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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-Q**(Mark One)   þ **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934****FOR QUARTERLY PERIOD ENDED September 30, 2006****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934****Commission File Number: 0-20117****ENCYSIVE PHARMACEUTICALS INC.**(Exact name of registrant as specified in its charter)   Delaware 13-3532643 (State or other jurisdiction of (I.R.S. Employer Identification No.)incorporation or organization)     4848 Loop Central Drive, Suite 700, Houston, Texas 77081 (Address of principal executive office) (Zip code)(713) 796-8822(Registrant’s telephone number, including area code)Not Applicable(Former name, former address and former fiscal year, if changed since last report)Indicate by check mark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No o     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” inRule 12b-2 of the Exchange Act. (Check One):Large accelerated filero   Accelerated filer þ   Non-accelerated filer oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o No þIndicate the number of shares outstanding of each of the issuer’s classes of Common Stock,exclusive of treasury shares, as of the latest practicable date.   Class Outstanding at October 31, 2006   Common stock, $0.005 par value **59,334,263**  
 

 
**ENCYSIVE PHARMACEUTICALS INC.****TABLE OF CONTENTS**     PAGE NO.Part I. Financial Information     Item 1: Financial Statements (Unaudited)     Consolidated Balance Sheets as of September 30, 2006, and December 31, 2005 1   Consolidated Statements of Operations and Comprehensive Loss for thethree and nine months ended September 30, 2006 and 2005 2   Consolidated Statements of Cash Flows for the nine months endedSeptember 30, 2006 and 2005 3   Notes to Consolidated Financial Statements 4   Item 2: Management’s Discussion and Analysis OfFinancial Condition and Results of Operations 14   Item 3: Quantitative and Qualitative DisclosuresAbout Market Risk 25   Item 4: Controls and Procedures 25   Part II. Other Information     Item 1: Legal Proceedings 25   Item 1A: Risk Factors 26   Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 29   Item 3: Defaults Upon Senior Securities 29   Item 4: Submission of Matters to a Vote of Security Holders 30   Item 5: Other Information 30   Item 6: Exhibits 30   SIGNATURES 31 Certification of CEO Pursuant to Rule 13a-14(a) Certification of CFO Pursuant to Rule 13a-14(a) Certification of CEO Pursuant to Section 1350 Certification of CFO Pursuant to Section 1350
 

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**ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES****CONSOLIDATED BALANCE SHEETS****($ in thousands, except per share data)****(Unaudited)**           September 30,  December 31,   2006  2005 ASSETS        Current assets:        Cash and cash equivalents $49,928  $127,913 Accounts receivable  6,051   5,337 Other current receivables  35   139 Inventory, net  2,400   2,183 Prepaids  1,038   1,677        Total current assets  59,452   137,249 Equipment and leasehold improvements, net  6,000   4,942 Deferred debt origination costs, net ofaccumulated amortization of $1,035 and $538  3,628   4,125 Intangible assets, net of accumulatedamortization of $659 and $580  307   386        Total assets $69,387  $146,702                 LIABILITIES AND STOCKHOLDERS DEFICIT        Current liabilities:        Accounts payable $2,529  $3,218 Accrued expenses  22,967   21,645 Deferred revenue  1,288   1,288        Total current liabilities  26,784   26,151 Deferred revenue  320   1,286 Long-term debt  130,000   130,000          Commitments and contingencies  —   —          Stockholders’ deficit:        Preferred stock, par value $.005 per share. 5,000,000Shares authorized; none issued or outstanding  —   — Common stock, par value $.005 per share.150,000,000 shares authorized. At September 30,2006, 59,537,294 shares issued, 59,324,294outstanding; at December 31, 2005, 58,869,398shares issued, 58,656,398 shares outstanding  298   294 Additional paid-in capital  315,129   306,402 Deferred compensation expense  (5,063)  (2,834)Treasury stock, 213,000 shares at September 30, 2006and December 31, 2005  (1,602)  (1,602)Accumulated other comprehensive income  (2)  — Accumulated deficit  (396,477)  (312,995)       Total stockholders’ deficit  (87,717)  (10,735)       Total liabilities and stockholders’ deficit $69,387  $146,702        **See accompanying notes to consolidated financial statements**
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**ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF OPERATIONS****AND COMPREHENSIVE LOSS****($ in thousands, except per share data)****(Unaudited)**                   Three Months Ended  Nine Months Ended   September 30,  September 30,   2006  2005  2006  2005 Revenues:                Royalty income $6,003  $2,643  $12,582  $7,643 License fee and milestones  322   322   966   784 Sales  7   —   7   —              Total Revenues  6,332   2,965   13,555   8,427                  Expenses:                Cost of goods sold  14   —   14   — Research and development  16,271   16,248   49,326   49,929 Sales and marketing  10,039   3,573   31,642   7,953 General and administrative  5,340   2,349   16,446   8,548              Total expenses  31,664   22,170   97,428   66,430              Operating loss  (25,332)  (19,205)  (83,873)  (58,003)Investment income  846   1,351   3,230   3,284 Interest expense  (988)  (975)  (2,946)  (2,122)             Loss from continuing operations  (25,474)  (18,829)  (83,589)  (56,841)Income from discontinued operations  —   —   —   1,335              Loss before cumulative effect ofchange in accounting principle $(25,474)  (18,829)  (83,589)  (55,506)Cumulative effect of change inaccounting principle  —   —   107   —              Net loss applicable to commonshares $(25,474) $(18,829) $(83,482) $(55,506)             Other comprehensive income:                Unrealized loss on foreign currency  (2)  —   (2)  — Reclassification adjustment for gains included in net loss  —   —   —   (189)             Comprehensive loss $(25,476) $(18,829) $(83,484) $(55,695)             Loss per share:                Continuing operations, basicand diluted $(0.44) $(0.32) $(1.43) $(0.96)             Weighted average common shares usedTo compute net loss per share basicAnd diluted  58,477,871   58,077,323   58,404,970   57,877,713              **See accompanying notes to consolidated financial statements**
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**ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF CASH FLOWS****($ in thousands)****(Unaudited)**           Nine Months Ended September 30,   2006  2005 (Revised) Cash flows from operating activities:        Net loss $(83,482) $(55,506)Adjustments to reconcile net loss to cash usedin operating activities:        Gain on discontinued operations  —   (1,335)Depreciation and amortization  811   813 Expenses paid with stock  97   666 Share-based compensation expense  5,973   179 Amortization of debt issue costs  497   370 Amortization of discount/premium on investments      (15)Loss on disposition of fixed assets  33   14 Change in interest receivable included inshort-term investments  —   (235)Changes in operating assets and liabilities:        Accounts receivable  (714)  2,076 Inventory  (586)  — Reserve for obsolescence  369   — Prepaids  639   (108)Other current receivables  104   (265)Accounts payable and accrued expenses  633   4,962 Deferred revenue  (966)  1,216        Net cash used in operating activities  (76,592)  (47,168)Net cash used in discontinued operations  —   (603)       Net cash used in operating activities  (76,592)  (47,771)                Cash flows from investing activities:        Purchases of equipment and leasehold improvements  (1,824)  (1,663)Purchases of investments  —   (83,187)Maturity of investments  —   82,447        Net cash used in investing activitiesinvesting activities  (1,824)  (2,403)       Cash flows from financing activities:        Borrowing of long-term debt  —   130,000 Debt issue costs  —   (4,663)Proceeds from option exercises  431   1,557        Net cash provided by financing activities  431   126,894        Effect of exchange rate changes on cash  —   (52)       Net (decrease) increase in cash and cashequivalents  (77,985)  76,668 Cash and cash equivalents at beginning of period  127,913   46,130        Cash and cash equivalents at end of period $49,928  $122,798        Supplemental schedule of cash flow information:        Interest paid  3,250   1,624 **See accompanying notes to consolidated financial statements**
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**ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****September 30, 2006 (unaudited)****(1) Basis of Presentation**     The accompanying unaudited consolidated financial statements of Encysive Pharmaceuticals Inc.,a Delaware corporation, and its subsidiaries (collectively referred to as the “Company” or“Encysive”) have been prepared in accordance with United States of America (“U.S.”) generallyaccepted accounting principles for interim financial information and with the instructions to Form10-Q and Rule 10-01 of Regulation S-X. They do not include all information and notes required byU.S. generally accepted accounting principles for complete financial statements. It is recommendedthat these interim condensed consolidated financial statements be read in conjunction with theconsolidated financial statements and notes thereto included in the Company’s Annual Report on Form10-K for the year ended December 31, 2005. Except as disclosed herein, there has been no materialchange in the information disclosed in the notes to the consolidated financial statements includedin the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion ofmanagement, all adjustments (consisting only of normal recurring accruals) considered necessary fora fair presentation have been included. Operating results for the three and nine month periodsended September 30, 2006, are not necessarily indicative of the results that may be expected forany other interim period or for the year ending December 31, 2006.**(2) Organization and Significant Accounting Policies**     *(a) Organization*     Encysive is a biopharmaceutical company focused on the discovery, development andcommercialization of novel synthetic small molecule compounds to address unmet medical needs.The Company’s research and development programs are predominantly focused on the treatmentand prevention of interrelated diseases of the vascular endothelium and exploit its expertisein the area of the intravascular inflammatory process, referred to as the inflammatorycascade, and vascular diseases. Since its formation in 1989, the Company has been engagedprincipally in research and drug discovery programs and clinical development of certain drugcompounds.     The Company is presently working on a number of long-term development projects thatinvolve experimental and unproven technology, which may require many years and substantialexpenditures to complete, and which may or may not be successful. Sales of the Company’sfirst product approved by the U.S. Food and Drug Administration, (“FDA”), Argatroban, forwhich it receives royalty income, began during November 2000.     *(b) Basis of Consolidation*     The Company’s consolidated financial statements include the accounts of the Company, itswholly owned subsidiaries, ImmunoPharmaceutics, Inc. (“IPI”), a California corporation;Encysive, L.P. (“ELP”), a Delaware limited partnership; EP-ET, LLC, a Delaware limitedliability company; Encysive Germany GmbH, a German corporation, and Encysive (UK) Limited, aUnited Kingdom (“UK”) private company. The Company’s consolidated financial statements forthe year ended December 31, 2005, and those related to prior year periods included in thisQuarterly Report on Form 10-Q also included Revotar Biopharmaceuticals AG (“Revotar”), aGerman corporation, which was a majority-owned subsidiary until May 2005. In May 2005, theCompany and the other shareholders of Revotar consummated a restructuring (the“Restructuring”) whereby the Company’s ownership of Revotar was divested. Financialstatements included in this quarterly report on Form 10-Q for prior-year periods have beenreclassified to reflect the Restructuring and report the results of Revotar under the caption“Income from discontinued operations.”
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     *(c) Share-Based Payment*     At September 30, 2006, the Company had five stock-based compensation plans for employeesand non-employee directors. Prior to January 1, 2006, the Company accounted for those plansunder the recognition and measurement principles of Accounting Principles Board Opinion No.25, “*Accounting for Stock Issued to Employees*,” and related interpretations (“APB25”).Share-based employee compensation expense related to stock options was not recognized in theCompany’s consolidated statements of earnings prior to January 1, 2006, as all stock optionawards granted under the plans had an exercise price equal to the market value of the commonstock on the date of the grant. Effective January 1, 2006, the Company adopted theprovisions of Statement of Financial Accounting Standards No. 123R, “*Share-Based Payment*”(“FAS 123R”), using the modified prospective transition method. Under this transitionmethod, compensation expense recognized during the three and nine months ended September 30,2006 included: (i) compensation expense for all share-based awards granted prior to, but notyet vested as of January 1, 2006, based on the grant date fair value estimated in accordancewith the original provisions of Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation,” (“FAS 123”), and (ii) compensation expense for allshare-based awards granted subsequent to January 1, 2006, based on the grant date fair valueestimated in accordance with FAS 123R. In accordance with the modified prospectivetransition method, results for prior periods have not been restated. The adoption of FAS123R resulted in a reduction of net earnings of $1,169,000 and $4,135,000, or $0.02 and $0.07per share basic and diluted for the three month and nine month periods ended September 30,2006, respectively. See Note 10 for further detail on the impact of FAS 123R on theCompany’s condensed consolidated financial statements.     Prior to the Company’s adoption of FAS 123R, if unvested shares of common stock wereforfeited, the Company reversed any compensation expense that it had previously recorded onthose shares at the time of forfeiture. Upon the adoption of FAS 123R, the Company willadjust the amount of expense recorded each period, based upon its estimate of futureforfeitures. The cumulative effect of estimating future forfeituresof unvested common shares granted before January 1, 2006, was $107,000, which is reported as a cumulative effectof change in accounting principle during the nine months ended September 30, 2006.     *(d) Debt Issue Costs*     The Company incurred costs, principally comprised of initial purchasers’ discounts andvarious legal and professional fees, of approximately $4,663,000 related to the issuance ofits 2.50% Convertible Senior Notes due 2012 (the “Notes”) in March 2005. Debt issue costsare deferred and recognized from the issuance of the Notes through the date that the Companyhas the ability to call the Notes, March 20, 2010. Interest expense in each of the threemonths ended September 30, 2006 and 2005, includes approximately $167,000 in amortized debtissue costs. Interest expense in the nine months ended September 30, 2006 and 2005 includesamortized debt issue costs of approximately $497,000 and $370,000, respectively. Remainingunamortized debt issue costs were approximately $3,628,000 at September 30, 2006. Foradditional information about the Notes, see Note 9.     *(e) Use of Estimates*     Management of the Company has made a number of estimates and assumptions relating to thereporting of assets and liabilities, revenues and expenses, and the disclosure of contingentassets and liabilities to prepare these consolidated financial statements in conformity withU.S. generally accepted accounting principles. Actual results could differ from theseestimates.     *(f) Reclassifications*     As discussed above in Note 2(b), prior period financial statements have beenreclassified to reflect discontinued operations and to conform to current year presentationwith no effect on net loss or stockholders’ equity previously reported. The Statement ofCash Flows for the nine months ended September 30, 2005, has been revised to conform tocurrent year presentation of cash used in discontinued operations.
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**(3) Inventory**     Based on management’s judgment of probable future commercial use and net realizable value,costs related to the production of work-in-process inventory of ThelinTM have been capitalized asinventory. The Company could be required to expense these costs upon a change in such judgment dueto a denial or significant delay of approval by regulatory bodies, a delay in commercialization orother potential factors. In September 2006, management determined, based upon inventory productionplans, expiration dates of product on hand and projected future sales, that it should record areserve for obsolescence of approximately $369,000.**(4) Capital Stock**     In March 2005, the Company issued the Notes in the principal amount of $130,000,000. As theNotes are convertible into Common Stock, the Company has reserved 9,322,001 shares for issuanceupon conversion, including 213,000 treasury shares. For additional information about the Notes,see Note 9. The Company has reserved Common Stock for issuance as of September 30, 2006, asfollows:     Stock option plans  7,767,386 2.50% Convertible Senior Notes due 2012  9,322,001     Total shares reserved  17,089,387     **(5) Cash, Cash Equivalents, and Short-Term Investments**     Cash equivalents are considered to be those securities or instruments with originalmaturities, when purchased, of three months or less and are recorded at cost. Short-terminvestments consist of debt securities with remaining maturities of less than one year and originalmaturities greater than three months at the purchase date. The Company classifies all short-terminvestments as held-to-maturity. Held-to-maturity securities are those securities in which theCompany has the ability and intent to hold the security until maturity. Short-term investments arestated at amortized cost plus accrued interest. Interest income is accrued as earned. The Companyevaluates the carrying value of its securities by comparing the carrying value of the securities totheir market value. In the event that the fair value of a security were to decline below itscarrying cost, and in the opinion of management such decline was other than temporary, the Companywould record a loss and reduce the carrying value of such security to its fair value. All of theCompany’s funds were invested in cash or cash equivalents at September 30, 2006 and December 31,2005.**(6) Net Loss per Common Share**     Basic net loss per common share is calculated by dividing the net loss by the weighted averagenumber of common and common equivalent shares outstanding during the period.     Securities convertible into common stock comprised of stock options, shares of common stockreserved for issuance upon conversion of the Notes and unvested shares of restricted common stocktotaling 15,853,522 and 14,860,799 shares at September 30, 2006 and 2005, respectively, were notused in the calculation of diluted net loss per common share because the effect would have beenantidilutive.**(7) Income Taxes**     The Company did not incur tax expense (benefit) during the three and nine month periods endedSeptember 30, 2006 and 2005, due to operating losses and the related increase in the valuationallowance.
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**(8) Entity-Wide Geographic Data**     The Company operates in a single business segment that includes research and development ofpharmaceutical products. The Company’s revenues are primarily derived from GlaxoSmithKline plc,(“GSK”). The following table summarizes the Company’s sources of revenues from its principalcustomers (dollars in thousands):                   Three Months Ended September 30,  Nine Months Ended September 30,   2006  2005  2006  2005 Entities:                GSK $6,003  $2,643  $12,582  $7,643 Others  329   322   973   784              Total $6,332  $2,965  $13,555  $8,427              **(9) Long-Term Debt**     In March 2005, the Company issued $130,000,000 in Notes, due 2012. The Company will pay 2.50%interest per annum on the Notes on March 15 and September 15 of each year. Accrued interest on theNotes is included in accrued expenses on the balance sheets as of September 30, 2006 and December31, 2005.     Holders of the Notes may convert the Notes into shares of common stock at any time prior tothe maturity date of the Notes at a conversion rate of 71.7077 shares of common stock per $1,000principal amount of Notes, which is equal to an initial conversion price of approximately $13.95per share, subject to adjustment as set forth in the indenture governing the Notes. In the eventof certain types of fundamental changes, the Company will increase the number of shares issuableupon conversion or, in lieu thereof, the Company may in certain circumstances elect to adjust theconversion rate and related conversion obligation so that the Notes are convertible into shares ofthe acquiring or surviving company, or at the option of the Company, the Company may elect to paythe additional value represented by an increase in the conversion rate in cash to holders electingto convert their Notes. On or after March 20, 2010, the Company may redeem some or all of theNotes for cash at 100% of the principal amount plus accrued interest, if the trading price of theCompany’s common stock exceeds 140% of the conversion price of the Notes then in effect for atleast 20 trading days within a period of 30 consecutive trading days ending on the trading dayprior to the date on which the redemption notice is mailed. Upon the occurrence of a fundamentalchange meeting certain conditions, holders of the Notes may require the Company to repurchase forcash all or part of their Notes.     The Notes are senior unsecured obligations and rank equally in right of payment with anysenior unsecured indebtedness that the Company may incur in the future. The Notes will beeffectively subordinated to all future secured indebtedness and all existing and future liabilitiesof the Company’s subsidiaries, including trade payables and senior in right of payment to anyfuture subordinated indebtedness that the Company may incur.**(10) Share-Based Payment**     The Company has share-based awards outstanding under five different plans as follows:     The Amended and Restated 1990 Incentive Stock Option Plan (“1990 Plan”) allows for theissuance of incentive and non-qualified options to employees, directors, officers, non-employeeindependent contractors and non-employee directors, pursuant to which 43,750 shares of Common Stockare reserved for issuance out of authorized but unissued shares of the Company. No new issuancesare being made under the 1990 Plan.     The Amended and Restated 1992 Incentive Stock Option Plan (“1992 Plan”) allows for theissuance of incentive and non-qualified options to employees, directors, officers, non-employeeindependent contractors and non-employee directors, pursuant to which 117,633 shares of CommonStock are reserved for issuance out of authorized but unissued shares of the Company. No newissuances are being made under the 1992 Plan.
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     The Amended and Restated 1995 Stock Option Plan (“1995 Plan”) allows for the issuance ofincentive and non-qualified options, shares of restricted stock and stock bonuses to employees,officers, and non-employee independent contractors, pursuant to which 731,853 shares of CommonStock are reserved for issuance out of authorized but unissued shares of the Company. No newissuances are being made under the 1995 Plan.     The Amended and Restated 1995 Non-Employee Director Stock Option Plan (“1995 Director Plan”)allows for the issuance of non-qualified options to non-employee directors, pursuant to which441,000 shares of Common Stock are reserved for issuance out of authorized but unissued shares ofthe Company. No new issuances are being made under the 1995 Director Plan.     The Amended and Restated 1999 Stock Incentive Plan (“1999 Plan”) allows for the issuance ofincentive and non-qualified options, shares of restricted stock and stock bonuses to directors,employees, officers and non-employee independent contractors, pursuant to which 6,433,150 shares ofCommon Stock are reserved for issuance out of authorized but unissued shares of the Company.Beginning in the second quarter of 2006, the Company granted phantom units to its internationalemployees. Grants of restricted stock units vest in a manner similar to grants of restrictedcommon stock, and can be settled upon vesting with either shares of common stock or cash, at thesole discretion of the Company.     Prior to January 1, 2006, the Company accounted for those plans under the recognition andmeasurement principles of APB25. Share-based employee compensation expense related to stockoptions was not recognized in the Company’s consolidated statements of earnings prior to January 1,2006, as all stock option awards granted under the plans had an exercise price equal to the marketvalue of the common stock on the date of the grant. Effective January 1, 2006, the Company adoptedthe provisions of FAS 123R using the modified prospective transition method. Under this transitionmethod, compensation expense recognized during the three and nine months ended September 30, 2006,included: (i) compensation expense for all share-based awards granted prior to, but not yet vestedas of January 1, 2006, based on the grant date fair value estimated in accordance with the originalprovisions of FAS 123, and (ii) compensation expense for all share-based awards granted subsequentto January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. Inaccordance with the modified prospective transition method, results for prior periods have not beenrestated.     As a result of adopting FAS 123R, the charge to earnings from continuing operations and netearnings related to stock option grants for the three and nine months ended September 30, 2006, was$1,169,000 and $4,135,000, respectively. The impact of adopting FAS 123R on both basic and dilutedearnings per share for the three and nine months ended September 30, 2006 was $0.02 and $0.07 pershare, respectively.     The following table illustrates the effect on net earnings and earnings per share for thethree and nine months ended September 30, 2005, as if the Company had applied the fair valuerecognition provisions of FAS 123 to options granted under the Company’s share-based payment plans.For purposes of this pro forma disclosure, the value of the stock options is estimated using aBlack-Scholes option pricing model and amortized to expense over the options’ vesting periods.           Three Months  Nine Months   Ended  Ended   September 30,  September 30, (In thousands, except per share amounts) 2005  2005 Net loss, as reported $(18,829) $(55,506)Add: Total stock-based employeecompensation expense included inreported net loss  5   43 Deduct: Total stock-based employeecompensation expense determined underfair value based method for all awards  (1,241)  (3,657)       Pro forma net loss $(20,065) $(59,120)       Loss per share:        As reported, basic and diluted $(0.32) $(0.96)       Pro forma, basic and diluted $(0.35) $(1.02)       
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     Compensation expense related to all share-based awards during the three months ended September30, 2006, was $1,863,000, of which $1,169,000 related to stock options resulting from the adoptionof FAS 123R and $694,000 related to unvested shares of restricted common stock and unvested phantomunits. Compensation expense related to all share-based awards during the nine months endedSeptember 30, 2006 was $6,070,000, of which $4,135,000 related to stock options resulting from theadoption of FAS 123R and $1,936,000 related to unvested shares of restricted common stock andunvested phantom units. During the three and nine months ended September 30, 2005, compensationexpense related to the Company’s share-based awards was $5,000 and $43,000, respectively, whichprimarily related to nonvested shares.     Cash received from stock options exercised during the three months ended September 30, 2006,and 2005, was $1,000 and $1,101,000, respectively. Cash received from stock options exercisedduring the nine months ended September 30, 2006, and 2005, was $431,000 and $1,557,000,respectively.     The fair value of the Company’s stock option awards is estimated on the date of grant using aBlack-Scholes option-pricing model that uses the assumptions in the table below. The fair value ofthe Company’s stock option awards, which are subject to graded vesting, is expensed over thevesting life of the stock options using the straight-line method. Expected volatility is based onan average of (i) historical volatility of the Company’s stock, (ii) implied volatility from theCompany’s convertible debt and (iii) implied volatility from traded options on the Company’s stock.The risk-free rate for periods within the contractual life of the stock option award is based onthe yield curve of a zero-coupon U.S. Treasury bond for the month during which the stock optionaward is granted with a maturity equal to the expected term of the stock option award granted. TheCompany uses historical data to estimate stock option exercises and forfeitures within itsvaluation model. The expected term of stock option awards granted is derived from historicalexercise experience under the Company’s share-based payment plans and represents the period of timethat stock option awards granted are expected to be outstanding.     The significant weighted average assumptions relating to the valuation of the Company’s stockoptions for the three and nine months ended September 30, 2006, and 2005, were as follows:                   Three Months Ended Nine Months Ended  September 30, September 30,  2006 2005 2006 2005Expected dividend yield  —   0.0%  0.0%  0.0%Risk-free interest rate  —   4.0%  4.7%  4.1%Expected volatility  —   55.2%  64.9%  67.2%Expected life in years  —   4.5   3.9   4.9 
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     A summary of the Company’s stock option activity for the three and nine months endedSeptember 30, 2006, was as follows:                       Weighted  Weighted Average  Aggregate   Stock  Average  Remaining  Intrinsic Value   Options  Exercise Price  Contractual Term  (in Thousands) Outstandingat December 31, 2005  5,340,142  $8.07   6.63     Grants  512,958  $8.85         Forfeited or expired  (46,081) $9.85         Exercises  (96,614) $4.34                        Outstandingat March 31, 2006  5,710,405  $8.18   6.75  $2,050 Grants  60,000  $3.57         Forfeited or expired  (44,454) $8.93         Exercises  (10,833) $0.93                        Outstandingat June 30, 2006  5,715,118  $8.13   6.39  $5,265 Grants  —             Forfeited or expired  (28,012) $10.36         Exercises  (1,499) $0.93                        Outstandingat September 30, 2006  5,685,607  $8.12   5.94  $1,580 Vested and expected to vestin the future atSeptember 30 2006  5,655,916  $8.11   0.31  $1,579 Exercisableat September 30, 2006  3,998,169  $7.38   5.02  $1,550 Available for grant atSeptember 30, 2006  2,081,779                  The weighted average grant date fair value of options granted and total intrinsic value ofoptions exercised during the three and nine months ended September 30, 2006, and 2005, was asfollows:                   Three Months Ended Nine Months Ended  September 30, September 30,  2006 2005 2006 2005Weighted average:                Grant date fair valueper option $—  $6.07  $4.34  $6.37 Total intrinsic value ofoptions exercised $6,000  $1,771,000  $538,000  $1,963,000      The fair value of unvested shares of restricted common stock is determined based on theclosing trading price of the Company’s common stock on the day before the grant date. The weightedaverage grant date fair value of unvested restricted shares and phantom units granted during thethree months ended September 30, 2006, and 2005 was $4.26 and $12.27, respectively, and during thenine months ended September 30, 2006, and 2005, was $6.92 and $10.95, respectively. A summary ofthe Company’s unvested restricted share activity for the three and nine months ended September 30,2006, was as follows:
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               Weighted Average   Restricted  Grant Date   Shares  Fair Value Unvested at December 31, 2005  441,923  $8.60 Activity during quarter ended March 31, 2006        Grants  436,659  $8.85 Vested  (127,438) $2.84 Forfeited  (12,870) $11.22        Unvested at March 31, 2006  738,274  $9.69 Activity during quarter ended June 30, 2006        Grants  65,127  $3.57 Vested  (10,000)  7.00 Forfeited  (15,678) $10.34        Unvested at June 30, 2006  777,723  $9.21 Activity during quarter ended September 30, 2006        Grants  89,976  $4.35 Vested  (7,428) $6.78 Forfeited  (14,357) $5.24        Unvested at September 30, 2006  845,914  $8.78      The fair value of unvested phantom units is determined based on the closing trading price ofthe Common Stock on the day before the grant date. The weighted average grant date fair value ofunvested phantom stock units granted during the three and nine months ended September 30, 2006, was$4.18 and $4.10, respectively. A summary of the Company’s unvested phantom unit activity for thenine months ended September 30, 2006, was as follows:               Weighted Average       Grant Date   Shares  Fair Value Unvested at March 31, 2006  —   —        Activity during quarter ended June 30, 2006        Grants  34,962  $3.86 Vested  —   — Forfeited  —   —        Unvested at June 30, 2006  34,962  $3.86 Activity during quarter ended September 30, 2006        Grants  98,692  $4.18 Vested  —   — Forfeited  —   —        Unvested at September 30, 2006  133,654  $4.10      At September 30, 2006, there was $15.4 million of unrecognized compensation expense related tounvested share-based awards granted under the Company’s share-based payment plans of which $6.4million relates to stock options expected to be recognized over a weighted-average period of 1.5years, and $9.0 million relates to unvested restricted shares and phantom units expected to berecognized over a weighted average period of 2.1 years.**(11) Commitments and Contingencies**     *(a) Liquidity and Management’s Plans*     The Company has financed its research and development activities and other operationsprimarily through public and private offerings of Common Stock and the Notes and from fundsreceived through collaborations, research agreements, licenses and partnerships. It also hasreceived royalty revenue from sales of Argatroban by GSK. At September 30, 2006, cash andshort-term investments were $49.9 million, which management believes is sufficient to fundthe Company’s cash requirements through 2006. Based upon expected future cash requirements,management
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believes that additional funding will be required to continue the Company’s ongoingresearch and development programs, and to fund the commercial launch of ThelinTM in Europe,whether or not ThelinTM is approved in the U.S. If ThelinTM is not approved by the FDA in thenear future, management believes that additional funding will be significantly more difficultto obtain on commercially acceptable terms, if at all. Even if ThelinTM is approved by theFDA, management believes that additional funding will be required to commercially launchThelinTM in the U.S. Such additional funding may be arranged through public or privateequity, debt financings, bank debt, or, if available, collaborative arrangements. TheCompany is continuing to review the possibility of licensing rights to ThelinTM outside ofNorth America and Europe. There can be no assurance that any licensing arrangements will beavailable on acceptable terms, if at all, or that this approach will be pursued. As theCompany reviews its operations and research and development programs, it may also considervarious methods to reduce costs in order to sustain the Company’s cash resources. Thosemeasures may include scaling back headcount and expenses, delaying or terminating researchand development programs, curtailing capital expenditures or reducing other operatingactivities. The Company may also consider relinquishing, licensing or otherwise disposing ofrights to technologies, product candidates or products that the Company could otherwise seekto develop or commercialize itself, on terms that are less favorable than might otherwise beavailable or at an earlier stage than would otherwise be desirable.     On October 19, 2006, the Company announced that it had secured a commitment from AzimuthOpportunity Ltd. to purchase up to $75 million, or a maximum of 11,853,012 shares of theCommon Stock, whichever occurs first, over an 18-month period, at a predetermined discount tothe prevailing market price. At the Company’s request, and upon the approval of the Company’sBoard of Directors, Azimuth will purchase a certain dollar amount of shares of Common Stock,with the exact number of shares to be determined based on the per share market price ofCommon Stock over the draw-down period for such purchase. The Company may request up to 24draw downs during the 18-month period, with each drawdown limited in size to the lesser of2.5% of the Company’s market capitalization or a fixed amount ranging from $6 million to$29.5 million based on the market price of Common Stock. Upon each sale of Common Stock toAzimuth, the Company has also agreed to pay Reedland Capital Partners, an InstitutionalDivision of Financial West Group, Member NASD/SIPC, a placement fee equal to one andone-eighth percent of the aggregate dollar amount of common stock purchased by Azimuth.     The shares will be offered pursuant to an effective registration statement filed withthe Securities and Exchange Commission on June 4, 2004. This report shall not constitute anoffer to sell or the solicitation of an offer to buy any of these securities. There shallnot be any sale of these securities in any state or jurisdiction where such an offer,solicitation or sale would be unlawful under the securities laws of such state orjurisdiction.     *(b) Ongoing litigation*     On September 26, 2006, a purported class action complaint (the “Massachusetts Laborerscomplaint”) was filed in the United States District Court for the Southern District of Texasby Massachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situatedinvestors against the Company, Bruce D. Given, M.D. (the Company’s President and ChiefExecutive Officer), Richard A.F. Dixon (the Company’s Senior Vice President, Research andChief Scientific Officer) and Stephen L. Mueller (the Company’s former Vice President,Finance and Administration, Secretary and Treasurer). The complaint alleges violations ofsections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Securities and ExchangeCommission Rule 10b-5, and focuses on statements that are claimed to be false and misleadingregarding the Company’s drug sitaxsentan sodium. The plaintiffs seek unspecified damages onbehalf of a purported class of purchasers of the Company’s securities during the period fromFebruary 19, 2004 through March 24, 2006.     In addition, on October 10, 2006, a second purported class action complaint was filed inthe United States District Court for the Southern District of Texas by Gustav R. Bastian, onbehalf of himself and all other similarly situated investors against the Company, Dr. Given,Mr. Dixon and Mr. Mueller. The complaint asserts substantially the same factual allegationsand legal claims as the
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Massachusetts Laborers complaint on behalf of the same putative class. A thirdsubstantially similar purported class action complaint was filed on October 20, 2006 bySteven O. Scott, and a fourth substantially similar purported class action complaint wasfiled on November 1, 2006 by Cami Janzen-Guare. These complaints assert substantially thesame factual allegations and legal claims as the Massachusetts Laborers’ complaint and werefiled in the same court on behalf of the same putative class.     It is possible that additional complaints regarding the same subject matter may be filedin the future. The Company expects that the existing four lawsuits, as well as any futurepurported class action lawsuits involving the same subject matter as the existing lawsuits,will be consolidated into a single civil action. Although the Company believes that theallegations in these cases are without merit and intends to defend all such litigationvigorously, litigation is subject to inherent uncertainties, and an adverse result in theseor other matters that may arise from time to time could have a material adverse effect on ourbusiness, results of operations and financial condition. Any litigation to which we aresubject may be costly and, further, could require significant involvement of our seniormanagement and may divert management’s attention from our business and operations.     *(c) Foreign Currency Exchange Risk*     The Company is exposed to market risk primarily from changes in foreign currencyexchange rates. We have contracts with entities outside the U.S. that are denominated in aforeign currency. To date, these currencies have not fluctuated materially.     *(d) Other contingencies*     Like other biopharmaceutical companies, the Company is subject to other contingencies,including legal proceedings and claims arising out of its business that cover a wide range ofmatters, including, among others, environmental matters, contract and employment claims, andproduct liability. The Company may be involved in legal actions from time to time. TheCompany has used various substances in its research and development that have been or may bedeemed to be hazardous or dangerous, and the extent of its potential liability, if any, underenvironmental, product liability and workers’ compensation statutes, rules, regulations andcase law is unclear.
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**Item 2.****ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****Three and Nine Months Ended September 30, 2006, and September 30, 2005****OVERVIEW**     The following discussion of our financial condition and results of operations should be readin conjunction with our consolidated financial statements and the related notes to the financialstatements included in our Annual Report on Form 10-K for the year ended December 31, 2005, andwith the consolidated financial statements and related notes to the financial statements includedelsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaningof Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934. Forward-looking statements represent our management’s judgment regarding future events. Inmany cases, you can identify forward-looking statements by terminology such as ‘‘may,’’ ‘‘will,’’‘‘should,’’ ‘‘could,’’ ‘‘plan,’’ ‘‘expect,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘believe,’’‘‘predict,’’ ‘‘intend,’’ ‘‘potential,’’ or ‘‘continue’’ or the negative of these terms or otherwords of similar import, although some forward-looking statements are expressed differently. Allstatements, other than statements of historical fact, included in this Form 10-Q regarding ourfinancial position, business strategy and plans or objectives for future operations areforward-looking statements. Among the factors that could cause actual results to differ materiallyfrom those indicated by such forward-looking statements are: additional delays in regulatoryapproval of ThelinTM (sitaxsentan sodium) by the FDA in the U.S. and Encysive’s other products underdevelopment; decisions by the FDA regarding whether and when to approve our New Drug Application,or NDA for ThelinTM; market acceptance of ThelinTM in the European Union and the actual rate ofacceptance; the results of clinical trials with respect to products under development; theavailability of sufficient funds to continue research and development efforts and thecommercialization of ThelinTM and Encysive’s other products; reduced estimates of patientpopulations; the impact of reimbursement policies and governmental regulation of prices for ThelinTMin the European Union; the impact of existing and future European Union regulatory provisions onproduct exclusivity, including orphan drug exclusivity for ThelinTM, the impact of legislation orregulations in countries within the European Union affecting ThelinTM’s pricing, reimbursement oraccess; the scope of Encysive’s patents and challenges by others of the scope of Encysive’spatents; the ability of Encysive to attract and retain qualified personnel; the impact ofcompetitive products on ThelinTM and Argatroban sales; the impact of strategic relationships amongour competitors; the breadth of approved labeling for approved products; the speed with whichreimbursement and pricing approvals, and product launches for ThelinTM may be achieved in theEuropean Union; difficulties or delays in manufacturing, packaging or distributing ThelinTM in theEuropean Union; Encysive’s ability to raise additional capital to fund cash requirements for futureoperations; timelines for initiating clinical trials; Encysive’s ability to earn a profit fromsales or licenses of ThelinTM or other drug candidates; Encysive’s ability to establish futurecollaborative arrangements or licenses; and the availability of materials necessary for themanufacture of our products; as well as more specific risks and uncertainties facing Encysive suchas those set forth in “Item 1A – Risk Factors” below.     You should read these forward-looking statements carefully because they discuss ourexpectations about our future performance, contain projections of our future operating results orour future financial condition, or state other “forward-looking” information. You should be awarethat the occurrence of any of the events described in “Business,” “Risk Factors,’’ “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and elsewhere in ourAnnual Report on Form 10-K for the year ended December 31, 2005, and in this Form 10-Q couldsubstantially harm our business, results of operations and financial condition and that upon theoccurrence of any of these events, the trading price of our common stock could decline, and youcould lose all or part of your investment.     All subsequent written and oral forward-looking statements attributable to us or to personsacting on our behalf are expressly qualified in their entirety by the applicable cautionarystatements. We cannot guarantee any future results, levels of activity, performance orachievements. Except as required by law, we undertake no obligation to update any of theforward-looking statements in this Form 10-Q after the date hereof.
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     As used in this Form 10-Q, the words “we,” “our,” “us,” “Encysive,” and the “Company” refer toEncysive Pharmaceuticals Inc., its predecessors and subsidiaries, except as otherwise specified.This Form 10-Q may contain trademarks and service marks of other companies.     Encysive Pharmaceuticals is a biopharmaceutical company engaged in the discovery, developmentand commercialization of novel, synthetic, small molecule compounds to address unmet medical needs.Our research and development programs are predominantly focused on the treatment and prevention ofinterrelated diseases of the vascular endothelium and exploit our expertise in the area of theintravascular inflammatory process, referred to as the inflammatory cascade, and vascular diseases.We have successfully developed one FDA approved drug, Argatroban, for the treatment ofHeparin-Induced Thrombocytopenia, or HIT, that is marketed by GSK. Our lead drug candidate, ThelinTM(sitaxsentan sodium) is an endothelin receptor antagonist being developed for the treatment ofpulmonary arterial hypertension, or PAH. ThelinTM has received marketing authorization in theEuropean Union from the European Agency for the Evaluation of Medicinal Products, or EMEA, and isunder review by the FDA in the United States and by regulatory authorities in Canada and Australia.     In addition, we have earlier stage clinical product candidates in development includingTBC3711, a next generation endothelin receptor antagonist. As discussed below, all clinical trialsof TBC3711 have been suspended and placed on clinical hold while we work with the FDA to resolve anoutstanding issue.     We have entered into a worldwide research collaboration and license agreement withSchering-Plough, to discover, develop and commercialize VLA-4 antagonists. In March 2005, theinitiation of clinical studies for TBC4746, an oral VLA-4 antagonist, by Schering-Plough triggereda milestone payment to us. VLA-4 is a potential target in the inflammatory cascade taking placewithin the vasculature. TBC4746 has the potential to address a number of diseases, including asthmaand multiple sclerosis.     Bimosiamose has been licensed to and is being developed by Revotar Biopharmaceuticals AG, orRevotar, which was formerly a majority-owned subsidiary.     In March 2005, we issued $130 million of 2.50% Convertible Senior Notes, or the Notes, due2012. For additional information about the Notes, see Note 9 to the consolidated financialstatements included herein.ThelinTM — for the treatment of Pulmonary Arterial Hypertension     In March 2006, we received a complete response from the FDA which indicated that ThelinTM(sitaxsentan sodium) is approvable, which we refer to elsewhere as the “March Approvable Letter.”In the March Approvable Letter, the FDA identified several concerns and observations that needed tobe resolved before the drug could be approved, including a request for additional clinical trialwork. The FDA accepted for review the Company’s complete response to the concerns and observationsnoted in the March Approvable Letter, and designated the review as a Class 1 resubmission. A newPrescription Drug User Fee Act (PDUFA) target action date of July 24, 2006, was established. OnJuly 24, 2006, we received a second approvable letter, which we refer to elsewhere as the “JulyApprovable Letter.” One of the substantive items raised in the March Approvable Letter remainsunresolved. The FDA acknowledged that the unresolved item is a matter of judgment and expressed awillingness to consider new arguments to address this remaining item. The FDA again offered thealternative of conducting additional clinical work. Following discussions with the FDA, wesubmitted a complete response to the July Approvable Letter on November 2, 2006. We believe theFDA will notify us within approximately 30 days whether the submission has been accepted and, ifso, we anticipate that the FDA will establish a new PDUFA target action date. We cannot assure youthat our submission will be accepted or, if accepted, that ThelinTM will be approved by the FDA.     We recently received marketing approval in the European Union from the European Commission forThelinTM 100 milligram tablets. ThelinTM is an oral endothelin A receptor antagonist indicated forthe treatment of patients with PAH classified as World Health Organization (“WHO”) functional classIII, to improve exercise capacity. Efficacy has been shown in primary pulmonary hypertension andpulmonary hypertension associated with connective tissue disease. The EMEA’s centralized licensingprocedure
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permits the Company to market ThelinTM in all 25 member states of the European Union.ThelinTM became commercially available in the United Kingdom inNovember 2006, and we anticipate that ThelinTM will be launched in Germany during the fourth quarter of2006, with subsequent launches in other European Union countries as their national governmentsapprove pricing and reimbursement. We began selling ThelinTM on a named patient basis in the U.K.during September 2006.     ThelinTM is also under review by the FDA in the United States and by regulatory authorities inAustralia and Canada. Additionally, during 2004, we obtained orphan drug designation for ThelinTMfrom both the FDA and the European Commission. Orphan drug designation grants exclusivity toThelinTM upon product approval for seven years in the U.S., however we anticipate that patentprotection for ThelinTM may extend beyond expiration of orphan drug exclusivity. In the EuropeanUnion, orphan drug designation grants exclusivity for ten years from product approval. The EMEAhas requested information from us to support the designation of ThelinTM as an orphan drug in theEuropean Union, or E.U. At this time, we cannot assure you that ThelinTM will maintain orphan drugdesignation and its associated exclusivity in the E.U. for the full 10 year period.     We have retained worldwide rights to ThelinTM and have announced our intention to market andsell ThelinTM ourselves in North America and Europe. To date, we have invested incommercialization-related expenses in both the U.S. and Europe. These investments include thehiring a U.S. field sales force, market development activities, product launch preparations, theestablishment of a European sales and marketing headquartersfunction, hiring a U.K. field salesforce, and other European staff.Argatroban     Argatroban, licensed from Mitsubishi Pharma Corporation (“Mitsubishi”) and developed in NorthAmerica by Encysive, is a synthetic direct thrombin inhibitor approved by the FDA in 2000. It isindicated for prophylaxis or treatment of thrombosis for patients with HIT, a profound allergicreaction to anticoagulation therapy with heparin, and for use in HIT patients undergoingpercutaneous coronary intervention. Argatroban was approved by Health Canada in 2001 for use as ananticoagulant therapy in patients with HIT syndrome. GSK markets Argatroban in the U.S. and Canada,and had Hatch-Waxman market exclusivity in the U.S. until June 2005. We have access to aformulation patent, which expires in 2014, and a process patent that expires in 2017. We are notaware of any regulatory submissions by other parties for generic compounds which could compete withArgatroban. In the three and nine months ended September 30, 2006, Encysive earned royalties fromthe sales of Argatroban totaling $6.0 million and $12.6 million, respectively.Other Development Programs     Our research and development programs include plans to develop oral ThelinTM more broadly inPAH and to explore indications beyond PAH. We have initiated a trial for ThelinTM as a treatmentfor diastolic heart failure. In addition, we began a dose-ranging study in patients with diagnosedresistant hypertension with TBC3711, a more potent and selective endothelin-A, or ETA,receptor antagonist with an improved metabolic profile, pre-clinically. On March 23, 2006,however, the TBC3711 clinical studies were placed on clinical hold, and all clinical trials havebeen suspended, due to an unusual finding following dosing with intravenous TBC3711 in a single ratthat had displayed abnormalities at baseline. We are continuing to work with the FDA to resolvethis issue.     In addition to ThelinTM, TBC3711and Argatroban, we have a number of projects inlate preclinical development. The Company’s next clinical candidates may be an intravenous or oralvasoactive antagonist or an oral antagonist for an inflammatory disease target. It is anticipatedthat we may submit two Investigational New Drug Applications in 2006.     In April 2005, the stockholders of Revotar agreed to restructure Revotar’s capitalization inan arrangement referred to as the “Restructuring.” As a result, we are no longer funding any drugdevelopment activities at Revotar. For additional information about the Restructuring, see Note2(b) to the consolidated financial statements included herein.
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Encysive’s Research Programs     Our research efforts are concentrated on targets within the vasculature, and the potentialindications of our drug candidates include cardiovascular diseases and a potentially wide varietyof inflammatory diseases involving two complementary sets of targets. The first set of targetsrelate to vascular G-protein coupled receptors (“GPCRs”). Historically, GPCRs have been some of themost amenable targets for developing commercially successful pharmaceuticals, such asbeta-blockers, antihistamines, and most anti-psychotics and anti-depressants. Endothelin receptors,targeted by ThelinTM and TBC3711, are examples of GPCRs.     Encysive also has developed expertise in pharmacologically intervening in the intravascularinflammatory cascade, representing a second set of intravascular targets. Bimosiamose and TBC4746are examples of drug candidates that we designed to target two distinct steps in this cascade, theselectins and VLA-4, respectively. Some of the targets in this cascade are GPCRs. Thus, our focuson endothelial cell and related vascular biology has opened up a broad range of disease targetswith high, unmet medical need.***Critical Accounting Policies****Revenue Recognition* **•** We recognize royalty revenue as a licensee sells products and we have receivedsufficient information to record a receivable. Our royalty revenue is based on net salesof product, that is, sales net of discounts, returns and allowances. Argatroban islicensed to GSK, which distributes and sells the product, and from which we receive aquarterly royalty payment. At the time of each payment, GSK provides us with limitedquarterly data related to the product’s gross sales, sales returns, discounts andallowances. While we are informed of the amount of product returns recorded each quarter,we do not have information necessary to identify the period or periods to which suchreturns correspond. We believe that substantially all discounts and allowances pertain tocurrent period sales. We also believe that a portion of sales recorded in each periodwill ultimately be returned, and therefore estimate future returns and their impact onroyalty revenues. In the pharmaceutical industry, product returns are primarilyinfluenced by remaining or expired shelf life, product withdrawals or recalls, significantprice changes from competitors or the introduction of generic products or other newcompetition. We are not aware of any pending product recalls or withdrawals, significantprice fluctuations or generic or new competition. Accordingly, we have estimated only theimpact of product dating on returns.    Since we do not manufacture, sell or distribute Argatroban, we do not have informationrelated to levels of inventory in the distribution channels. However, due to the cost ofthe drug and pressures on hospitals to minimize operating expenditures, we believeinventory levels are maintained at a minimally acceptable level. Inventory level istherefore not a part of the Company’s estimate process.    We have estimated remaining shelf life, which is an important reason for product returns,based upon the fact that Argatroban has an expiration date of two years from manufacture.Common industry practice is that prescription drugs can be returned to the manufacturer atany time; however, product is normally returned when the remaining shelf life is reduced tosix months or less. Our reserve is, therefore, based upon an estimate of the percentage ofsales made in the preceding 18-month period that may be returned in future periods.Initially, lacking any historical sales data for Argatroban and based upon management’sexperience with other pharmaceutical products in the industry, management estimated thatfour percent of gross sales of Argatroban would be returned during future periods. Basedupon subsequent analysis of historical sales data, we believe that differences betweenestimated and actual future returns will not have a material effect upon our results ofoperations or financial condition.  **•** Revenue from collaborative research and development activities is recognized asservices are performed.
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 **•** We defer the recognition of milestone payments related to contractual agreements thatare still in the development stage. Such deferred revenues are amortized into income overthe estimated remaining development period. Milestone payments received under contractualagreements which have completed the development stage are evaluated, and either recognizedinto income when earned, or amortized over a future period, depending upon whether wecontinue to have obligations under the terms of the arrangement.  **•** License fees received under the terms of licensing agreements for our intellectualproperty are deferred and amortized into income over the estimated development period ofthe licensed item or items.  **•** Revenue from grants is recognized as earned under the terms of the related grantagreements, typically as expenses are incurred.  **•** Sales revenue is reported net of discounts, allowances, and returns.     Amounts received in advance of services being performed under contracts are recorded asdeferred revenue and recognized as services are performed. We periodically evaluate our estimatesof remaining development periods and adjust the recognition of remaining deferred revenues over theadjusted development period remaining. At September 30, 2006, remaining deferred revenue wasapproximately $1.6 million, of which we expect to recognize approximately $1.3 million over thenext 12 months. A future change in our estimate of development periods could accelerate ordecelerate the timing of future recognition of deferred revenue.*Cost of goods sold*     We began selling ThelinTM in the U.K. in September 2006 on a named patient basis utilizing theservices of a third party. Cost of goods sold is comprised of the direct cost of inventoryconsumed, along with the fees associated with the third party.*Share-Based Payments*     At September 30, 2006, the Company had five stock-based compensation plans for employees andnon-employee directors. Prior to January 1, 2006, the Company accounted for those plans under therecognition and measurement principles of Accounting Principles Board Opinion No. 25, “*Accountingfor Stock Issued to Employees*,” and related interpretations (“APB25”). Share-based employeecompensation expense related to stock options was not recognized in the Company’s consolidatedstatements of earnings prior to January 1, 2006, as all stock option awards granted under the planshad an exercise price equal to the market value of the common stock on the date of the grant.Effective January 1, 2006, the Company adopted the provisions of Statement of Financial AccountingStandards No. 123R, “*Share-Based Payment*” (“FAS 123R”) using the modified prospective transitionmethod. Under this transition method, compensation expense recognized during the three and ninemonths ended September 30, 2006, included: (i) compensation expense for all share-based awardsgranted prior to, but not yet vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-Based Compensation” (“FAS 123”), and (ii) compensation expense forall share-based awards granted subsequent to January 1, 2006, based on the grant date fair valueestimated in accordance with FAS 123R. In accordance with the modified prospective transitionmethod, results for prior periods have not been restated. The adoption of FAS 123R resulted in areduction of net earnings of $1,169,000, or $0.02 per share basic and diluted, and $4,135,000 or$0.07 per share, basic and diluted, for the three months and nine months ended September 30, 2006,respectively, arising from unvested stock options. See Note 10 to the consolidated financialstatements for further detail on the impact of FAS 123R on the Company’s condensed consolidatedfinancial statements.*Drug Manufacturing and Packaging*     Costs arising from the manufacturing and packaging of drug product, which is intended for usein clinical trials, are recognized as incurred and included in research and development expenses.We capitalize inventory costs associated with certain products prior to regulatory approval andproduct launch,
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based on management’s judgment of probable future commercial use and net realizable value. Wecould be required to expense previously capitalized costs related to pre-approval or pre-launchinventory upon a change in such judgment, due to a denial or additional delays of approval byregulatory bodies, additional delays in commercialization, or other potential factors. InSeptember 2006, we determined, based upon inventory production plans, expiration dates of producton hand and projected future sales, that we should record a reserve for inventory obsolescence ofapproximately $369,000. At September 30, 2006, we had $2.4 million of capitalized inventory costs,net of the reserve for obsolescence.*Costs Related to Issue of Long-Term Debt*     Costs incurred in the issuance of the Notes, primarily comprised of initial purchasers’discounts, legal and other professional fees have been deferred, and will be amortized and reportedas a component of interest expense during the periods beginning with the Notes’ issuance date tothe date that we have the ability to call the debt.**Results of Operations**     The preparation of financial statements in conformity with U.S. generally accepted accountingprinciples requires us to make estimates and assumptions that affect the reported amounts of assetsand liabilities, disclosures of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reporting period. Ouroperating results have fluctuated significantly during each quarter and year and we anticipate thatsuch fluctuations, which are largely attributable to varying research and development and otheroperating commitments and expenditures, will continue for the next several years. We have beenunprofitable to date and expect to incur substantial operating losses for the next several years aswe invest in product research and development, preclinical and clinical testing, commercializationexpenses related to ThelinTM and regulatory compliance. We have sustained net losses ofapproximately $396.5 million from the date of our inception to September 30, 2006. We haveprimarily financed our operations to date through a series of private placements and publicofferings of our common stock, the sale of Notes and several collaborative agreements with thirdparties to jointly pursue product research and development. See “Liquidity and Capital Resources”below. See also Item IA – Risk Factors, in our Annual Report on Form 10-K for the year endedDecember 31, 2005 and Item 1A – Risk Factors, in this Form 10-Q.**Three and nine month periods ended September 30, 2006 and 2005****Revenues**     Total revenues increased $3.3 million and $5.1 million in the three and nine months endedSeptember 30, 2006, compared with the three and nine months ended September 30, 2005, respectively.Royalties earned on sales of Argatroban under our agreement with GSK are based upon a tieredstructure, which provides for increases in royalty revenue earned, as a percentage of sales, asArgatroban sales increase. The increase in royalties is due to higher sales of Argatroban, and acorresponding higher royalty rate, as a percentage of sales, in the three and nine months endedSeptember 30, 2006 as sales exceeded higher thresholds within the agreement. Such sales thresholdsare evaluated annually. Additionally, license fees and milestones revenue increased $0.2 million inthe nine months ended September 30, 2006, reflecting the amortization of the receipt of a milestonepayment from Schering-Plough received in March 2005.ThelinTM became commercially available in the U.K. inNovember 2006, and was sold on a named patent basis beginning inSeptember 2006. As discussed above, regulatory approval of ThelinTM in theU.S. has been delayed, pending satisfaction of the one substantive item contained in the JulyApprovable Letter. Following discussions with the FDA, we submitted a complete response to theJuly Approvable Letter on November 2, 2006. We believe the FDA will notify us within approximately30 days whether the submission has been accepted and, if so, we anticipate that the FDA willestablish a new PDUFA target action date. We cannot assure you that our submission will beaccepted or, if accepted, that ThelinTM will be approved by the FDA. Since the outcome ofregulatory filings for ThelinTM in the U.S., Canada and Australia is uncertain, we do not anticipateproviding specific financial guidance for 2006.
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**Research and Development Expense**     Research and development expense was comparable in the three months ended September 30, 2006and 2005. Research and development expense in the three months ended September 30, 2006, includedincremental share-based compensation expense of $0.7 million, resulting from our adoption of FAS123R on January 1, 2006. Clinical trial activities declined in the three months ended September30, 2006, compared with the prior year period. Research and development expenses during the threemonths ended September 30, 2005, included costs associated with the STRIDE-2X and STRIDE-3 clinicaltrials, costs associated with the preparation of the NDA for ThelinTM, which was submitted to theFDA in May 2005, and submission of a Marketing Authorization Application for ThelinTM orMAA with the EMEA in July 2005.     Research and development expense decreased $0.6 million in the nine months ended September 30,2006, compared with the nine months ended September 30, 2005. Research and development expense inthe nine months ended September 30, 2006 included incremental share-based compensation expense of$2.4 million, resulting from our adoption of FAS 123R on January 1, 2006. The decrease in researchand development expenses in the nine months ended September 30, 2006, is primarily due to reducedclinical trial and regulatory activities during the period, compared with the prior year period.As discussed above, research and development expenses during the nine months ended September 30,2005, included costs associated with the STRIDE-2X and STRIDE-3 clinical trials, costs associatedwith the preparation of the ThelinTM NDA, which was submitted to the FDA in May 2005, and submissionof the ThelinTM MAA with the EMEA in July 2005.**Sales and Marketing Expense**     Sales and marketing expense increased $6.5 million and $23.7 million in the three and ninemonths ended September 30, 2006, compared with the three and nine months ended September 30, 2005,respectively. The increases are primarily due to costs associated with preparation for theanticipated commercial launch of ThelinTM in the U.S., including the addition of a U.S. sales force,and related sales launch preparation activities. We are also actively preparing for the commerciallaunch of ThelinTM in Europe, having added a vice president of European sales and marketing and aEuropean headquarters staff. We have hired a sales force in the U.K. and are in the process ofhiring a sales force in Germany. Sales and marketing expense also included incremental share-basedcompensation expense of $0.4 million, and $1.2 million in the three and nine months ended September30, 2006, respectively, resulting from our adoption of FAS 123R on January 1, 2006.**General and Administrative Expense**     General and administrative expense increased $3.0 million and $7.9 million in the three andnine months ended September 30, 2006, compared with the three and nine months ended September 30,2005, respectively. The increases are due to costs associated with building the infrastructure tosupport the potential commercial launch of ThelinTM, including the addition of several keymanagement appointments, such as a chief financial officer, chief operating officer and generalcounsel. General and administrative expense in the three and nine months ended September 30, 2006,also included incremental share-based compensation expense of $0.6 million and $2.0 million,respectively, resulting from our adoption of FAS 123R on January 1, 2006.**Total Operating Expenses**     Total operating expenses increased $9.5 million and $31.0 million in the three and nine monthsended September 30, 2006, compared to the three and nine months ended September 30, 2005,respectively, primarily due to the ThelinTM pre-commercialization activities discussed above. Aspreviously discussed, regulatory approval of ThelinTM in the U.S. has been delayed, pendingsatisfaction of one substantive item included in the July Approvable Letter. We intend to continueto develop the infrastructure necessary to commercialize ThelinTM, should we receive regulatoryapproval in the U.S., and to support our sales launch in Europe. Accordingly, we expect tocontinue to incur significant operating expenses for the remainder of 2006 and in the future. Asdiscussed in “Liquidity and Capital Resources,”
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below, if we are unable to obtain FDA regulatory approval of ThelinTM in the near future, andif we are not able to secure additional funding, we will not be able to sustain our current levelsof operations.**Operating Loss**     Operating loss in the three and nine months ended September 30, 2006, increased $6.1 millionand $25.9 million, respectively, compared with the three and nine months ended September 30, 2005,due to increased operating expenses in current year periods. The effect of increased operatingexpenses was partially offset by increased royalty revenues during the current year periods.**Interest Expense**     Interest expense in each of the three and nine month periods ended September 30, 2006, isprimarily due to interest payable on the Notes.**Investment Income**     Investment income in the three-month period ended September 30, 2006, decreased approximately$0.5 million compared with the three-month period ended September 30, 2005, as we had less cashavailable for investment in the current period. Investment income in the nine months endedSeptember 30, 2006 was comparable to the nine months ended September 30, 2005, as we investedproceeds received upon issuance of the Notes in March 2005.**Income from discontinued operations**     The results of Revotar in the three and nine months ended September 30, 2005, have beenreclassified as discontinued operations as a result of the Restructuring, and are primarilycomprised of a gain recorded on the Restructuring.**Liquidity and Capital Resources**     We have financed our research and development activities and other operations primarilythrough public and private offerings of our common stock and the Notes and from funds receivedthrough our collaborations, research agreements, licenses and partnerships. We also have receivedroyalty revenue from sales of Argatroban. At September 30, 2006, we had cash and short-terminvestments of $49.9 million, which we believe is sufficient to fund our cash requirements through2006. Based upon our current cash position and our expected future cash requirements, we believethat we will require additional funding in order to continue our ongoing research and developmentprograms, and to fund the commercial launch of ThelinTM in Europe, whether ThelinTM is approved inthe U.S. or not. If ThelinTM is not approved by the FDA in the near future, we believe thatadditional funding will be significantly more difficult to obtain on commercially acceptable terms,if at all. If ThelinTM is approved by the FDA, we anticipate that we will require additionalfunding to commercially launch ThelinTM in the U.S. Such additional funding could be arrangedthrough public or private equity, debt financings, bank debt, or, if we choose to do so,collaborative arrangements. As we assess the options regarding the worldwide marketing of ThelinTM,we will also continue to review the possibility of licensing rights to ThelinTM outside of NorthAmerica and Europe. We cannot assure you that any licensing arrangements will be available onacceptable terms, if at all, or that we will choose this approach. As we review our operations andresearch and development programs, we may also consider various methods to reduce our costs inorder to sustain our cash resources. Those measures may include scaling back headcount andexpenses, delaying or terminating research and development programs, curtailing capitalexpenditures or reducing other operating activities. We may also consider relinquishing, licensingor otherwise disposing of rights to technologies, product candidates or products that we couldotherwise seek to develop or commercialize ourselves, on terms that are less favorable than mightotherwise be available or at an earlier stage than would otherwise be desirable.     On October 19, 2006, we announced that the Company had secured a commitment from AzimuthOpportunity Ltd. to purchase up to $75 million, or a maximum of 11,853,012 shares of the Company’scommon stock, whichever occurs first, over an 18-month period, at a predetermined discount to the
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prevailing market price. At our request, and upon the approval of our Board of Directors,Azimuth will purchase a certain dollar amount of shares, with the exact number of shares to bedetermined based on the per share market price of our common stock over the draw-down period forsuch purchase. We may request up to 24 draw downs during the 18-month period, with each drawdownlimited in size to the lesser of 2.5% of our market capitalization or a fixed amount ranging from$6 million to $29.5 million based on our stock price. Upon each sale of our common stock toAzimuth, we have also agreed to pay Reedland Capital Partners, an Institutional Division ofFinancial West Group, Member NASD/SIPC, a placement fee equal to one and one-eighth percent of theaggregate dollar amount of common stock purchased by Azimuth.     The shares will be offered pursuant to an effective registration statement filed with theSecurities and Exchange Commission on June 4, 2004. This report shall not constitute an offer tosell or the solicitation of an offer to buy any of these securities. There shall not be any saleof these securities in any state or jurisdiction where such an offer, solicitation or sale would beunlawful under the securities laws of such state or jurisdiction.     Cash, cash equivalents and investments in marketable securities, including accrued interestthereon, was $49.9 million at September 30, 2006, compared with $127.9 million at December 31,2005. We used $76.6 million in cash in continuing operations during the nine months endedSeptember 30, 2006, compared to $47.8 million during the nine months ended September 30, 2005. Cashused in discontinued operations was $603,000 in the nine months ended September 30, 2005. In March2005, we received a $2 million milestone payment from Schering Plough which is included in deferredrevenue at September 30, 2005. The primary operating uses of cash in the 2006 and 2005 periodswere to fund our general operating expenses and the ongoing research and development programs, aswell as preparations for the commercialization of ThelinTM, partially offset by cash received frominvestment income and milestone payments.     Investing activities are primarily comprised of purchases of equipment and leaseholdimprovements, and of our investments in debt securities. Cash is generated from investingactivities when marketable securities mature and the resulting cash is utilized primarily to fundoperating activities. Purchases of equipment and leasehold improvements were $1.8 million in thenine months ended September 30, 2006 and $1.7 million in the nine months ended September 30, 2005.Cash used in investing activities during the nine months ended September 30, 2005, was primarilycomprised of the investment of funds received from our sale of the Notes in March 2005.     Cash provided by financing activities of $0.4 million during the nine months ended September30, 2006 was comprised of proceeds of employee stock option exercises. Cash provided by financingactivities in the nine months ended September 30, 2005, included net proceeds of $125.3 millionfrom the sale of the Notes in March 2005 and approximately $1.6 million in proceeds from theexercise of employee stock options.*Material Commitments*     Our material contractual obligations are comprised of (i) amounts borrowed through theissuance of the Notes, (ii) obligations under our operating lease agreements and (iii) a contingentobligation to pay the other party to a research agreement a termination fee in the event that weelect to terminate the project prior to completion. In addition, we have signed a long-termpurchase agreement for the manufacturing and supply of ThelinTM; however, our obligations under theagreement are contingent upon receiving regulatory approval for the marketing of ThelinTM in theU.S.
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     As of September 30, 2006, the Company had contractual obligations as follows (dollars inthousands):                           Less than  1-3  3-5  After 5 Contractual Obligations Total  1 year  Years  Years  years Long-term debt $130,000  $—  $—  $—  $130,000 Operating leases  2,287   1,828   459   —   — Purchaseobligations  232   232   —   —   —                 Total $132,519  $2,060  $459  $—  $130,000 *Outlook for 2006*     Royalty revenues in 2006 have been higher than those received in 2005, and our operatingexpenses have been significantly higher in 2006. We have incurred, and expect to incur,significant expenses related to commercialization-related activities and expenses, includingestablishing a sales and marketing organization in the U.S. and Europe, in anticipation ofreceiving regulatory approval of ThelinTM in the U.S., and in support of our commercial launch inEurope. We intend to enroll patients in additional clinical trials of ThelinTM for otherindications. We have initiated a clinical trial to study the use of ThelinTM in patients withdiastolic heart failure, or DHF, and have announced plans to initiate a combination clinical trialinvolving ThelinTM and a PDE5 compound. As previously discussed, we have initiated a phase IIdose-ranging clinical trial for TBC3711 and are assuming that the issue which resulted in placingsuch trials on clinical hold can be resolved. We also intend to continue development work ofcompounds in our research pipeline. Since the outcomes of regulatory filings for ThelinTM in theU.S., Canada and Australia are uncertain, we do not anticipate providing specific financialguidance for 2006.*Longer-Term Outlook*     We expect to incur substantial research and development expenditures as we design and developbiopharmaceutical products for the prevention and treatment of cardiovascular and other diseases.We anticipate that our operating expenses will significantly increase in subsequent years because: **•** In connection with the commercial launch of ThelinTM in Europe and the anticipatedlaunch in the U.S., we have incurred and will incur significant commercializationexpenses. These costs include: **–** developing post-marketing surveillance systems;  **–** market research;  **–** hiring a general counsel, vice president of sales, chief financial officer, chiefoperating officer and other key staff personnel;  **–** hiring a marketing and field sales force in the U.S., Canada and Europe;  **–** establishing appropriate infrastructure to support the various field sales forces;  **–** preparation and production of educational and promotional materials;  **–** engaging an advertising agency to support our product promotion;  **–** hiring personnel and engaging third-party support to administer reimbursement fromgovernment and private third-party payers; and  **–** establishing manufacturing, warehousing and distribution processes for ourproducts.
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 **•** We expect to incur significant expenses in conjunction with clinical trial costs forour ongoing long-term safety study of ThelinTM, for clinical trials in new indications forThelinTM and for clinical trials related to other compounds. These costs include: **–** hiring personnel to direct and carry out all operations related to clinical trials;  **–** hospital and procedural costs;  **–** services of a contract research organization; and  **–** purchasing and formulating large quantities of the compound to be used in such trials.     We will require substantial additional spending to complete the research and development ofour product candidates, to establish commercial scale manufacturing facilities, if necessary, andto market our products. Estimates of our future capital requirements will depend on many factors,including: **•** expenses and risks associated with clinical trials to expand the indications for ThelinTM;  **•** regulatory approval of ThelinTM, including breadth of any approved labeling;  **•** continued scientific progress in our drug discovery programs;  **•** the magnitude of these programs;  **•** progress with preclinical testing and clinical trials;  **•** the time and costs involved in obtaining regulatory approvals;  **•** the costs involved in filing, prosecuting and enforcing patent claims;  **•** competing technological and market developments and changes in our existing researchrelationships;  **•** increased administrative costs and costs to commercialize our products as our productsare further developed and marketed;  **•** working capital requirements to support inventory and accounts receivable;  **•** our ability to maintain and establish additional collaborative arrangements; and  **•** effective commercialization activities and arrangements.*Off-Balance Sheet Arrangements*     We have not engaged in off-balance sheet financing arrangements.**Impact of Inflation and Changing Prices**     The pharmaceutical research industry is labor intensive and wages and related expensesincrease in inflationary periods. The leases of space and related building services for our Houstonoffice and laboratory facilities each contain clauses that escalate rent and related services eachyear based on the increase in building operating costs and the increase in the Houston ConsumerPrice Index, respectively. To date, inflation has not had a significant impact on our operations.
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**Item 3.****Quantitative and Qualitative Disclosures About Market Risk****Foreign Currency Exchange Risk**     The Company is exposed to market risk primarily from changes in foreign currency exchangerates. We have contracts with entities outside the U.S. that are denominated in a foreigncurrency. To date, these currencies have not fluctuated materially.**Item 4.****Controls and Procedures**Evaluation of Disclosure Controls and Procedures     As of the end of the period covered by this report, our management carried out an evaluation,with the participation of our principal executive officer (the “CEO”) and our principal financialofficer (the “CFO”), of the effectiveness of our disclosure controls and procedures pursuant toRule 13a-15 of the Securities Exchange Act of 1934. Based on those evaluations, the CEO and CFOconcluded:          (i) that our disclosure controls and procedures are designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under the Securities ExchangeAct of 1934 is recorded, processed, summarized and reported within the time periods specified inthe SEC’s rules and forms, and that such information is accumulated and communicated to ourmanagement, including the CEO and CFO, as appropriate to allow timely decisions regarding requireddisclosure; and          (ii) that our disclosure controls and procedures are effective.Changes in Internal Controls Over Financial Reporting     There have been no changes in our internal controls over financial reporting during the periodcovered by this report that have materially affected, or that are reasonably likely to materiallyaffect, our internal control over financial reporting.**PART II. OTHER INFORMATION****Item 1.****Legal Proceedings**     On September 26, 2006, a purported class action complaint (the “Massachusetts Laborerscomplaint”) was filed in the United States District Court for the Southern District of Texas byMassachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situatedinvestors against the Company, Bruce D. Given, M.D. (the Company’s President and Chief ExecutiveOfficer), Richard A.F. Dixon (the Company’s Senior Vice President, Research and Chief ScientificOfficer) and Stephen L. Mueller (the Company’s former Vice President, Finance and Administration,Secretary and Treasurer). The complaint alleges violations of sections 10(b) and 20(a) of theSecurities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and focuses onstatements that are claimed to be false and misleading regarding the Company’s drug sitaxsentansodium. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of theCompany’s securities during the period from February 19, 2004 through March 24, 2006.     In addition, on October 10, 2006, a second purported class action complaint was filed in theUnited States District Court for the Southern District of Texas by Gustav R. Bastian, on behalf ofhimself and all other similarly situated investors against the Company, Dr. Given, Mr. Dixon andMr. Mueller. The complaint asserts substantially the same factual allegations and legal claims asthe Massachusetts Laborers complaint on behalf of the same putative class. A third substantiallysimilar purported class action complaint was filed on October 20, 2006 by Steven O. Scott, and afourth substantially similar purported class action complaint was filed on November 1, 2006 by CamiJanzen-Guare. These complaints assert substantially the same factual allegations and legal claimsas the Massachusetts Laborers’ complaint and were filed in the same court on behalf of the sameputative class.
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     It is possible that additional complaints regarding the same subject matter may be filed inthe future. The Company expects that the existing four lawsuits, as well as any future purportedclass action lawsuits involving the same subject matter as the existing lawsuits, will beconsolidated into a single civil action. Although the Company believes that the allegations inthese cases are without merit and intends to defend all such litigation vigorously, litigation issubject to inherent uncertainties, and an adverse result in these or other matters that may arisefrom time to time could have a material adverse effect on our business, results of operations andfinancial condition. Any litigation to which we are subject may be costly and, further, couldrequire significant involvement of our senior management and may divert management’s attention fromour business and operations .**Item 1A.****Risk Factors*****Unless we receive regulatory approval for ThelinTM in the U.S. and receive additional funding,we will not be able to continue our current level of operations.***          In November 2000, we began to market our first product, Argatroban, through our agreement withGSK. However, the royalties produced to date by Argatroban have not made us profitable, and areunlikely to make us profitable in the future. To date, the majority of our resources have beendedicated to the research and development of Argatroban, ThelinTM and other small molecule drugs forcertain vascular and related inflammatory diseases. We do not have any drug candidates that arelikely to be commercialized in the near future other than ThelinTM.     At September 30, 2006, we had cash and short-term investments of $49.9 million, which webelieve is sufficient to fund our cash requirements through 2006. Based upon our current cashposition and expected future cash requirements, we believe that we will require additional fundingin order to continue our ongoing research and development programs and to fund the commerciallaunch of ThelinTM in Europe, whether or not ThelinTM is approved in the U.S.. If ThelinTM is notapproved by the FDA in the near future, we believe that additional funding will be significantlymore difficult to obtain on commercially acceptable terms, if at all. We will also considervarious methods to reduce our costs in order to sustain our cash resources. Those measures mayinclude scaling back headcount and expenses, delaying or terminating research and developmentprograms, curtailing capital expenditures or reducing other operating expenses. We may alsoconsider relinquishing, licensing or otherwise disposing of rights to technologies, productcandidates or products that we could otherwise seek to develop or commercialize ourselves on termsthat are less favorable than might otherwise be available or at an earlier stage than wouldotherwise be desirable. Even if ThelinTM is approved by the FDA, we believe that we will requireadditional funding to commercially launch ThelinTM in the U.S.     We believe that the commercial launch of ThelinTM in Europe and the anticipated launch in theU.S. will require additional funding due to higher levels of sales and marketing expenditures,particularly in Europe, than in recent periods. The amount of and timing of future revenues fromThelinTM sales will be dependent upon a number of factors, including market acceptance of ThelinTM,pricing and reimbursement approvals, and the content of those approvals by third parties, and howquickly government pricing and reimbursement approvals and product launches may be achieved. Wecannot predict when we will become profitable and cannot assure you that we will ever achieveprofitability.     ***We have a history of losses and we may never become profitable.***     We have been unprofitable to date. As the outcome of our regulatory filings with the FDA andother regulatory authorities is uncertain, we are unable to project revenues for ThelinTM. Even ifwe receive regulatory approval to market ThelinTM in the U.S., significant uncertainties withrespect to the market acceptance of ThelinTM and reimbursement policies of third-party payers, andthe speed with which government or other third-party payers grant pricing and reimbursementapprovals and product launches are achieved, could materially affect any revenue projections.Accordingly, we could continue to incur operating losses in future quarters as we invest in productresearch and development, preclinical and clinical testing, regulatory compliance andcommercialization. At September 30, 2006, we had an accumulated deficit of approximately $396.5million, and for the fiscal years ended December 31, 2005, 2004 and 2003 we have incurred netlosses of approximately $74.9 million, $54.7 million and, $35.3 million, respectively. If we do notbecome profitable, we may require substantial additional funding to
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complete the research and development of our product candidates, to establish commercial scalemanufacturing facilities, if necessary, and to market our products. To become profitable, we,either alone or with our collaborators, must successfully develop, manufacture and market ourproduct candidates, or continue to identify, develop, acquire, manufacture and market other newproduct candidates. We may never have any significant revenues or become profitable.***We are the subject of securities class action lawsuits that may result in substantial expenditures,and divert management’s attention.***     On September 26, 2006, a purported class action complaint (the “Massachusetts Laborerscomplaint”) was filed in the United States District Court for the Southern District of Texas byMassachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situatedinvestors against the Company, Bruce D. Given, M.D. (the Company’s President and Chief ExecutiveOfficer), Richard A.F. Dixon (the Company’s Senior Vice President, Research and Chief ScientificOfficer) and Stephen L. Mueller (the Company’s former Vice President, Finance and Administration,Secretary and Treasurer). The complaint alleges violations of sections 10(b) and 20(a) of theSecurities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and focuses onstatements that are claimed to be false and misleading regarding the Company’s drug sitaxsentansodium. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of theCompany’s securities during the period from February 19, 2004 through March 24, 2006.     In addition, on October 10, 2006, a second purported class action complaint was filed in theUnited States District Court for the Southern District of Texas by Gustav R. Bastian, on behalf ofhimself and all other similarly situated investors against the Company, Dr. Given, Mr. Dixon andMr. Mueller. The complaint asserts substantially the same factual allegations and legal claims asthe Massachusetts Laborers complaint on behalf of the same putative class. A third substantiallysimilar purported class action complaint was filed on October 20, 2006 by Steven O. Scott, and afourth substantially similar purported class action complaint was filed on November 1, 2006 by CamiJanzen-Guare. These complaints assert substantially the same factual allegations and legal claimsas the Massachusetts Laborers’ complaint and were filed in the same court on behalf of the sameputative class.     It is possible that additional complaints regarding the same subject matter may be filed inthe future. The Company expects that the existing four lawsuits, as well as any future purportedclass action lawsuits involving the same subject matter as the existing lawsuits, will beconsolidated into a single civil action. Although the Company believes that the allegations inthese cases are without merit and intends to defend all such litigation vigorously, litigation issubject to inherent uncertainties, and an adverse result in these or other matters that may arisefrom time to time could have a material adverse effect on our business, results of operations andfinancial condition. Any litigation to which we are subject may be costly and, further, couldrequire significant involvement of our senior management and may divert management’s attention fromour business and operations.**Legislative or regulatory changes may adversely impact our business.**     The FDA has designated ThelinTM as an orphan drug under the Orphan Drug Act. TheOrphan Drug Act provides incentives to manufacturers to develop and market drugs for rare diseases,generally by entitling the first developer that receives FDA marketing approval for an orphan drugto at least a seven-year exclusive marketing period in the United States for that product. Inrecent years Congress has considered legislation to change the Orphan Drug Act to shorten theperiod of automatic market exclusivity and to grant marketing rights to simultaneous developers ofa drug. If the Orphan Drug Act is amended in this manner, ThelinTM will face increasedcompetition, which may decrease the amount of revenue we receive from these products.     In addition, the United States government and other governments have shown significantinterest in pursuing healthcare reform. Any government-adopted reform measures could adverselyimpact: **•** the pricing of therapeutic products and medical devices in the United Statesor internationally;
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 **•** our ability to protect the United States market from the purchase byconsumers of therapeutic products and medical devices that have been imported frommanufacturers and distributors located outside of the United States;  **•** the amount of reimbursement available from governmental agencies or otherthird-party payers; and  **•** Medicare reimbursement of pharmaceutical products.     New laws, regulations and judicial decisions, or new interpretations of existing laws,regulations and decisions, which relate to health care availability, methods of delivery or paymentfor products and services, or sales, marketing or pricing may cause our revenue to decline, andnecessitate revision of our research and development programs.***Legislative changes or regulatory decisions in Europe may adversely impact our orphan drug statuswhich may result in loss of revenues in the European Union.     The European Commission has designated ThelinTM as an orphan drug. Orphan drug statusprecludes European regulators from approving marketing applications in the European Union formedicinal products that are chemically similar to ThelinTM for a period of ten years. We have beenrequested to provide information to support the designation of ThelinTM as an orphan drug in theE.U. If the European Commission amends its decision designating ThelinTM as an orphan drug, or ifthe European Commission decides not to renew the orphan drug designation of ThelinTM after the firstfive years following marketing approval, ThelinTM will lose its orphan drug status and Europeanregulators may approve medicinal products that are chemically similar to ThelinTM. In such case,the Company would need to rely on its existing patent protection to prevent the commercializationof competing products in the European Union. This protectionpresently extends to 2016, subject to any available extensions, and may be broader or narrower than thatoffered by orphan drug status, depending on the scope of patent claims applicable to ThelinTM. IfThelinTM loses its orphan drug status in the European Union and existing patent claims applicable toThelinTM cannot prevent commercialization of competing products, ThelinTM will face increasedcompetition, which may decrease the amount of revenue we receive from ThelinTM.***We face substantial competition that may result in others developing and commercializing productsmore successfully than we do.***     The biopharmaceutical industry is highly competitive. Our success will depend on our abilityto develop products and apply technology and to establish and maintain a market for our products.Potential competitors in the U.S. and other countries include major pharmaceutical and chemicalcompanies, specialized biotechnology firms, universities and other research institutions. Many ofour competitors have substantially greater research and development capabilities and experience andgreater manufacturing, marketing and financial resources. Accordingly, our competitors may developproducts or other novel technologies that are more effective, safer or less costly than any thathave been or are being developed by us or may obtain FDA and other applicable regulatory approvalfor products more rapidly than we are able.     Based on industry research analysts, other pharmaceutical companies and our internal marketresearch, we estimate that PAH afflicts approximately 100,000 to 200,000 individuals in the UnitedStates, Canada and Europe.     Should we receive regulatory approval in the U.S., we will have significant competition fromother companies for ThelinTM for the treatment of PAH. These include: **•** A number of companies have endothelin receptor antagonists, or ETRA, compounds eitheron the market, or in clinical development. – Actelion Ltd., a biotechnology company located in Switzerland,markets Tracleer® (bosentan) an oral compound for the treatment of PAHin the United States, Europe, Japan and other countries and they continue todevelop bosentan for other indications.
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   Actelion’s compound, bosentan, will compete directly with ThelinTM. Actelion salesof bosentan exceeded $500 million in 2005.  – Myogen, Inc. is evaluating ambrisentan, an oral endothelin receptorantagonist, in PAH and has announced that it intends to file an NDA with the FDAin the fourth quarter of 2006. In early October, Gilead Sciences announced itsintention to purchase Myogen in a cash transaction worth approximately $2.5billion, which would give Gilead rights to market ambrisentan in the U.S. Earlierthis year, Myogen licensed GSK the right to market ambrisentan in all territoriesoutside the U.S. If Myogen’s compound, ambrisentan, receives regulatory approval,it will compete directly with ThelinTM.  – Abbott Laboratories is developing atrasentan for treatment of cancerand we cannot assure you that it will not compete with ThelinTM.  – Speedel is developing SPP301, which started Phase III clinicaldevelopment for diabetic nephropathy in July 2005. **•** In addition to ETRA compounds, other agents are being marketed for the treatment ofPAH. – Pfizer Inc. markets RevatioTM (sildenafil citrate) in PAH for patientsin WHO Group I. We believe that phosphodiesterase type-5 inhibitors such asRevatioTM may be used as first-line therapy and as additive or combination therapywith endothelin antagonists.  – Myogen markets Flolan® (epoprostenol), a vasodilator requiringcontinuous infusion through a central venous catheter and special infusion pump inthe U.S. Outside the U.S., Flolan is marketed by GSK. Flolan is typicallyreserved by clinicians for patients with the most severe symptoms, WHO functionalclass IV status.  – CoTherix, Inc. markets Ventavis® (iloprost), an inhalation solutionfor the treatment of PAH in WHO Group I, patients with NYHA Class III or IVsymptoms in the U.S. Ventavis® is marketed outside the U.S. by Schering, A.G. orone of its subsidiaries. During clinical trials, Ventavis® was administered sixto nine times a day.  – United Therapeutics Corporation markets Remodulin® (treprostinilsodium injection), a prostaglandin analog that is required to be administeredsubcutaneously or intravenously through an infusion pump, and is also beingstudied for potential use through inhalation     We have significant competition for Argatroban for the treatment of HIT. The products thatcompete with Argatroban include: **•** Refludan®, which was approved by the FDA in 1997 for the treatment of HIT;and  **•** Angiomax®, which is approved for use in the U.S. as an anticoagulant inpatients with unstable angina undergoing percutaneous transluminal coronary angioplastyand for the treatment of HIT.     We cannot assure you that technological development by others will not render our products orproduct candidates uncompetitive or that we will be successful in establishing or maintainingtechnological competitiveness.**Item 2**. **Unregistered Sales of Equity Securities and Use of Proceeds**     None.**Item 3**. **Defaults Upon Senior Securities**     None
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**Item 4****.****Submission of Matters to a Vote of Security Holders**     None**Item 5****.****Other Information**     None.**Item 6** . **Exhibits**   **Exhibit No.** **Description**31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) / Rule15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.   31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) / Rule15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.   32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section906 of the Sarbanes-Oxley Act of 2002.   32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section906 of the Sarbanes-Oxley Act of 2002.
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**ENCYSIVE PHARMACEUTICALS INC.****November 9, 2006****SIGNATURES**Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersigned thereunto duly authorized, on the 9th dayof November 2006.      ENCYSIVE PHARMACEUTICALS INC.***