISSUE SHARES IN THE FUTURE,  DILUTING  YOUR
INTEREST IN US.

     As of March 7, 2006, our Series C Cumulative Convertible Preferred Stock is
convertible  into an aggregate  of, giving  effect to the  beneficial  ownership
restrictions on conversion,  4,057,882 shares of common stock (7,861,900  shares
of common stock  without  regard to the  beneficial  ownership  restrictions  on
conversion).  In addition,  we are required to issue quarterly  dividends on our
Series C  Cumulative  Convertible  Preferred  Stock which we may elect to pay in
shares  of our  common  stock.  In  addition,  as of March 7,  2006,  there  are
outstanding and exercisable warrants to purchase approximately  8,725,270 shares
of our common stock, at a weighted average exercise price of $1.89 per share. As
of March 7, 2006, there also are outstanding and exercisable options to purchase
approximately 430,264 shares of our common stock, at a weighted average exercise
                                       25
<PAGE>

price of $34.06 per share.  Moreover,  we expect to issue additional  options to
purchase  shares of our common stock to compensate  employees,  consultants  and
directors  and may issue  additional  shares  to raise  capital,  acquire  other
companies or technologies, to pay for services, or for other corporate purposes.
Any such issuances will have the effect of further  diluting the interest of our
common stockholders.

                                       26
<PAGE>


PART II - OTHER INFORMATION

Item 6.       EXHIBITS.

The following is a list of exhibits to this Quarterly Report on Form 10-Q:

3.1  Amended  and  Restated   Certificate  of  Incorporation,   incorporated  by
     reference to Exhibit 3.1 to the  Company's  Annual  Report on Form 10-K for
     the year ended December 31, 2005 (File No. 0-13634).

3.2  Amended and Restated  By-Laws of the Company,  incorporated by reference to
     Exhibit 5 to the Company's Current Report on Form 8-K dated August 13, 1999
     (File No. 0-13634).

31.1 Certification of Principal Executive Officer Pursuant to Section 302 of the
     Sarbanes-Oxley Act of 2002.

31.2 Certification of Principal Financial Officer Pursuant to Section 302 of the
     Sarbanes-Oxley Act of 2002.

32.1 Certification  of Principal  Executive  Officer  Pursuant to Section  1350,
     Chapter 63 of Title 18, United States Code, as Adopted  Pursuant to Section
     906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification  of Principal  Financial  Officer  Pursuant to Section  1350,
     Chapter 63 of Title 18, United States Code, as Adopted  Pursuant to Section
     906 of the Sarbanes-Oxley Act of 2002.

                                       27
<PAGE>


                                   SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the  Registrant  has duly  caused  this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                           MacroChem Corporation
                           (Registrant)



November 14, 2006          /s/  Robert J. DeLuccia
                           Robert J. DeLuccia
                           President and Chief Executive Officer
                           (Principal Executive Officer)

                           /s/  Bernard R. Patriacca
                           Bernard R. Patriacca
                           Vice President, Chief Financial Officer and Treasurer
                           (Principal Financial Officer)

                                       28
<PAGE>


                                  EXHIBIT INDEX


The following is a list of exhibits to this Quarterly Report on Form 10-Q:

3.1    Amended  and  Restated  Certificate  of  Incorporation,  incorporated  by
       reference to Exhibit 3.1 to the Company's  Annual Report on Form 10-K for
       the year ended December 31, 2005 (File No. 0-13634).

3.2    Amended and Restated By-Laws of the Company, incorporated by reference to
       Exhibit 5 to the  Company's  Current  Report on Form 8-K dated August 13,
       1999 (File No. 0-13634).

31.1   Certification of Principal  Executive  Officer Pursuant to Section 302 of
       the Sarbanes-Oxley Act of 2002.

31.2   Certification of Principal  Financial  Officer Pursuant to Section 302 of
       the Sarbanes-Oxley Act of 2002.

32.1   Certification  of Principal  Executive  Officer Pursuant to Section 1350,
       Chapter  63 of Title 18,  United  States  Code,  as Adopted  Pursuant  to
       Section 906 of the Sarbanes-Oxley Act of 2002.

32.2   Certification  of Principal  Financial  Officer Pursuant to Section 1350,
       Chapter  63 of Title 18,  United  States  Code,  as Adopted  Pursuant  to
       Section 906 of the Sarbanes-Oxley Act of 2002.

                                       29