Document:

exv4w2

 

Exhibit 4.2

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

 

NOTICE is hereby given that the Annual Meeting of Shareholders (the “Meeting”) of Labopharm Inc.
(“Labopharm” or the “Company”) will be held at the Hotel Omni Mont-Royal, in the Pierre Coubertin
Room, 1050 Sherbrooke West, Montreal, Quebec, on Thursday, May 4, 2006 at 10:00 a.m. (Montreal
time), for the purposes of:

	(a)	 	receiving Labopharm’s audited consolidated financial statements for the financial year ended
December 31, 2005 and the report of the auditors thereon;
	 
	(b)	 	electing directors;
	 
	(c)	 	appointing the auditors and authorizing the directors to fix their remuneration; and
	 
	(d)	 	transacting such other business as may properly come before the Meeting or any adjournment or
adjournments thereof.

DATED at Laval, Quebec, this 20th day of March, 2006.

By order of the Board of Directors

 

 

 

Lynda Covello

General Counsel and Corporate Secretary

 

SHAREHOLDERS MAY EXERCISE THEIR RIGHTS BY ATTENDING THE MEETING OR BY COMPLETING A FORM OF PROXY.
SHOULD YOU BE UNABLE TO ATTEND THE MEETING IN PERSON, KINDLY COMPLETE, DATE AND SIGN THE ENCLOSED
FORM OF PROXY AND RETURN IT IN THE ENVELOPE PROVIDED AT YOUR EARLIEST CONVENIENCE. TO BE VALID,
PROXIES MUST REACH THE OFFICE OF NATIONAL BANK TRUST INC., 1100 UNIVERSITY STREET, MONTREAL,
QUEBEC, H3B 2G7, NO LATER THAN AT THE CLOSE OF BUSINESS ON THE LAST BUSINESS DAY PRECEDING THE DATE
OF THE MEETING OR ANY ADJOURNMENT THERETO. YOUR SHARES WILL BE VOTED IN ACCORDANCE WITH YOUR
INSTRUCTIONS AS INDICATED ON THE PROXY.

 

 

 

INFORMATION CIRCULAR

FOR THE ANNUAL MEETING OF SHAREHOLDERS

TO BE HELD ON MAY 4, 2006

 

SOLICITATION OF PROXIES

     This information circular (the “Circular”) is provided in connection with the solicitation by
the Management of Labopharm Inc. of proxies for use at our 2006 Annual Meeting of Shareholders (the
“Meeting”) to be held at the time and place and for the purposes mentioned in the Notice of Meeting
and at all adjournments thereof. As used in this Circular, all references to “Labopharm”, the
“Company”, “we”, “us”, “our” or similar terms are to Labopharm Inc.

     Except as otherwise indicated, the information contained in this Circular is given as of March
1, 2006. Any information, policies or rules posted on our website as described in this Circular
(including Schedules A and B hereto) does not form part of, and shall not be deemed to be
incorporated by reference into, this Circular, unless expressly otherwise indicated. The
solicitation will be made primarily by mail. However, our employees or mandataries designated by us
may also solicit proxies by telephone or in writing. The cost of the solicitation will be borne by
us. Upon request, we will reimburse all brokers, banks, depositaries, nominees and other trustees
for the reasonable costs incurred by them in order to send the proxy documents to the beneficial
owners of our shares.

RULES CONCERNING PROXIES

     Any proxy to be used at the Meeting must be received no later than the close of business on
the last business day preceding the date of the Meeting by our transfer agent, National Bank Trust
Inc. A person giving a proxy may revoke it at any time including at any adjournment, unless the
proxy has already been used. A proxy may be revoked by a written notice executed by the shareholder
or by his attorney authorized in writing or, if the shareholder is a corporation, by an officer or
an attorney thereof duly authorized and sent to our Corporate Secretary. The authority conferred
upon the proxyholder may also be revoked if the shareholder attends the Meeting in person and makes
a request to that effect.

     The persons named in the enclosed form of proxy will exercise the voting rights attached to
the shares for which they have received the proxy in accordance with the instructions indicated in
the form of proxy. In the absence of instructions, the voting rights attached to the shares shall
be exercised IN FAVOUR of the matters mentioned in the attached Notice of Meeting. The enclosed
form of proxy confers upon the proxyholder a discretionary power in respect of amendments to the
matters set forth in the Notice of Meeting and regarding all other matters which may properly be
brought before the Meeting and all adjournments thereof. Our Management is not aware of any such
changes or other matters that may come before the Meeting. If, however, such amendments or other
matters do properly come before the Meeting or any adjournment thereof, the shares represented by
the form of proxy will be voted at the discretion of the proxyholder.

 

 

     Every shareholder has the right to appoint a person (who need not be a shareholder) to act for
and on behalf of the shareholder at the Meeting other than the persons designated in the form of
proxy. To do so, the shareholder must strike out the names of the persons named in the proxy and
insert the name of the proxyholder in the blank space provided for that purpose in the form of
proxy.

NON-REGISTERED SHAREHOLDERS

     Non-registered shareholders may vote shares that are held by their nominees in one of two
manners. Applicable securities laws and regulations, including National Instrument 54-101
—Communication with Beneficial Owners of Securities of a Reporting Issuer, require nominees of
non-registered shareholders to seek their voting instructions in advance of the Meeting.
Non-registered shareholders will receive (or will have received) from their nominees either a
request for voting instructions or a proxy form for the number of shares held by them. The
nominees’ voting instructions or proxy forms will contain instructions relating to signature and
return of the document and these instructions should be read carefully and followed by
non-registered shareholders to ensure that their shares are accordingly voted at the Meeting.

     Non-registered shareholders who would like their shares to be voted for them must therefore
follow the voting instructions provided by their nominees.

     Non-registered shareholders who wish to vote their shares in person at the Meeting must insert
their own name in the space provided on the request for voting instructions or proxy form, as the
case may be, in order to appoint themselves as proxyholder and follow the signature and return
instructions provided by their nominees. Non-registered shareholders who appoint themselves as
proxyholders should present themselves at the Meeting to a representative of our transfer agent,
National Bank Trust Inc. Non-registered shareholders should not otherwise complete the form sent to
them by their nominees as their votes will be taken and counted at the Meeting.

VOTING SHARES AND PRINCIPAL HOLDERS THEREOF

     As at March 1, 2006, we had 43,816,913 of our common shares (the “Shares”) issued and
outstanding. Shareholders are entitled to one vote per Share.

     At the Meeting and all adjournments thereof, each shareholder is entitled to exercise the
votes attached to the Shares registered in his name at the close of business on March 10, 2006,
which is the “record date” that has been set for the Meeting.

     To the knowledge of our directors and officers and based upon publicly available information,
the only person, company or other entity that held or exercised control or direction over, as at
March 1, 2006, 10% or more of our issued and outstanding Shares was Fonds de Solidarité des
travailleurs du Québec (F.T.Q.) (“FSTQ”), which held 4,544,671 Shares, representing approximately
10.4% of all issued and outstanding Shares on such date.

     Given the fact that the former Labopharm shareholders’ agreement entered into on May 2, 1996
no longer reflected our shareholding, we and the FSTQ entered into a new agreement on May 29, 2001
(the “FSTQ Agreement”) pursuant to which: (i) as long as FSTQ holds 5% or more of the issued and
outstanding Shares, FSTQ has the right to designate two nominees to represent it on our Board of
Directors; (ii) as long as FSTQ holds 1% or more and less than 5% of the issued and outstanding
Shares, FSTQ has the right to designate one nominee to represent it on our Board of Directors; and
(iii) the FSTQ Agreement will be in force as long as FSTQ holds 1% or more of the issued and
outstanding Shares. As at March 1, 2006, to the knowledge of our directors and officers, FSTQ held
4,544,671 Shares representing approximately 10.4% of all issued and outstanding Shares.
Consequently, FSTQ is entitled under

 

 

the FSTQ Agreement to designate two nominees for election to the Board of Directors. However, given the size of the
current and proposed Board of Directors, FSTQ has advised us that it will only exercise its right
to designate one nominee to represent it on our Board of Directors.

PRESENTATION OF FINANCIAL STATEMENTS

     The annual report including our audited consolidated financial statements for the financial
year ended December 31, 2005 and the auditors’ report thereon will be presented at the Meeting.

ELECTION OF DIRECTORS

     In accordance with our Corporate Governance Rules (reproduced at Schedule B to this Circular),
including the Charter of the Human Resources and Corporate Governance Committee, the Human
Resources and Corporate Governance Committee, which reports to the Board of Directors, annually
reviews the composition of our Board of Directors with respect to the skills, experience and
expertise of its members and draws up, for purposes of review and approval by the Board of
Directors, a list of nominees to be proposed as directors of our Company, subject to the
requirements of the FSTQ Agreement.

     In accordance with the recommendations of the Human Resources and Corporate Governance
Committee, which recommendations were approved by the Board of Directors, the eight persons listed
in the table below will be proposed as nominees for election to the Board of Directors at the
Meeting. Mr. Jacques L. Roy is FSTQ’s nominee for election to the Board of Directors.

     The name of each person proposed by our Human Resources and Corporate Governance Committee as
a nominee for election to the position of director, the year in which each nominee first became a
director of Labopharm, the principal occupation of each nominee and the number of Shares which each
nominee directly or indirectly held as beneficial owner or over which he exercised control or
direction as at March 1, 2006, are provided in the table below:

	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	 	 	Number of Labopharm
	 	 	 	 	 	 	 	 	Shares Held
	 	 	 	 	 	 	 	 	Directly or
	 	 	Director	 	 	 	Indirectly as
	Name and Municipality of Residence	 	Since	 	Principal Occupation	 	Beneficial Owner
	Santo J. Costa

Cary, North Carolina

	 	 	2006	 	 	Attorney,

Maupin Taylor, p.a. (law firm)
	 	—

	 
	 	 	 	 	 	 	 	 	 	 
	James R. Howard-Tripp

Burlington, Ontario

	 	 	1999	 	 	President and Chief Executive Officer,

Labopharm Inc.
	 	 	99,800	 
	 
	 	 	 	 	 	 	 	 	 	 
	Richard J. MacKay(A)

Laval, Quebec

	 	 	1995	 	 	President and Chief Executive
Officer, Stiefel Canada Inc.
(international pharmaceutical
company)
	 	 	129,071	 
	 
	 	 	 	 	 	 	 	 	 	 
	Anthony C. Playle

Wendover, United Kingdom

	 	 	2001	 	 	President, ACPharma Limited
(consulting firm specializing in the
pharmaceutical industry) and Managing
Director of Labopharm Europe Limited
	 	 	15,000	 
	 
	 	 	 	 	 	 	 	 	 	 
	Frédéric Porte(B)

Montreal, Quebec

	 	 	1998	 	 	President, Medipress Management Inc.
(strategic and financial planning
company in the health care and
communications sectors)
	 	 	45,000	 
	 
	 	 	 	 	 	 	 	 	 	 
	Robert Raich(A)

Montreal, Quebec

	 	 	2004	 	 	Managing Partner,

Spiegel Sohmer (law firm)
	 	 	5,500	 
	 
	 	 	 	 	 	 	 	 	 	 
	Jacques L. Roy(A)(B)

Montreal, Quebec

	 	 	2001	 	 	Vice-President, Finance & Corporate

Development, Omega Laboratories

Limited (privately held

pharmaceutical company)
	 	—(1)

 

 

	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	 	 	Number of Labopharm
	 	 	 	 	 	 	 	 	Shares Held
	 	 	 	 	 	 	 	 	Directly or
	 	 	Director	 	 	 	Indirectly as
	Name and Municipality of Residence	 	Since	 	Principal Occupation	 	Beneficial Owner
	James S. Scibetta(B)

Glen Rock, New Jersey, United States

	 	 	2001	 	 	Executive Vice-President and Chief
Financial Officer, Merrimack
Pharmaceuticals, Inc. (privately held
biotechnology company)
	 	 	10,000	 

 

			
	(A)	 	Member of the Human Resources and Corporate Governance Committee.

	 
	(B)	 	Member of the Audit Committee.
	 
	(1)	 	Mr. Roy is FSTQ’s nominee pursuant to the FSTQ Agreement. FSTQ holds 4,544,671 Shares.

     Each director will hold office until the close of the next annual meeting of
shareholders, unless he resigns or his position becomes vacant by death, removal or otherwise prior
to the said meeting.

     Prior to joining Omega Laboratories Limited as Vice-President, Finance & Corporate
Development, on July 11, 2005, Mr. Jacques L. Roy was Investment Director, Life Sciences with FSTQ.
Mr. Santo J. Costa was Vice-Chair of the Board of Directors of Quintiles Transnational Corp. until
June 2001. Except Messrs. Roy and Costa, all of the nominees for election to the position of
director have held the principal occupations shown above during the last five years.

     In connection with his functions at FSTQ, Mr. Jacques L. Roy was elected director of LBL
Skysystems Corporation (“LBL”) on February 6, 2003. On September 27, 2005, LBL was declared
bankrupt pursuant to the Bankruptcy and Insolvency Act (Canada). Mr. Santo J. Costa was the
non-executive chairman of the board of Argomed, Inc., a privately held company, until be resigned
from such position on August 2, 2002. On the day Mr. Costa resigned from his position, Argomed,
Inc. filed for bankruptcy under the laws of the United States. Mr. Frédéric Porte was elected
director of Avance Pharma Inc. in October 2004 and resigned from such position in January 2005. In
June 2005, Avance Pharma Inc. instituted proceedings under the Companies’ Creditors Arrangement Act
(Canada).

     Unless instructions are given to abstain from voting with respect to the election of
directors, the persons named in the enclosed form of proxy intend to vote FOR the election of the
nominees named in the table on the preceding page. Our Management has no reason to believe that
any of such persons will be unable to serve as a director, but if that should occur for any reason
prior to the election, the persons named in the enclosed form of proxy reserve the right to vote
for another nominee of their choice.

 

 

REMUNERATION OF DIRECTORS

     Since May 1, 2005, each non-executive director received $1,000 per Board meeting or committee
meeting, with the exception of the Chairman of the Board of Directors and the committee
chairperson, each of whom received $1,500. These amounts were respectively reduced to $500 and $750
for attendance by way of conference call. Each such director entitled to be remunerated as
described above also received an annual fee of $15,000 for his tenure as director and an additional
$5,000 for a committee chairperson, all of which were payable in quarterly instalments. The
Chairman of the Board received an annual fee of $40,000, payable in quarterly instalments. The
previously mentioned amounts are denominated in United States dollars for non-resident directors.
Unless otherwise determined by the Board of Directors, each such director also received options to
purchase Shares pursuant to our stock option plan. In 2005, the formula for option grants was
10,000 options per non-executive director per year and an additional 5,000 options per year for
each member of a committee of the Board of Directors. The Chairman of the Board of Directors
received 40,000 options. Finally, each director is entitled to be reimbursed for the travelling
costs incurred by him in order to attend the meetings. During the financial year ended December 31,
2005, we paid an aggregate of $241,531.30 in cash to our directors then in office (excluding
reimbursement of expenses) and granted a total of 130,000 options under our stock option plan to
such directors during the same period.

REMUNERATION OF EXECUTIVE OFFICERS

     The following table sets forth detailed information regarding the compensation earned by our
President and Chief Executive Officer, our Chief Financial Officer and our four other most highly
compensated executive officers who were serving as such as at December 31, 2005 and whose total
salary and bonus exceeded $150,000 during the most recently completed financial year (collectively
referred to as the “Named Executive Officers”), in consideration of services rendered during the
financial years ended December 31, 2005, December 31, 2004 and December 31, 2003. The information
includes the basic salary, the bonuses granted, the number of stock options granted as well as all
other compensation paid that is not mentioned elsewhere.

 

 

Summary Compensation Table

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	Annual Compensation	 	Long-term Compensation	 	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	Awards	 	Payouts	 	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	Securities	 	Restricted	 	 	 	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	under Options/	 	Shares or	 	 	 	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	Other Annual	 	SARs	 	Restricted	 	LTIP	 	All Other
	Name and Principal	 	Financial	 	Salary	 	Bonus	 	Compensation	 	Granted	 	Share Units	 	Payouts	 	Compensation
	Occupation	 	Year	 	($)	 	($)	 	($)(1)	 	(#)	 	($)	 	($)	 	($)
	James R. Howard-Tripp
	 	Dec. 31, 2005	 	 	425,000	 	 	 	340,000	 	 	 	—	 	 	 	155,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	President and Chief
	 	Dec. 31, 2004	 	 	425,000	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 
	Executive Officer
	 	Dec. 31, 2003	 	 	385,000	 	 	 	300,000	 	 	 	—	 	 	 	100,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Warren Whitehead
	 	Dec. 31, 2005	 	 	207,848	 	 	 	31,177	 	 	 	—	 	 	 	20,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Chief Financial Officer
	 	Dec. 31, 2004	 	 	197,950	 	 	 	19,795	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 
	 
	 	Dec. 31, 2003	 	 	185,000	 	 	 	41,625	 	 	 	—	 	 	 	35,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Sylvie Bouchard
	 	Dec. 31, 2005	 	 	265,522	 	 	 	100,000	 	 	 	—	 	 	 	80,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Vice President,
	 	Dec. 31, 2004	 	 	226,573	 	 	 	45,315	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 
	Clinical Development
	 	Dec. 31, 2003	 	 	211,750	 	 	 	58,250	 	 	 	—	 	 	 	50,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Allan Mandelzys
	 	Dec. 31, 2005	 	 	228,408	 	 	 	100,000	 	 	 	—	 	 	 	70,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Vice President,
	 	Dec. 31, 2004	 	 	217,531	 	 	 	21,753	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 
	Business Development
	 	Dec. 31, 2003	 	 	203,300	 	 	 	50,825	 	 	 	—	 	 	 	50,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Damon Smith
	 	Dec. 31, 2005	 	 	226,633	 	 	 	67,990	 	 	 	—	 	 	 	70,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Vice President,
	 	Dec. 31, 2004	 	 	211,807	 	 	 	42,361	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 	 	 	—	 
	Research & Development
	 	Dec. 31, 2003	 	 	197,950	 	 	 	39,600	 	 	 	—	 	 	 	35,000	 	 	 	—	 	 	 	—	 	 	 	—	 
	Anthony C. Playle
	 	Dec. 31, 2005	 	 	116,912	 	 	 	100,000	 	 	 	—	 	 	 	75,000	(2)	 	 	—	 	 	 	—	 	 	 	329,667	(3)
	Managing Director
	 	Dec. 31, 2004	 	 	113,832	 	 	 	23,145	 	 	 	—	 	 	 	40,000	(4)	 	 	—	 	 	 	—	 	 	 	350,333	(5)
	Labopharm Europe
	 	Dec. 31, 2003	 	 	101,280	 	 	 	—	 	 	 	—	 	 	 	20,000	(6)	 	 	—	 	 	 	—	 	 	 	272,519	(7)
	Limited
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 

 

			
	(1)	 	Perquisites that do not exceed the lesser of $50,000 and 10% of the total of annual base
salary and bonus are not included in this column.
	 
	(2)	 	These options were granted to Mr. Playle in his capacity as Managing Director of Labopharm
Europe Limited.
	 
	(3)	 	We paid an amount of $324,768 as consulting fees to ACPharma Ltd., a consulting firm
controlled by Mr. Playle and an amount of $4,899 was paid by us as director’s fees.
	 
	(4)	 	20,000 options were granted to Mr. Playle in his capacity as Managing Director of Labopharm
Europe Limited; 15,000 options were granted to Mr. Playle in his capacity as a director of
Labopharm; and 5,000 options were granted to Mr. Playle in his capacity as member of the Board
of Directors of Labopharm Europe Limited.
	 
	(5)	 	We paid an amount of $318,840 as consulting fees to ACPharma Ltd., a consulting firm
controlled by Mr. Playle, and an amount of $31,493 was paid to Mr. Playle by us as director’s
fees.
	 
	(6)	 	Options granted to Mr. Playle in his capacity as a director of Labopharm.
	 
	(7)	 	We paid an amount of $244,714 as consulting fees to ACPharma Ltd., a consulting firm
controlled by Mr. Playle, and an amount of $27,805 was paid to Mr. Playle by us as director’s
fees.

     During the financial year ended December 31, 2005, we paid an aggregate of $2,539,157 in
cash to all of our Named Executive Officers for all compensation during such period, including
salary, bonus payments and other compensation. During the same period, we granted a total of
470,000 options to our Named Executive Officers.

 

 

Stock Options Granted and Exercised During the Most Recently Completed Financial Year

     The following table indicates the individual grants of stock options to our Named Executive
Officers during the financial year ended December 31, 2005. The aggregate number of Shares
underlying the options granted during such period to all of our employees was 1,071,400 at prices
ranging from $2.56 to $6.61 per Share.

Options Granted During the Most Recently Completed Financial Year

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	Percentage of Total	 	 	 	 	 	Market Value of Shares	 	 
	 	 	Shares under	 	Options Granted	 	 	 	 	 	Underlying the Options	 	 
	 	 	Options	 	During the	 	Exercise Price	 	on the Date of Grant	 	 
	Name	 	(#)	 	Financial Year	 	(per Share)	 	(per Share)(1)	 	Expiration Date
	James R. Howard-Tripp
	 	 	65,000	 	 	 	6.1	%	 	$	3.10	 	 	$	3.10	 	 	May 4, 2010
	 
	 	 	90,000	 	 	 	8.4	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010
	Warren Whitehead
	 	 	20,000	 	 	 	1.9	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010
	Sylvie Bouchard
	 	 	40,000	 	 	 	3.7	%	 	$	3.10	 	 	$	3.10	 	 	May 4, 2010
	 
	 	 	40,000	 	 	 	3.7	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010
	Allan Mandelzys
	 	 	30,000	 	 	 	2.8	%	 	$	3.10	 	 	$	3.10	 	 	May 4, 2010
	 
	 	 	40,000	 	 	 	3.7	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010
	Damon Smith
	 	 	35,000	 	 	 	3.3	%	 	$	3.10	 	 	$	3.10	 	 	May 4, 2010
	 
	 	 	35,000	 	 	 	3.3	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010
	Anthony C. Playle
	 	 	35,000	 	 	 	3.3	%	 	$	3.10	 	 	$	3.10	 	 	May 4, 2010
	 
	 	 	40,000	 	 	 	3.7	%	 	$	6.61	 	 	$	6.61	 	 	December 14, 2010

 

			
	(1)	 	Based on the closing price of the Shares on the TSX on the date of the grant.

     The following table sets forth the stock options exercised by our Named Executive
Officers during the financial year ended December 31, 2005. The closing price of the Shares on
December 31, 2005 on the TSX was $6.97.

Aggregate Options Exercised During the Most Recently Completed Financial Year

and Financial Year-End Option Values

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	Value of Unexercised
	 	 	Shares	 	Aggregate	 	Unexercised Options as at	 	in-the-Money Options
	 	 	Acquired on	 	Value	 	December 31, 2005	 	as at December 31, 2005(1)
	 	 	Exercise	 	Realized	 	Exercisable	 	Unexercisable	 	Exercisable	 	Unexercisable
	Name	 	(#)	 	($)	 	(#)	 	(#)	 	($)	 	($)
	James R. Howard-Tripp
	 	 	253,000	 	 	 	270,720	 	 	 	601,700	 	 	 	103,300	 	 	 	906,779	 	 	 	189,171	 
	Warren Whitehead
	 	 	70,000	 	 	 	207,600	 	 	 	141,700	 	 	 	13,300	 	 	 	200,912	 	 	 	4,788	 
	Sylvie Bouchard
	 	 	100,000	 	 	 	284,300	 	 	 	251,600	 	 	 	53,400	 	 	 	478,459	 	 	 	112,941	 
	Allan Mandelzys
	 	 	100,000	 	 	 	47,000	 	 	 	223,300	 	 	 	46,700	 	 	 	241,988	 	 	 	87,012	 
	Damon Smith
	 	 	—	 	 	 	—	 	 	 	158,400	 	 	 	46,600	 	 	 	396,791	 	 	 	98,559	 
	Anthony C. Playle
	 	 	—	 	 	 	—	 	 	 	208,300	 	 	 	56,700	 	 	 	690,217	 	 	 	99,783	 

 

			
	(1)	 	Value of unexercised options at year-end is calculated by subtracting the option exercise
price from the closing price of our Shares on the TSX on December 31, 2005 ($6.97) and
multiplying the result by the number of Shares underlying an option. There is no guarantee
that this value will ever be realized.

 

 

Employment Contracts

     Pursuant to their respective employment agreements, in the event of a change of control of the
Company, Mr. James R. Howard-Tripp is entitled to receive a cash payment in an amount equal to 24
months of his annual base salary, while Mr. Warren Whitehead and Drs. Sylvie Bouchard, Allan
Mandelzys, Damon Smith and Mr. Anthony C. Playle are each entitled to receive a cash payment in an
amount equal to 18 months of their annual base salary. All of our Named Executive Officers
mentioned above would also be entitled to their insurance and health care benefits and all
unexercised stock options would fully vest in the event of a change of control. These agreements
also contain customary non-competition, non-solicitation and confidentiality provisions. In
addition, these agreements provide, in the event of termination of employment (except where such
termination is due to gross negligence of duty), for severance payments of 18 months’ salary (24
months for Mr. Howard-Tripp), plus benefits.

REPORT ON EXECUTIVE COMPENSATION

Compensation Philosophy

     Our executive compensation program is based on the belief that the interests of our executives
and shareholders should be closely aligned with one another. Under this philosophy:

				
	 	 ̈ 	 	A significant portion of each executive’s total compensation is linked directly to the
attainment of personal objectives that are intended to create value for shareholders in
both the short- and long-term.
	 
	 	 ̈ 	 	Executives are incented to improve our overall performance and profitability and will
only be rewarded when the specific goals established by the Human Resources and Corporate
Governance Committee (for the Chief Executive Officer and, based on the recommendations of
the Chief Executive Officer, for the other Named Executive Officers) have been achieved.
	 
	 	 ̈ 	 	Each year an executive’s individual performance and contribution will be rewarded
through differentiated salary adjustments and bonus paid, if any. We believe that this
enables us to attract, retain, and motivate the leadership talent we need to maintain and
grow our businesses successfully.

Determining Executive Compensation

     Aside from benefits, the three main components to an executive’s total compensation package
are (i) salary, (ii) bonus awards and (iii) option grants.

     In determining the proper amount for each compensation component, the Human Resources and
Corporate Governance Committee reviews the compensation paid for similar positions at other
publicly traded Canadian corporations with which we compete for executive talent. In addition to
the foregoing, surveys of remuneration across both the Canadian and U.S. biopharmaceutical
industries, as well as general industry and geographical trends, are taken into account and a
comparator group of companies (the “Comparator Group”) is then identified. Each year the Human
Resources and Corporate Governance Committee reviews the compensation paid to the top executives,
including the president and chief executive officer, at the companies comprising the Comparator
Group, as well as their corporate performance and other factors in determining the appropriate
performance measures and compensation levels for our executives.

 

 

     (i) Base Salary

     Under our compensation program, the Human Resources and Corporate Governance Committee
establishes a range of base salaries for the President and Chief Executive Officer, after having
reviewed and analyzed the salaries paid to presidents and chief executive officers occupying
similar positions and performing similar functions at the companies within the Comparator Group.
For our Named Executive Officers other than the President and Chief Executive Officer, the
President and Chief Executive Officer recommends the range of base salaries for each individual
executive to the Board of Directors, which then determines the specific salary within that range
for each individual executive based upon (i) the attainment of a given Named Executive Officer’s
personal objectives and (ii) his or her contribution to our global corporate performance, each in
the most recently completed financial year.

     For our President and Chief Executive Officer, the Human Resources and Corporate Governance
Committee also recommends to the Board of Directors the range for his base salary based upon the
salaries paid to the presidents and chief executive officers of the companies within the Comparator
Group and, upon its recommendation, the Board of Directors fixes his specific salary from within
that range based upon (i) the attainment of his personal objectives and (ii) our global corporate
performance. For the financial year ended December 31, 2005, the President and Chief Executive
Officer’s annual base salary was $425,000.

     (ii) Bonus Awards

     All Named Executive Officers are eligible to receive annual bonus awards. Payment, if any, is
based on our overall performance as compared to the objectives established in advance by the Human
Resources and Corporate Governance Committee, as well as individual performance. The Human
Resources and Corporate Governance Committee may choose to make adjustments to awards to reflect
the impact of unplanned events.

     The process whereby the President and Chief Executive Officer recommends the amount of a given
Named Executive Officer’s bonus award, if any, is based on the same underlying philosophy as that
for determining salaries. The President and Chief Executive Officer reviews and analyzes the
bonuses paid to executives occupying similar positions and performing similar functions at the
companies within the Comparator Group. In accordance with a recommendation of the President and
Chief Executive Officer, the Board of Directors has decided that, based upon its review of bonuses
paid to executives of companies forming the Comparator Group, our vice presidents should be
eligible to receive an annual bonus of up to 30% of their annual base salary. Every year, the
President and Chief Executive Officer assesses the performance of each individual executive, makes
his recommendations to the Human Resources and Corporate Governance Committee; the Committee then
reviews and analyzes the recommendations of the President and Chief Executive Officer and presents
them to the Board of Directors, which in turn votes on such recommendations. Specific amounts of
any bonus award to be paid to each individual executive are based upon (i) the attainment of a
given Named Executive Officer’s personal objectives and (ii) his or her contribution to our global
corporate performance, each in the most recently completed financial year.

     The Board of Directors, upon the recommendation of the Human Resources and Corporate
Governance Committee, has also decided that, based upon a review of bonuses paid to the presidents
and chief executive officers of the companies forming the Comparator Group, our President and Chief
Executive Officer should be eligible to receive an annual bonus of up to 80% of his annual base
salary. In addition, the Human Resources and Corporate Governance Committee recommends to the Board
of Directors the specific amount of the bonus award, if any, to be paid to the President and Chief
Executive Officer based upon (i) the attainment of his personal objectives and (ii) our global
corporate performance, each in the most recently completed financial year. For the financial year
ended December 31, 2005, a bonus in the amount of $340,000 was awarded to our President and Chief
Executive Officer.

 

 

     (iii) Option Grants

     All Named Executive Officers are also eligible to be considered for stock option grants. We
believe that stock options provide value in three ways: (1) by closely aligning management
interests with those of shareholders vis-à-vis share price performance, (2) by acting as a means to
attract high potential executives in competition to larger, more established companies, and (3) by
having long-term retention value. When, upon the recommendation of the Human Resources and
Corporate Governance Committee, the Board of Directors grants options, it follows competitive
long-term incentive compensation practices such that the size and value of these grants is intended
to place our Named Executive Officers, including our President and Chief Executive Officer, in a
competitive position as compared to the estimated value of the options granted to executives
occupying similar positions and performing similar functions at companies within the Comparator
Group.

     When the Human Resources and Corporate Governance Committee recommends to the Board of
Directors the size of new grants to each Named Executive Officer, it considers the number of
options each executive has previously been granted. Options granted by the Board of Directors upon
the recommendation of the Human Resources and Corporate Governance Committee to our Named Executive
Officers normally vest as follows: (i) one-third on the date of the grant, (ii) an additional
one-third on the first anniversary of the date of the grant, and (iii) the remainder on the second
anniversary of the date of the grant:

     A total of 470,000 options were granted to our Named Executive Officers during our most
recently completed financial year under our stock option plan

     For the Human Resources and Corporate Governance Committee:

Richard J. MacKay (Chairman)

Robert Raich

Jacques L. Roy

 

 

PERFORMANCE GRAPH

     The performance graph presented below illustrates the cumulative total return of a $100
investment in Canadian dollars in Labopharm Shares, compared with the cumulative total return of
the S&P/TSX Health Care Index and the S&P/TSX Composite Index.

     The year-end values of each investment are based on share appreciation plus dividends, if any,
reinvested on the date they were paid. The calculations exclude brokerage fees and taxes. Total
shareholder returns from each investment can be calculated from the year-end investment values
shown below the graph.

Labopharm Inc. — Share Price Evolution

February 28, 2001 to December 31, 2005

(February 2001 = 100)

	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	02-28-01	 	02-28-02	 	12-31-02	 	12-31-03	 	12-31-04	 	12-31-05
	Labopharm Inc.
	 	$100	 	$369	 	$144	 	$353	 	$156	 	$268
	S&P/TSX Health Care Index
	 	$100	 	$92	 	$66	 	$60	 	$50	 	$48
	S&P/TSX Composite Index
	 	$100	 	$95	 	$81	 	$102	 	$114	 	$140

STATEMENT OF CORPORATE GOVERNANCE PRACTICES

     Our statement of corporate governance practices is set forth in Schedule A to this Circular.

AUDIT COMMITTEE DISCLOSURE

     Multilateral Instrument 52-110 — Audit Committees, which was amended as of June 30, 2005,
requires issuers to disclose in their annual information forms certain information with respect to
the existence, charter, composition, and education and experience of the members, of their audit
committees, as well as all fees paid to external auditors. However, since an issuer’s information
(or management proxy) circular is more widely disseminated than is its annual information form, we
have decided to present such information with respect to our Audit Committee (other than such
committee’s charter) in the Circular and to incorporate this

 

 

information by reference into our Annual Information Form. The Charter of our Audit Committee
forms part of our Corporate Governance Rules and is attached as Schedule B to this Circular. Our
Corporate Governance Rules are also accessible on our website at www.labopharm.com.

Composition of the Audit Committee

     Frédéric Porte, Jacques L. Roy and James S. Scibetta are the current members of our Audit
Committee, each of whom is independent and financially literate within the meaning of MI 52-110.
Mr. Scibetta is currently Chair of the Audit Committee.

Education and Relevant Experience

     The education and related experience of each of the members of our Audit Committee is
described below.

     Frédéric Porte — Mr. Porte holds a Diplôme d’études approfondies (D.E.A.) in social and
economic information from L’Université Paris-Sorbonne in France, as well as a Master’s degree in
Business Administration and Finance from L’École Supérieure de Commerce in Lyon, France. Mr. Porte
is the founder and President of Medipress Management Inc., a company offering strategic and
financial planning in the health care sector. Mr. Porte also serves as the President of Angelus
Investment Corporation, a venture capital organization, since 2003. In 1981, he founded L’Actualité
Médicale Inc., a publishing company the assets of which were sold in 1985. In 1987, he founded and
was President of Clinidata Inc., a medical and pharmaceutical software company, which was purchased
by Hoechst Marion Roussel (now sanofi-aventis S.A.) in 1994.

     Jacques L. Roy — Mr. Roy holds a Bachelor of Commerce degree (B.Comm.) from McGill
University. He has over 25 years of experience working in the fields of finance, venture capital
and mergers and acquisitions. Throughout the course of his career, Mr. Roy has served on the board
of directors of more than 15 companies (including various life sciences companies) as well as on
the audit committee of a number of such companies.

     James S. Scibetta — Mr. Scibetta holds a Master’s of Business Administration degree (M.B.A.)
from the University of Michigan. He is currently the Executive Vice-President and Chief Financial
Officer of Merrimack Pharmaceuticals, Inc., a privately held biotechnology company located in
Cambridge, Massachusetts, on whose audit committee he previously served as a member. Mr. Scibetta
also has 18 years of experience in investment banking having worked on Wall Street.

Pre-Approval Policies and Procedures

     Form 52-110F1 requires an issuer to disclose whether its audit committee has adopted specific
policies and procedures for the engagement of non-audit services and to prepare a summary of these
policies and procedures. In 2004, we adopted an Audit Committee Pre-Approval Policy for Audit and
Non-Audit Services, which is available on our website at www.labopharm.com.

Appointment and Remuneration of External Auditors

     At the Meeting, our shareholders will be called upon to appoint auditors to hold office until
the next annual meeting of shareholders and to authorize the directors to establish the
remuneration of the auditors so appointed.

     Unless instructions are given to abstain from voting with regard to the appointment of
auditors, the persons named in the enclosed form of proxy intend to vote

 

 

FOR the appointment of Ernst & Young llp as auditors of the Company, compensation for
their services to be determined by the Board of Directors.

     Ernst & Young llp have been acting as our auditors since July 2002, prior to which
Arthur Andersen llp acted as our auditors since 2001. From 1998 until 2001, Mallette Maheu
acted as our auditors. In addition to performing the audit of our consolidated financial
statements, Ernst & Young llp provided other services to us and they billed us the
following fees in respect of each of our two most recently completed financial years:

	 	 	 	 	 
	 	 	Financial Year Ended	 	Financial Year Ended
	Fees	 	December 31, 2005	 	December 31, 2004
	Audit Fees(1)
	 	$164,004	 	$377,559
	Audit-Related Fees(2)
	 	—	 	$9,255
	Tax Fees(3)
	 	$120,940	 	$111,166
	All other Fees(4)
	 	$6,415	 	$22,304
	Total:
	 	$291,359	 	$520,284

 

			
	(1)	 	Refers to the aggregate fees billed by our external auditor for audit services, as well as
services that are normally provided by the external auditor, such as services in connection
with regulatory filings, prospectuses and consents. The audit fees for the year ended
December 31, 2004 included $241,955 related to financing initiatives. No such fees were
incurred for the year ended December 31, 2005.
	 
	(2)	 	Refers to the aggregate fees billed for assurance and related services by our external
auditor that are reasonably related to the performance of the audit or review of our financial
statements and are not reported under (1) above, including professional services rendered by
our external auditor for accounting consultations on proposed transactions, and consultations
related to accounting and reporting standards.
	 
	(3)	 	Refers to the aggregate fees billed for professional services rendered by our external
auditor for tax compliance, tax advice and tax planning.
	 
	(4)	 	Refers to the aggregate fees billed for products and services provided by our external
auditor, other than the services reported under (1), (2) and (3) above.

DESCRIPTION OF THE STOCK OPTION PLAN

     On January 1, 2005, the TSX enacted new rules with respect to, among other things, stock
option plans. These new rules enable issuers to modify any existing stock option plan in order to
express the maximum number of securities issuable thereunder as a percentage of the issuer’s issued
and outstanding shares rather than a fixed number.

     On March 9, 2005, our Board of Directors adopted modifications to our then existing stock
option plan. The purpose of the modifications was to align our stock option plan with the new rules
of the TSX. The modifications to our stock option plan were approved by a majority of our
shareholders at our 2005 annual meeting of shareholders. For the purposes of this section of the
Circular, we refer to our stock option plan, as amended in 2005, as the “Stock Option Plan”.

     Since our last annual meeting of shareholders, a total of 711,950 Shares have been issued upon
the exercise of options, representing approximately 1.6% of our issued and outstanding Shares. As
of March 1, 2006, there were options outstanding in respect of 3,469,825 Shares under the Stock
Option Plan, representing approximately 7.9% of our issued and outstanding Shares. The following is
a description of the purpose, terms and conditions of our Stock Option Plan.

     The purpose of the Stock Option Plan is to enable us to attract and retain highly experienced
and skilled directors, officers, employees, members of the Scientific Advisory

 

 

Committee and service providers of Labopharm and its subsidiaries (collectively the
“Participants”) and to provide incentives to such Participants to promote the creation of
shareholder value by aligning such Participants’ interests with the market value of our Shares.

     The Stock Option Plan authorizes the Board of Directors to grant options to purchase Shares to
employees, directors, officers, members of the Scientific Advisory Committee or service providers
of Labopharm or its subsidiaries from time to time.

     The maximum number of Shares that can be issued under the Stock Option Plan may not exceed
9.9% of the total number of Shares issued and outstanding at any given time. In the event that
options are exercised, vested or cancelled, the Board of Directors may grant an equivalent number
of new options under the Stock Option Plan. On April 20, 2005, we undertook in favour of FSTQ (the
“FSTQ Undertaking”) not to grant options that have been previously exercised in accordance with the
Stock Option Plan, even though this would be possible under the terms of the Stock Option Plan. The
FSTQ undertaking shall expire upon the Stock Option Plan being further amended by Labopharm and
such amendments being approved by the shareholders at a duly called meeting.

     No Participant may hold options to purchase more than 5% of the number of Shares issued and
outstanding at any time. The number of securities issuable (or reserved for issuance) to insiders
under all of our security-based compensation arrangements may not, at any time, exceed 10% of our
issued and outstanding securities. Furthermore, the number of securities issued to insiders under
all of our security-based compensation arrangements, within a one-year period, may not exceed 10%
of all of our issued and outstanding securities.

     The exercise price of options granted under the Stock Option Plan is established by the Board
of Directors but may not be lower than the closing market price of the Shares on the TSX on the
date of the grant. If no transaction has been reported on such stock exchange on the option grant
date, the closing price will be deemed to be the closing price of the Shares on the TSX on the last
date on which transactions were reported immediately prior to the option grant date. The Board of
Directors determines as part of each option grant the applicable vesting period provided that
options may have an expiry date of up to ten years from the date of the grant. Notwithstanding the
foregoing, unless the Board of Directors decides otherwise, an option is not exercisable from and
after each of the following dates:

	 	(i)	 	in the case of a Participant that is an officer or an employee of Labopharm
or one of our subsidiaries:

	 	•	 	the date on which such Participant resigns or voluntarily leaves his
employment;
	 
	 	•	 	the date on which such Participant’s employment is terminated for cause;
	 
	 	•	 	six months following the termination of such Participant’s employment by
reason of death;
	 
	 	•	 	90 days following the termination of such Participant’s employment by
reason other than those mentioned above, for example, disability, illness,
retirement or early retirement;

 

 

	 	(ii)	 	in the case of a Participant that is a director or a member of the Scientific
Advisory Committee of Labopharm or one of our subsidiaries but is not employed by
Labopharm or one of Labopharm subsidiaries:

	 	•	 	the date on which such Participant ceases to be a director or a member of
the Scientific Advisory Committee for any reason other than death;
	 
	 	•	 	six months following the date on which such Participant ceases to be a
director or a member of the Scientific Advisory Committee by reason of death.

     No option or interest therein is assignable by a Participant other than by testamentary
disposition or by operation of the law of succession. No financial assistance is provided by us to
facilitate the purchase of Shares upon the exercise of options under the Stock Option Plan.

     The Stock Option Plan contains provisions permitting accelerated vesting in the event that an
offer to purchase is made to all holders of Shares (i.e. a takeover bid). In such case, all options
become exercisable immediately but only to the extent necessary to enable the Participant to tender
his Shares in response to the offer.

     The Stock Option Plan is administered by the Human Resources and Corporate Governance
Committee. The Board of Directors, on the advice of the Human Resources and Corporate Governance
Committee, and subject to any necessary regulatory approval, may amend, suspend or terminate the
Stock Option Plan in whole or in part at any time but will not be entitled to implement any
material amendment to the Stock Option Plan, such as an increase in the aggregate maximum number of
Shares issuable under the Stock Option Plan or a reduction of the exercise price of an option,
without having obtained the approval of the holders of a majority of the votes cast by shareholders
who vote in person or by proxy at a meeting of our shareholders.

     Every three years, all unallocated options under the Stock Option Plan will have to be
approved by (i) our Board of Directors, (ii) a majority of our unrelated directors, and (iii) our
shareholders.

     There is no longer a Scientific Advisory Committee of the Company. However options have been
issued to members of such committee in the past.

SECURITY-BASED COMPENSATION ARRANGEMENTS

Securities Authorized for Issuance under Equity Compensation Plans

     The following table sets forth, as at December 31, 2005, the information with respect to all
of our compensation plans pursuant to which our equity securities are authorized for issuance.

 

 

	 	 	 	 	 	 	 
	 	 	 	 	 	 	Number of securities
	 	 	 	 	 	 	remaining available for
	 	 	 	 	 	 	further issuance under
	 	 	Number of securities to be	 	 	 	Labopharm's equity
	 	 	issued upon exercise of	 	Weighted-average exercise	 	compensation plans
	 	 	outstanding options,	 	price of outstanding	 	(excluding securities
	 	 	warrants and rights	 	options, warrants and rights	 	reflected in column (a))
	Plan Category	 	(a)	 	(b)	 	(c)
	Equity
compensation plans
approved by
securityholders
	 	3,560,875	 	$5.59	 	193,937(1)
	Total:
	 	3,560,875	 	$5.59	 	193,937(1)

 

			
	(1)	 	This number takes into account the FSTQ Undertaking.

TRANSACTIONS WITH INTERESTED PARTIES

     Except as described below, we are not aware that any of our directors, officers, nominees for
election as directors, other informed persons or any persons associated with or otherwise related
to any of the foregoing has had an interest in any material transaction carried out since the
beginning of our most recently completed financial year or in any proposed transaction which has
materially affected or is likely to materially affect us or any of our subsidiaries.

     We have entered into a consulting services agreement with ACPharma Ltd., a company controlled
by Anthony C. Playle, who is a director of Labopharm and Managing Director and member of the Board
of Directors of our wholly-owned subsidiary, Labopharm Europe Limited. The fees paid by us to
ACPharma Ltd. during each of the three most recently completed financial years are indicated in
notes (3), (5) and (7) to the Summary Compensation Table found at page 6 of this Circular.

INDEBTEDNESS OF DIRECTORS, EXECUTIVE OFFICERS AND SENIOR OFFICERS

     None of our directors, executive officers or senior officers or persons who held such
positions during the most recently completed financial year or any nominees proposed as a director
nor any person associated with any of the foregoing is indebted to us or any of our subsidiaries or
was indebted to us or any of our subsidiaries either at any time during the most recently completed
financial year or as at March 1, 2006.

LIABILITY INSURANCE

     We take out liability insurance for the benefit of our directors and officers to cover them
against certain liabilities contracted by them in such capacity. For the most recently completed
financial year, this insurance provided for a coverage limit of US$30,000,000 per event and policy
year. During the same period, the premium paid by us amounted to US$416,380. When we are
authorized or required to indemnify an insured, a deductible of US$250,000 per securities claim
applies and a deductible of US$100,000 for all other claims also applies.

OTHER BUSINESS

     Management of Labopharm knows of no other matters to be put before the Meeting. If, however,
any other matters properly come before the Meeting, the persons designated in the accompanying form
of proxy shall vote on such matters in accordance with their best judgment

 

 

pursuant to the discretionary authority conferred thereon by the proxy with respect to such
matters.

ADDITIONAL INFORMATION

     Additional Information relating to us may be found on SEDAR at www.sedar.com. Financial
information related to us is provided in our comparative financial statements and management’s
discussion and analysis thereon for the financial year ended December 31, 2005. We provide the
following documents to any person who requests same from our Corporate Secretary at 480 Armand
Frappier Boulevard, Laval, Quebec, H7V 4B4:

	 	i.	 	a copy of the financial statements and management’s discussion and analysis
thereon; and
	 
	 	ii.	 	a copy of this Circular.

     In addition, it will be possible to obtain our Annual Information Form after the date it is
filed with the securities commissions or similar securities regulatory authorities in Canada as
well as any document incorporated by reference therein. We may require the payment of reasonable
expenses if documents are requested by a person who is not a holder of Labopharm’s securities,
unless we make a distribution of our securities in accordance with a short form prospectus, in
which case such documents will be provided at no charge.

APPROVAL OF THE INFORMATION CIRCULAR

     The directors of Labopharm have approved the contents and the sending of this Circular.

 
 
 

By order of the Board of Directors

Laval, Quebec, March 20, 2006

 
 
 

Lynda Covello

General Counsel and Corporate Secretary

 

 

SCHEDULE A

STATEMENT OF CORPORATE GOVERNANCE PRACTICES

Recent Corporate Governance Developments in Canada

In January 2004, the Canadian Securities Administrators (the “CSA”) adopted Multilateral Instrument
52-110 — Audit Committees, which was amended as of June 30, 2005 (“MI 52-110”). MI 52-110 sets
forth certain requirements regarding audit committee composition and responsibilities, as well as
reporting obligations with respect to audit-related matters.

Effective June 30, 2005, the CSA also adopted Multilateral Instrument 58-101 — Disclosure of
Corporate Governance Practices (“MI 58-101”) and National Policy 58-201 — Effective Corporate
Governance (“NP 58-201” and, together with MI 52-110, the “CSA Corporate Governance Standards”). NP
58-201 provides guidance to Canadian issuers with respect to corporate governance practices, while
MI 58-101 requires issuers to make certain disclosures regarding their governance practices. The
CSA Corporate Governance Standards, particularly MI 58-101 and NP 58-201, have replaced the former
guidelines of the Toronto Stock Exchange that had, prior to the coming into force of the CSA
Corporate Governance Standards, served as the primary source of codified recommendations in respect
of corporate governance practices in Canada.

Labopharm’s Corporate Governance Practices

In accordance with MI 58-101, we are required to disclose information with respect to our system of
corporate governance. Over the past few years, we have undertaken a comprehensive review of our
corporate governance practices in order to best comply with and, whenever practicable, exceed the
CSA Standards.

We commenced our review and updating of our corporate governance practices in 2002 and, in 2003 and
2004, we adopted and implemented a number of charters and policies, including revised formal
charters of our Board of Directors, Audit Committee and Human Resources and Corporate Governance
Committee, a Disclosure and Confidentiality Policy, a Trading Policy, an Audit Committee
Pre-Approval Policy for Audit and Non-Audit Services, a Code of Ethics and Business Conduct, a
Policy Governing Director Nominations, Shareholder-Board Communications and Director Attendance
Meetings and a Whistle-Blowing Policy. We refer to our Board and Committee Charters as our
“Corporate Governance Rules”.

We are of the view that adopting and implementing good corporate governance practices is a
cornerstone of our corporate and management practices and policies and that our existing corporate
governance practices already meet or surpass the prevailing corporate governance standards. We
further believe that the measures we have adopted with respect to corporate governance comply
substantially with the CSA Standards.

We encourage our shareholders to consult our Corporate Governance Rules and Code of Ethics and
Business Conduct available on our website at www.labopharm.com and also available in print to any
shareholder who requests copies by contacting our Corporate Secretary.

Our 2005 Annual Information Form, which will be available on or before March 31, 2006 and which may
be obtained upon request from our Corporate Secretary or at www.sedar.com, will also contain
certain information with respect to our corporate governance practices.

We are dedicated to updating our corporate governance practices on an ongoing basis in order to
respond to the evolution of best practices. We and our Board of Directors are of the view that our
corporate governance practices, as summarized in the following table, are in substantial compliance
with the CSA Corporate Governance Standards. Copies of our Corporate Governance Rules and all
related policies (including those mentioned above) are available on our website at
www.labopharm.com.

 

 

- 2 -

	 	 	 	 	 	 	 
	CSA Guidelines	 	Labopharm’s Corporate Governance Practices
	1.	 	Board of Directors
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Disclose the identity of directors who are independent.
	 	Of the current eight (8) members of our board of directors of the Company
(the “Board” or the “Board of Directors”), six (6) are “independent”
within the meaning of NP 58-201, namely Messrs. Santo J. Costa, Richard
J. MacKay, Frédéric Porte, Robert Raich, Jacques L. Roy and James S.
Scibetta.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Disclose the identity of directors who are not independent,
and describe the basis for that determination.
	 	The following directors do not qualify as “independent” within the
meaning of NP 58-201, as they are officers of Labopharm or one of its
subsidiaries, namely Messrs. James R. Howard-Tripp, President and Chief
Executive Officer of both Labopharm and our wholly-owned subsidiary,
Labopharm Europe Limited, and Anthony C. Playle, Managing Director and
member of the board of directors of Labopharm Europe Limited.
	 
	 	 	 	 	 	 
	 

	 	(c)
	 	Disclose whether or not a majority of directors are
independent. If a majority of directors are not independent,
describe what the board of directors does to facilitate its
exercise of independent judgement in carrying out its
responsibilities.
	 	See above. Six of our eight current directors are independent. The
proposed nominees for election to our Board of Directors are all the same
individuals as our current directors.
	 
	 	 	 	 	 	 
	 

	 	(d)
	 	If a director is presently a director of any other issuer
that is a reporting issuer (or the equivalent) in a
jurisdiction or a foreign jurisdiction, identify both the
director and the other issuer.
	 	Mr. Santo J. Costa is a director of CV Therapeutics, Inc. and NPS
Pharmaceuticals, Inc., two Nasdaq-listed companies, and NeuroMedix Inc.,
a Toronto Stock Exchange-listed company. Mr. Jacques L. Roy is a
director of LBL Skysystems Corporation. Mr. Anthony Playle is a director of Phoqus
Group plc, a public company listed on London Stock Exchange’s Alternative
Investment Market. Mr. Frédéric Porte is a director of Stukely Capital
Inc., a capital pool company.

 

- 3 -

	 	 	 	 	 	 	 
	 

	 	(e)
	 	Disclose whether or not the independent directors hold
regularly scheduled meetings at which non-independent directors
and members of management are not in attendance. If the
independent directors hold such meetings, disclose the number
of meetings held since the beginning of the issuer’s most
recently completed financial year. If the independent directors
do not hold such meetings, describe what the board does to
facilitate open and candid discussion among its independent
directors.
	 	Since 2004, a session has been held outside the presence of management
and all non-independent directors, except Anthony C. Playle, at every
regular Board meeting. During the Financial year ended December 31, 2005,
14 such sessions were held.
	 
	 	 	 	 	 	 
	 

	 	(f)
	 	Disclose whether or not the chair of the board is an
independent director. If the board has a chair or lead director
who is an independent director, disclose the identity of the
independent chair or lead director, and describe his or her
role and responsibilities. If the board has neither a chair
that is independent nor a lead director that is independent,
describe what the board does to provide leadership for its
independent directors.
	 	The Interim Chairman of the Board of Directors, Mr. MacKay, is not a
member of management and qualifies as an “independent” director.
	 
	 	 	 	 	 	 
	 

	 	(g)
	 	Disclose the attendance record of each director for all
board meetings held since the beginning of the issuer’s most
recently completed financial year.
	 	The table below indicates the directors’ record of attendance at meetings
of the Board of Directors and its committees during the financial year
ended December 31, 2005:

	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	 	 	 	 	 	 	 	 	Total Board and
	 	 	Board	 	Committee	 	Committee
	 	 	meetings	 	meetings	 	meetings
	Director	 	attended	 	attended	 	attended
	 
	James R. Howard-Tripp
	 	14 of 14	 	 	 	N/A	 	 	100	%
	Richard J. MacKay
	 	14 of 14	 	8 of 8	 	 	100	%
	Anthony C. Playle
	 	12 of 14	 	 	 	N/A	 	 	86	%
	Frédéric Porte*
	 	14 of 14	 	4 of 4	 	 	100	%
	Robert Raich
	 	12 of 14	 	8 of 8	 	 	91	%
	Jacques L. Roy**
	 	14 of 14	 	8 of 8	 	 	100	%
	James S. Scibetta
	 	14 of 14	 	6 of 6	 	 	100	%
	 
	Attendance Rate:
	 	 	96	%	 	 	 	100%	 	 	97	%
	 

			
	*	 	Mr. Porte was appointed to the Audit Committee on April 20, 2005.
	 
	**	 	Mr. Roy was appointed to the Human Resources and Corporate Governance Committee on October 26, 2005.

 

- 4 -

	 	 	 	 	 	 	 
	2.	 	Board Mandate — Disclose the text of the board’s written mandate. If the board does not have
a written mandate, describe how the board delineates its role and responsibilities.	 	The mandate of the Board of Directors,
a copy of which is included in our
Corporate Governance Rules attached as
Schedule B to this Circular, is to
oversee the conduct of our business and
supervise our senior management which
is responsible for the conduct of the
business. The Board of Directors
determines matters of corporate policy,
assesses management’s execution of
these policies and reviews the results
obtained.
	 
	 	 	 	 	 	 
	3.	 	Position Descriptions
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Disclose whether or not the board has developed written position descriptions for the chair
of the board and the chair of each board committee. If the board has not developed written
position descriptions for the chair and/or the chair of each board committee, briefly describe
how the board delineates the role and responsibilities of each such position.
	 	Labopharm’s Corporate Governance Rules
describes the mandate of the board and
each of its committees and states that
every committee shall appoint one of
its members to act as chair of the
committee.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Disclose whether or not the board and CEO have developed a written position description for
the CEO. If the board and CEO have not developed such a position description, briefly describe
how the board delineates the role and responsibilities of the CEO.
	 	The corporate objectives of the
President and Chief Executive Officer
are set according to the strategic plan
and the budget approved each year by
the Board of Directors. Performance of
the President and Chief Executive
Officer is assessed against the
achievement of the strategic plan and
the budget. The Board of Directors is
responsible for evaluating the
performance of the Chief Executive
Officer. In addition, the Board of
Directors establishes our annual
objectives, which the President and
Chief Executive Officer is charged with
accomplishing.

 

- 5 -

	 	 	 	 	 	 	 
	4.	 	Orientation and Continuing Education
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Briefly describe what measures the board takes to orient new directors regarding

(i) the role of the
board, its committees and its directors, and

(ii) the nature and operation of the issuer’s business.
	 	An orientation and training program for
new Board members has been set up by
our Human Resources and Corporate
Governance Committee The Board of
Directors holds individual meetings
with the President and Chief Executive
Officer and other executive officers
for each new director. New directors
are provided with an extensive
information package containing: (i)
information about Labopharm; (ii)
copies of minutes of the previous
fiscal year; (iii) a copy of our
articles and by-laws; (iv) a copy of
the FSTQ Agreement; (v) information on
insurance coverage; and (vi) various
policies/plans governing the Board
and/or senior executives.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Briefly describe what measures, if any, the board takes to provide continuing education for
its directors. If the board does not provide continuing education, describe how the board ensures
that its directors maintain the skill and knowledge necessary to meet their obligations as
directors.
	 	Strategic planning sessions, using
external consultants and advisors, and
including management, are conducted
periodically. The Board also has
presentations and seminars with
external consultants, advisors, and
members of the management team, on
particular topics on an as-needed
basis.

 

- 6 -

	 	 	 	 	 	 	 
	5.	 	Ethical Business Conduct
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Disclose whether or not the board has adopted a written code for the directors, officers and
employees. If the board has adopted a written code:
	 	We adopted a Code of Ethics and
Business Conduct on April 21, 2004,
(the “Code of Ethics”).
	 
	 	 	 	 	 	 
	 

	 	 	 	(i)
disclose how a person or company may obtain a copy of the code;

	 	The Code of Ethics is accessible on our
website at www.labopharm.com. A paper
copy is also available upon request
from our Corporate Secretary.
	 
	 	 	 	 	 	 
	 

	 	 	 	(ii) describe how the board monitors compliance with its code, or if the board does not
monitor compliance, explain whether and how the board satisfies itself regarding
compliance with its code; and

	 	The Human Resources and Corporate
Governance Committee is responsible for
monitoring compliance with our Code of
Ethics. Our directors, officers and
employees are asked to annually
acknowledge in writing review of and
compliance with the Code of Ethics as a
condition of their engagement or
employment relationship with us, as the
case may be.
	 
	 	 	 	 	 	 
	 

	 	 	 	(iii) provide a cross-reference to any material change report filed since the beginning
of the issuer’s most recently completed financial year that pertains to any conduct of a
director or executive officer that constitutes a departure from the
code.

	 	No material change report has been
required or filed during our financial
year ended December 31, 2005 with
respect to any conduct constituting a
departure from our Code of Ethics.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Describe any steps the board takes to ensure directors exercise independent judgement in
considering transactions and agreements in respect of which a director or executive officer has a
material interest.
	 	The Human Resources and Corporate
Governance Committee reviews and
approves all related party transactions
for potential conflict of interest
situations on an ongoing basis.
	 
	 	 	 	 	 	 
	 

	 	(c)
	 	Describe any other steps the board takes to encourage and promote a culture of ethical
business conduct.
	 	We have arranged for an Ethics Hotline
through which directors, officers and
employees can, on an anonymous basis,
disclose any information or knowledge
they may have regarding violations of
the Code of Ethics or any information
or knowledge regarding questionable
accounting practices or auditing
matters.

 

- 7 -

	 	 	 	 	 	 	 
	6.	 	Nomination of Directors
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Describe the process by which the board identifies new candidates for board nomination.
	 	Together with our Chief Executive
Officer, the Human Resources and
Corporate Governance Committee is
responsible for determining the
criteria for selection of Board and
committee members, including
establishing and periodically reviewing
our practice relating to the
recruitment of Board members. The Human
Resources and Corporate Governance
Committee identifies candidates for
election to the Board in consultation
with management, through the use of
search firms or other advisers, or
through such other methods as the Human
Resources and Corporate Governance
Committee deems to be helpful to
identify candidates. The Human
Resources and Corporate Governance
Committee will also consider candidates
for election to the Board recommended
by shareholders.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Disclose whether or not the board has a nominating committee composed entirely of independent
directors. If the board does not have a nominating committee composed entirely of independent
directors, describe what steps the board takes to encourage an objective nomination process.
	 	The Human Resources and Corporate
Governance Committee is currently
composed of three outside and
independent directors, namely Messrs.
Richard J. MacKay, Robert Raich and
Jacques L. Roy.
	 
	 	 	 	 	 	 
	 

	 	(c)
	 	If the board has a nominating committee, describe the responsibilities, powers and operation
of the nominating committee.
	 	The Charter of the Human Resources and
Corporate Governance Committee
includes:
	 

	 	 	 	 	 	- recommending candidates for
election to the Board;
	 

	 	 	 	 	 	- reviewing, on an annual basis,
credentials of nominees for
re-election; and

	 

	 	 	 	 	 	- recommending candidates for
filling vacancies on the Board.

 

- 8 -

	 	 	 	 	 	 	 
	7.	 	Compensation
	 
	 	 	 	 	 	 
	 

	 	(a)
	 	Describe the process by which the board determines the compensation for the issuer’s
directors and officers.
	 	The Human Resources and Corporate
Governance Committee reviews the amount
and the form of compensation of
directors. In making recommendations to
the Board of Directors for appropriate
adjustments, the Human Resources and
Corporate Governance Committee
considers the time commitment, risks
and responsibilities of directors, as
well as comparative compensation data
of other companies at a similar stage
of development.
	 
	 	 	 	 	 	 
	 

	 	(b)
	 	Disclose whether or not the board has a compensation committee composed entirely of
independent directors. If the board does not have a compensation committee composed entirely of
independent directors, describe what steps the board takes to ensure an objective process for
determining such compensation.
	 	The Human Resources and Corporate
Governance Committee is currently
composed of three outside and
independent directors, namely Messrs.
Richard J. MacKay, Robert Raich and
Jacques L. Roy.
	 
	 	 	 	 	 	 
	 

	 	(c)
	 	If the board has a compensation committee, describe the responsibilities, powers and
operation of the compensation committee.
	 	The Charter of the Human Resources and
Corporate Governance Committee provides
that the committee is responsible for
reviewing and recommending our
aggregate compensation level, as well
as guidelines to be applied to
management employees, with the
assistance of outside human resources
consultants where appropriate. The
Human Resources and Corporate
Governance Committee is also
responsible for reviewing and
recommending to the Board of Directors
any proposed amendments to our stock
option plan, subject to obtaining any
required consents of applicable stock
exchanges or securities regulatory
authorities and for reviewing annually
the level of ownership of Labopharm
Shares by our various directors.

 

- 9 -

	 	 	 	 	 	 	 
	 

	 	(d)
	 	If a compensation consultant or advisor has, at any time since the beginning of the issuer’s
most recently completed financial year, been retained to assist in determining compensation for
any of the issuer’s directors and officers, disclose the identity of the consultant or advisor
and briefly summarize the mandate for which they have been retained. If the consultant or advisor
has been retained to perform any other work for the issuer, state that fact and briefly describe
the nature of the work.
	 	In 2005, Mercer Human Resources
Consulting was retained by Labopharm to
assist in determining compensation of
its directors and officers. $45,060
were paid in fees to Mercer with
respect to this retainer.
	 
	 	 	 	 	 	 
	8.	 	Other Board Committees — If the board has standing committees other than the audit, compensation
and nominating committees, identify the committees and describe their function.	 	There are no other standing committees.
	 
	 	 	 	 	 	 
	9.	 	Assessments — Disclose whether or not the board, its committees and individual directors are
regularly assessed with respect to their effectiveness and contribution. If assessments are regularly
conducted, describe the process used for the assessments. If assessments are not regularly conducted,
describe how the board satisfies itself that the board, its committees, and its individual directors
are performing effectively.	 	In July 2003, the Human Resources and
Corporate Governance Committee was
mandated by the Board of Directors to
conduct a full assessment of the Board.
An expert firm was hired to conduct the
assessment. The main purpose of this
exercise was to determine how the Board
compares with the best Canadian
corporate governance practices and to
ensure that we are well-positioned
moving forward.
	 
	 

	 	 	 	 	 	In addition, the Human Resources and
Corporate Governance Committee monitors
and makes recommendations regarding the
effectiveness of our system of
corporate governance, including the
frequency and content of meetings, the
need for any special meetings,
communication processes between the
Board and management and mandates of
Committees of the Board.
	 
	 	 	 	 	 	 
	 	 	MI 52-110 provides that the audit committee must be composed of a minimum of three (3) members,
who must be “independent” directors (as defined in those rules).	 	The charter of our Audit Committee
provides that all the members of the
committee must be “independent”
directors. All members of the Audit
Committee are in fact “independent”
directors within the meaning of MI
52-110. No member of the Audit
Committee receives, other than in his
or her capacity as a director or member
of a Board committee, directly or
indirectly, any fee from us or any of
our subsidiaries, nor is an affiliated
person with us, or any of our
subsidiaries.

 

- 10 -

	 	 	 	 	 
	 

	 	MI 52-110 provides that each audit committee member must be financially literate.
	 	The Charter of the Audit Committee
provides that all members of the
Committee must have a working
familiarity with basic finance and
accounting practices, and at least one
member of the Committee must have
accounting or related financial
management expertise.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must have a written charter that sets out its
mandate and responsibilities.
	 	The written Charter of the Audit
Committee, which forms part of our
Corporate Governance Rules attached to
this Circular as Schedule “B”, sets out
the role, mandate and responsibilities
of the Audit Committee.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must recommend to the Board of Directors: (a) the
external auditor to be nominated for the purposes of preparing or issuing an auditors’ report
or performing other audit, review or attest services for the issuer; and (b) the compensation
of the external auditor.
	 	The Charter of the Audit Committee
provides that the committee is
responsible for recommending to the
Board of Directors the appointment,
compensation and/or retention
(including the authority not to retain
or terminate) of any independent
auditor engaged by us for the purpose
of preparing or issuing an auditor’s
report or related work.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must be directly responsible for overseeing the
work of the external auditor engaged for the purpose of preparing or issuing an auditors report
or performing other audit, review or attest services for the issuer, including the resolution
of disagreements between management and the external auditor regarding financial reporting.
	 	The Charter of the Audit Committee
provides that the committee is
responsible for the overseeing of any
independent auditor engaged by us for
the purpose of preparing or issuing an
auditor’s report or related work.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must pre-approve all non-audit services to be
provided to the issuer or its subsidiary entities by the issuer’s external auditor.
	 	In April 2004, our Board of Directors
approved an Audit Committee
Pre-Approval Policy for Audit and
Non-Audit Services Policy, which policy
sets forth the procedures and the
conditions pursuant to which services
proposed to be performed by the
independent auditor may be pre-approved
and is available on our website at
www.labopharm.com.

 

- 11 -

	 	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must review the issuer’s financial statements, MD&A
and annual and interim earnings press releases before the issuer publicly discloses this
information. These rules also mention that the audit committee must be satisfied that adequate
procedures are in place for the review of the issuer’s public disclosure of financial
information extracted or derived from the issuer’s financial statements, other than the public
disclosure referred to in the preceding sentence, and must periodically assess the adequacy of
those procedures.
	 	The Charter of the Audit Committee
provides that the committee is
responsible for reviewing, together
with representatives of Management and
representatives of the independent
auditors, our interim quarterly
financial statements and our annual
audited financial statements prior to
their filing, as well as the related
press release, and it shall report
thereon to the Board of Directors. The
committee is also responsible for
monitoring our internal accounting
controls, informational gathering
systems and management reporting on
internal control.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must establish procedures for: (a) the receipt,
retention and treatment of complaints received by the issuer regarding accounting, internal
accounting controls, or auditing matters; and (b) the confidential, anonymous submission by
employees of the issuer of concerns regarding questionable accounting or auditing matters.
	 	The Charter of the Audit Committee
provides that the committee must
establish procedures for: (a) the
receipt, retention and treatment of
complaints received by us regarding
accounting, internal accounting
controls, or auditing matters; (b) the
confidential, anonymous submissions by
our employees of concerns regarding
questionable accounting or auditing
matters; and (c) any other material
matters.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must review and approve the issuer’s hiring
policies regarding partners, employees and former partners and employees of the present and
former external auditor of the issuer.
	 	If this situation were to arise, the
audit committee would review and
approve such an event.
	 
	 	 	 	 
	 

	 	MI 52-110 provides that the audit committee must have the authority: (a) to engage independent
counsel and other advisors as it determines necessary to carry out its duties; (b) to set and
pay the compensation for any advisors employed by the audit committee; and (c) to communicate
directly with the internal and external auditors.
	 	The audit committee has such authority.

 

 

SCHEDULE B

CORPORATE GOVERNANCE RULES

 

 

(See attached)

 

 

 

 

Corporate Governance Rules

 

 

 
 

Amended and ratified by the Board of Directors on February 26, 2003

Charter of the Human Resources and Corporate Governance Committee amended and approved by the Board
of Directors on April 21, 2004

Charter of the Audit Committee amended and approved by the Board of Directors on April 21, 2004

 

 

 

FOREWORD

 

This document establishes the corporate governance rules and practices (hereinafter the
“Rules”) which the Board of Directors (hereinafter the “Board”) of Labopharm Inc. (hereinafter
“Labopharm” or the “Company”) wishes to establish.

These Rules shall be interpreted in relation to the Corporate Governance Guidelines adopted by the
Toronto Stock Exchange. In addition, the Rules shall be interpreted in light of the General
By-laws of the Company as well as any existing Shareholder Agreement.

These Rules are intended as a “tool” by which to ensure the effectiveness of the Board, in the best
interests of all shareholders. This document sets out the operating guidelines of the Board and
its committees. The form or style of drafting of these Rules should not be substituted for the
intent or decisions of the Board.

These descriptions are enumerative and not exhaustive and may be re-evaluated annually or as needed
in order to reflect the development and needs of the Company.

The Board may make all amendments it deems necessary or useful in order to ensure the effectiveness
of these Rules and the complementary documents.

The Board of Directors shall elect annually from among its members a committee to be known as the
Human Resources and Compensation Committee (to be renamed the Human Resources and Corporate
Governance Committee) and an Audit Committee to be composed of at least three directors, a majority
of whom are not officers or employees of the Company or of any of its affiliates. The Board of
Directors shall also elect any other committee, for punctual or special purposes, such as an M&A
Committee or a Strategic Committee.

No decision may be taken by the Board of Directors or by any of its Committees except at properly
convened meetings at which a quorum of the Board or the Committee, as the case may be, is present
or by a resolution in writing signed by all the members of the Board of Directors or the Committee,
as the case may be. A majority of the members of the Board of Directors or the Committee, as the
case may be, shall constitute a quorum, provided that if the number of members of the Board or the
Committee is an even number, one half of the number of members plus one shall constitute a quorum.

Any member of a Committee may be removed or replaced at any time by the Board of Directors and
shall cease to be a member of the Committee as soon as such member ceases to be a director.
Subject to the foregoing, each member of a Committee shall hold such office until the next annual
meeting of shareholders after his or her election as a member of a Committee.

Every Committee shall appoint one of its members to act as Chairman of the Committee.

As prescribed by the By-Law of the Company, the Secretary shall also act as secretary of any
Committee unless otherwise ordered by the Board of Directors.

The time at which and the place where the meetings of a Committee shall be held, the calling of
meetings and the procedure in all respects of such meetings shall be determined by the Committee,
unless otherwise provided for in the by-laws of the Company or otherwise determined by resolution
of the Board of Directors.

Legend:

AC = Audit Committee

HRCGC = Human Resources and Corporate Governance Committee

 

 

COMPLEMENTARY DOCUMENTS

 

Role and Mandate of the Board

 

	 	 	The majority of the Board should be composed of unrelated directors.
	 
	 	 	A related director is a director who is not an unrelated director. If the
Company has a significant shareholder, in addition to a majority of unrelated
directors, the Board should include a number of directors who do not have
interests in or relationships with either the company or the significant
shareholder and which fairly reflects the investment in the Company by
shareholders other than the significant shareholder.
	 
	 	 	The application of the definition of “unrelated director” to the circumstances
of each individual director is the responsibility of the Board, which will be
required to disclose on an annual basis whether the Board has a majority of
unrelated directors.
	 
	 	 	The Board will ensure that appropriate structures and procedures are in place
to ensure that the Board can function independently of management. To this
end, the Board has chosen to appoint a chair of the Board who is not a member
of management with responsibility to ensure the Board discharges its
responsibilities or, if the chair of the Board is a member of management, to
assign this responsibility to the human resources and corporate governance
committee.
	 
	 	 	The Board will also be involved in the review of the corporate financial goals
and strategic plan and in this connection two meetings of the Board of
Directors will be set aside every year for strategic planning purposes.

	 	 	 	 	 
	Mandate
	 	 
	 	 
	 
	 	 	• Assumes general responsibility for the stewardship of the Company
	 	 
	Decisions
	 	 
	 	 
	 
	 	 	• Makes any decision enumerated in the General By-laws and required by
law as well as all decisions reserved to the Board pursuant to the
Schedule of Delegated Authority approved by the Board from time to
time
	 	 
	 	 	• Determines, jointly with the Chief Executive Officer, the corporate
objectives and establishes expectations of management
	 	 
	 	 	• Adopts a strategic planning process and approves a strategic plan
which takes into account, among other things, the opportunities and
risks of the business
	 	 
	 	 	• Company management will identify the principal risks of the business
and ensure, in cooperation with the Board, the implementation of
appropriate systems to manage these risks
	 	 
	 	 	• The Chief Executive Officer will be responsible for providing an
orientation and education program for new directors. The program
guidelines are enumerated at the end of this document �
	 	 
	 	 	• Proposes amendments, where deemed appropriate, to the General
By-laws of the Company
	 	 
	 	 	• Adopts a Disclosure and Confidentiality Policy for the Company,
which should include measures for receiving shareholder feedback
	 	 
	 	 	• Approves the budget and its modifications, if any, throughout the
year
	 	 

 

 

	 	 	 	 	 
	Decisions
	 	 
	 	 
	 
	 	 	• Reviews and approves the Quarterly and Annual
Financial Statements

	 	Recommended by AC
	 	 	• Reviews and approves the Quarterly and Annual
Management Discussion and Analysis (MD&A)

	 	”
	 	 	• Ensures the integrity of internal control
systems and management information systems of the
Company

	 	”
	 	 	• Declares dividends

	 	”
	 	 	• Proposes auditors and their remuneration

	 	”
	 	 	• Approves the Annual Information Form

	 	”
	 	 	• Receives report of AC on review of risks and
uncertainties and considers AC’s recommendations

	 	”
	 	 	 
	 	 	• Revises annually and amends the Rules, if
necessary

	 	Recommended by HRCGC
	 	 	• Appoints new directors

	 	”
	 	 	• Approves the Proxy Circular and related
documents

	 	”
	 	 	• Approves all stock-option grants

	 	”
	 	 	• Changes to the option plan and amendments to the
“terms and conditions” of the Company plan

	 	”
	 	 	• Evaluates the performance of directors based on
evaluation criteria enumerated at the end of this
document Œ

	 	”
	 	 	• Reviews and approves the remuneration of
directors

	 	”
	 	 	• Adopts a policy on the use of privileged
information or any other relevant policy

	 	”
	 	 	• In cooperation with management, the Board will
be responsible for succession planning and the
training and monitoring of senior management

	 	”
	Revision and
Discussion
	 	 
	 	 
	 
	 	 	• Progress reports (R&D and Corp. Aff./Business
Development and Invest. Rel.)
	 	 
	 	 	• Message to shareholders for quarterly reports
	 	 
	 	 	• Message to shareholders and report on operations
for the annual report
	 	 
	 	 	• Communication Plan
	 	 
	 

 

 

CHARTER OF THE HUMAN RESOURCES AND CORPORATE GOVERNANCE COMMITTEE

	I.	 	PURPOSE

The Human Resources and Corporate Governance Committee of Labopharm Inc. (the “Company”) shall
ensure a compensation policy and practice that is supportive of the Company’s business strategies
and that appropriately links senior management performance and compensation. In addition, the
Committee shall ensure the recruitment, ongoing long term development and deployment of high
calibre senior management. In particular, the Committee shall establish levels of salary, bonus,
benefits and incentives (collectively, “Compensation”) provided to officers of the Company and its
affiliates who have the title of Vice-President or higher, or persons performing duties that would
normally be performed by persons with such titles (collectively, “ Officers”).

The Committee is also charged with responsibility for:

	(i)	 	developing and monitoring the effectiveness of the Company’s system of corporate governance;
	 
	(ii)	 	establishing procedures for the identification of new nominees to the Board of Directors of
the Company and leading the candidate selection process;
	 
	(iii)	 	developing and implementing orientation procedures for new directors;
	 
	(iv)	 	assessing the effectiveness of directors, the Board of Directors and the various committees
of the Board of Directors;
	 
	(v)	 	ensuring appropriate corporate governance and proper delineation of the roles, duties and
responsibilities of management, the Board of Directors, and its Committees; and
	 
	(vi)	 	assisting the Board of Directors in setting the objectives for the Chief Executive Officer of
the Company (the “CEO”) and evaluating CEO performance.

In performing its functions, the Committee may retain at the expense of the Company human resources
consultants, external legal counsel and such other advisors as it sees fit.

This Charter of the Committee has been established and adopted by the Board of Directors in order
to provide appropriate guidance to the Committee members as to their duties. This Charter
complements Section 8 of By-law No. One of the Company which deals with the constitution of
committees and procedural rules at their meetings.

	II.	 	RESPONSIBILITIES
	 
	A.	 	Human Resources
	 
	•	 	To annually review and report to the Board of Directors on the effectiveness, from a corporate governance perspective,
of the organizational structure and succession planning processes of the Company.
	 
	•	 	To review and monitor executive development programs and management assessment practices.
	 
	•	 	To review management’s recommendations respecting recruitment, hirings, firings, transfers and promotions of Officers
and related severance packages, with the assistance of outside human resources consultants where appropriate.

 

 

	•	 	To review and recommend the overall employment environment of the Company.
	 
	•	 	To consider such other human resources and compensation issues as it considers appropriate or as may be referred to it
by the Board of Directors.
	 
	•	 	To review annually the level of ownership of shares of the Company by the various officers and to continue to encourage
share ownership by officers of the Company.

	B.	 	Compensation
	 
	•	 	To establish industry benchmarks and comparables for the Company’s approach to compensation.
	 
	•	 	To review and recommend aggregate compensation levels for the Company, as well as compensation guidelines to be applied
generally to management employees, with the assistance of outside human resources consultants where appropriate.
	 
	•	 	Review and recommend corporate goals and objectives relevant to compensation of the CEO, evaluate the CEO’s performance
in light of those goals and objectives and recommend to the Board of Directors the appropriate level of base
compensation and all bonus and other incentive compensation for the CEO based on this evaluation.
	 
	•	 	Following discussions with the CEO, and after reviewing his or her recommendations, to establish the annual
Compensation of all Officers, other than the CEO, subject to the approval of the Board of Directors.
	 
	•	 	The review of the Compensation for the CEO and the Officers shall be conducted in light of the employment agreements
(if any) entered into by them with the Company.
	 
	•	 	The review and recommendation to the Board of Directors of stock option grant guidelines and specific grants proposed
by the CEO (taking into account the limits of stock option plan requiring shareholder approval).
	 
	•	 	The review and recommendation to the Board of Directors of any proposed amendment to the stock option plan, subject to
the obtaining of any required consents of applicable stock exchanges or securities regulatory authorities, including
appropriateness of implementing restrictions on the resale of shares of the Company purchased upon the exercise of
options through a minimum hold period.
	 
	•	 	To recommend to the Board of Directors from time to time the remuneration to be paid by the Company to directors in
light of time commitment and responsibilities, fees paid by comparable companies.
	 
	•	 	To review annually the level of ownership of shares of the Company by the various directors and to continue to
encourage share ownership by directors.
	 
	•	 	To report on executive compensation as required by public disclosure requirements.
	 
	•	 	Together with the CEO, consider and recommend to the Board of Directors the taking of actions with respect to the
adoption, amendment, administration or termination of compensation, welfare, benefit, pension and other plans related
to compensation of current and former executive officers of the Corporation, in each case taking into account
appropriate industry benchmarks and, as

 

 

	 	 	appropriate, the compensation policies pursued by companies similarly situated to the
Corporation.
	C.	 	Corporate Governance

Oversight

	•	 	To ensure that appropriate processes are established by the Board of Directors to fulfill its responsibility for: (i)
oversight of strategic direction and development and review of ongoing results of operations; (ii) oversight of the
Company’s investor relations and public relations activities and ensuring that procedures are in place for the
effective monitoring of the shareholder base, receipt of shareholder feedback and response to shareholder concerns.
	 
	•	 	To assist the Board of Directors in its annual review and revision of the written objectives of the CEO and guidance
for the development of corporate strategy.
	 
	•	 	To ensure that an effective CEO succession plan is in place, including emergency succession.
	 
	•	 	To assist the Board of Directors in assessing and evaluating CEO performance.

Board Meetings

	•	 	To establish procedures for Board of Directors’ meetings and to otherwise ensure that processes, procedures and
structures are in place to ensure that the Board of Directors functions independently of management and without
conflicts of interest.
	 
	•	 	To review the proposed annual agenda for, and provide recommendations as to, additional topics for discussion at
meetings of the Board of Directors.

Board and Committee Structure and Membership

	•	 	To review and consider the size of the Board of Directors in relation to the needs of the Company and
the commitment required of individual directors.
	 
	•	 	Evaluate the current composition and organization of the Board of Directors and its committees in light
of requirements established by the Ontario Securities Commission, The Autorité des Marchés Financiers,
the United States Securities and Exchange Commission, the National Association of Securities Dealers,
any exchange upon which securities of the Company are traded, or any governmental or regulatory body
exercising authority over the Company (each a “Regulatory Body” and collectively, the “Regulatory
Bodies”) or any other applicable statute, rule or regulation which the Committee deems relevant and make
recommendations regarding the foregoing to the Board of Directors for approval.
	 
	•	 	To review the mandates of the Board of Directors’ committees and recommend appropriate changes.
	 
	•	 	Together with the CEO, determine the criteria for selection of Board of Directors’ members and committee
members, including establishing and periodically reviewing the Company’s practices relating to the
recruitment of Board of Directors’ members, in accordance with the criteria set forth in the Company’s
Policy Governing Director Nominations, Shareholder-Board Communications and Director Attendance at
Meetings.

 

 

	•	 	To recommend allocation of directors of the Company to the various committees.
	 
	•	 	To identify and propose to the Board of Directors from time to time new nominees to the Board of
Directors and candidates for the filling of vacancies on the Board of Directors.
	 
	•	 	Review all shareholder proposals submitted to the Company (including any proposal relating to the
nomination of a member of the Board of Directors) and the timeliness of the submission thereof and
recommend to the Board of Directors appropriate action on each such proposal.
	 
	•	 	To maintain an orientation and educational program for new recruits to the Board of Directors in order
to familiarize new directors with the business of the Company, its management and professional advisors
and its facilities.
	 
	•	 	To assess and provide recommendations to the Board of Directors on the effectiveness of the Board of
Directors and its committees and the contribution of each of the Company’s directors.
	 
	•	 	To devise and implement a process for yearly director written self-assessments and to review and analyze
results and to report to the Board of Directors self-assessment, as well as analyze and report to the
Board of Directors on the results of same.
	 
	•	 	To receive and consider any concerns of individual directors.
	 
	•	 	To consider adoption of a rotation policy for membership on committees of the Board as well as rotation
of the position of Chairman of the Board.

Board Relations with Management

	•	 	To monitor the quality of the relationship between management and the Board of Directors and to
recommend improvements for ensuring an effective and appropriate working relationship.
	 
	•	 	To assist in the proper delineation of the roles, duties and responsibilities of management and the
Board of Directors and review and recommend to the Board of Directors a Schedule of Delegated Authority.

Establishment of Policies

	 	 	To review and recommend to the Board of Directors strategic corporate policies such as the
Code of Ethics and Business Conduct, the Disclosure and Confidentiality Policy, the Trading
Policy, the Policy Governing Director Nominations, Shareholder-Board Communications and
Director Attendance at Meetings, and other relevant policies associated with ensuring an
effective system of corporate governance.

Code of Ethics and Business Conduct

	•	 	The Code of Ethics and Business Conduct (the “Code of
Ethics”) at a minimum shall (i) comply with any
requirements established by any Regulatory Body or any
other applicable statute, rule or regulation that the
Committee deems relevant, (ii) address conflicts of
interest and full and fair disclosure and compliance
with laws, (iii) encourage reporting of any illegal or
unethical behavior and expressly prohibit retaliation
of any kind for any such reports or complaints, (iv)
provide clear and objective standards for compliance
with the Code of Ethics and a fair process by which to
determine violations thereof, and (v) contain an
enforcement mechanism. Once established the Committee
shall recommend the adoption of Code of Ethics to the
Board of Directors.

 

 

	•	 	Review and assess the adequacy of the Code of Ethics on
a periodic basis, but at least annually. The Committee
shall recommend any modifications to the Code of Ethics
to the Board of Directors for approval.
	 
	•	 	Collaborate with the Company’s officers and legal
counsel to disclose publicly any amendments to the Code
of Ethics required to be disclosed by any Regulatory
Body.
	 
	•	 	Direct members of the Company’s senior management to
report any allegations of violations of or
non-compliance with the Code of Ethics to the Committee
and to inform employees that such violations should be
reported and to make themselves reasonably available to
receive complaints of any such violations.
	 
	•	 	Be available to the Board of Directors and members of
the Company’s senior management team to consult with
and to resolve reported violations or instances of
non-compliance with the Code of Ethics.
	 
	•	 	Instruct outside legal counsel to report to the
Committee any evidence of a material violation of the
Code of Ethics by any officer or director of the
Company or any other person acting under the direction
of any such person or any agent thereof that are not
appropriately addressed by the Company’s CEO or, if the
violation is made by the CEO, by the General Counsel.
	 
	•	 	Determine an appropriate response to material
violations of or non-compliance with the Code of Ethics
including, at the discretion of the Committee,
reporting any material violations of or non-compliance
with the Code of Ethics to any appropriate Regulatory
Body.

General

	•	 	To report on corporate governance as required by public
disclosure requirements, including posting policies and
other matters on the Company’s website as required by
any Regulatory Body.
	 
	•	 	Review and assess the adequacy of this Charter
periodically as conditions dictate, but at least
annually, and recommend any modifications to this
Charter if and when appropriate to the Board of
Directors for its approval.
	 
	•	 	To undertake such other initiatives as are needed to
help the Board of Directors deliver exemplary corporate
governance.
	 
	III.	 	STRUCTURE
	 
	•	 	The Committee shall be composed of at least three
directors, none of whom are officers or employees of
the Company or of any of its affiliates, a majority of
whom are “unrelated” to the Company (as defined in the
applicable guidelines of the Toronto Stock Exchange)
and all of whom meet any applicable independence
requirements promulgated by the Regulatory Bodies.
	 
	•	 	The Committee shall have access to such officers and
employees of the Company, its auditors, legal counsel
and to such information respecting the Company as it
considers necessary or advisable in order to perform
its duties and responsibilities.

 

 

	IV.	 	PROCESS FOR DETERMINING ANNUAL COMPENSATION OF OFFICERS
	 
	•	 	The Committee will:

	 	(a)	 	obtain compensation data concerning companies that would be regarded as
comparable to the Company, and to the extent possible, understand the basis upon which
such comparable companies compensate their Officers; and
	 
	 	(b)	 	ensure that the CEO meets with Officers from time to time with a view to
understanding personal needs, requirements and expectations and monitor the Company’s
responsiveness to the concerns of its Officers.

 

 

CHARTER OF THE AUDIT COMMITTEE

	I.	 	PURPOSE

The Audit Committee (the “Committee”) of Labopharm inc. (the “Company”) is a committee of the Board
of Directors which has responsibility to review the financial statements, accounting policies and
reporting procedures of the Company.

This Charter of the Committee has been established and adopted by the Board of Directors in order
to provide appropriate guidance to the Committee members as to their duties. This Charter
complements Section 8 of By-law No. One of the Company which deals with the constitution of
committees and procedural rules at their meetings. The primary function of the Committee is to
oversee the accounting and financial reporting processes of the Company and the audits of the
financial statements of the Company, including the review and oversight of: the financial reports
and other financial information provided by the Company to any governmental body or the public; the
Company’s systems of internal controls regarding finance, accounting, and legal compliance that
management and the Board have established; and the Company’s auditing, accounting and financial
reporting processes generally. Consistent with this function, the Committee should encourage
continuous improvement of, and should foster adherence to, the Company’s policies, procedures and
practices at all levels.

	 	 	 	The Committee’s primary duties and responsibilities are to:
	 
	 	•	 	Serve as an independent and objective party to monitor the Company’s financial
reporting process and the system of internal controls.
	 
	 	•	 	Monitor the independence and performance of the Company’s external auditors and the
internal auditing department (when established).
	 
	 	•	 	Provide an open avenue of communication among the independent auditors, financial
and senior management, the internal auditing department and the Board of Directors.
	 
	 	•	 	In performing its functions, the Committee may retain at the expense of the Company
financial advisors, legal counsel and such other advisors as it deems necessary.

	II.	 	COMPOSITION

	 	•	 	The Committee shall be comprised of three or more directors, each of whom shall meet
the independence and audit committee composition requirements promulgated by the
Securities and Exchange Commission of the United States (the “SEC”), the National
Association of Securities Dealers, The Ontario Securities Commission, The Authorité des
Marchés Financiers, any exchange upon which securities of the Company are traded, or
any governmental or regulatory body exercising authority over the Company (each a
“Regulatory Body” and collectively, the “Regulatory Bodies”), as in effect from time to
time.
	 
	 	•	 	All members of the Committee shall have a working familiarity with basic finance and
accounting practices, and at least one member of the Committee shall have accounting or
related financial management expertise. Committee members may enhance their familiarity
with finance and accounting by participating in educational programs conducted by the
Company or an outside consultant.

 

 

	III.	 	MEETINGS

	 	•	 	The Committee may invite such other persons to its meetings, as it deems necessary.
The Controller and external auditors should be invited to make presentations to the
Committee as appropriate.

	IV.	 	RESPONSIBILITIES AND DUTIES

To fulfill its responsibilities and duties the Committee shall:

Documents/ Reports Review

	 	•	 	Review with representatives of management and representatives of the independent
auditors the Company’s interim quarterly financial statements and the annual audited
financial statements prior to their filing, and the related press release of the
Company and shall report thereon to the Board of Directors.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that the Company’s quarterly
and annual audited financial statements are fairly presented in accordance with
generally accepted accounting principles and shall recommend to the Board of Directors
whether the quarterly and annual financial statements should be approved and included
in the filings required by the Regulatory Bodies.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that the information contained
in the Company’s quarterly financial statements, Annual Report to Shareholders and
other financial publications, such as Management’s Discussion and Analysis (MD&A), the
Annual Information Form (AIF) (and similar documentation required by the Regulatory
Bodies) and the information contained in a prospectus or registration statement does
not contain any untrue statement of any material fact or omit to state a material fact
that is required or necessary to make a statement not misleading, in light of the
circumstances under which it was made.
	 
	 	•	 	Review material financial reports or other financial information of the Company
submitted to any Regulatory Body, or the public.
	 
	 	•	 	Have the right:

	 	•	 	to inspect all the books and records of the Company and its subsidiaries;
	 
	 	•	 	to discuss such accounts and records and any matters relating
to the financial position of the Company with the officers and auditors of the
Company and its subsidiaries; and
	 
	 	•	 	to engage advisors, including to commission reports or
supplemental information relating thereto; and any member of the Committee may
require the auditors to attend any or every meeting of the Committee.

	 	•	 	Review such matters and questions relating to the financial position of the Company
and its affiliates or the reporting related thereto as the Board of Directors may from
time to time refer to the Committee.

 

 

	 	•	 	Together with the Board of Directors, review, assess the adequacy of this Charter
periodically, at least annually, as conditions dictate, and update this Charter if and
when appropriate.

Independent Auditors

	 	•	 	Recommend to the Board of Directors the appointment, compensation, retention
(including the authority not to retain or to terminate) and oversight of any
independent auditor engaged by the Company for the purpose of preparing or issuing an
audit report or related work. The Board of Directors shall then put the selection of
independent auditors to the vote of the Company’s shareholders.
	 
	 	•	 	Recommend to the Board of Directors the funding necessary for compensation of any
independent auditor and advise the Board of Directors of anticipated funding needs of
the Committee.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that the Company’s auditors are
“independent” of management and that they are ultimately accountable to the Board of
Directors and the Committee as representatives of the shareholders, within the meaning
given to such term in the rules and pronouncements of the Regulatory Bodies. Obtain
from the independent auditors, at least annually, a formal written statement
delineating all relationships between the independent auditors and the Company.
	 
	 	•	 	Approve in advance any and all audit and non-audit assignments awarded to
independent auditors and adopt and implement policies for such pre-approval and review
all remuneration paid to independent auditors, including for such additional audit and
non-audit services; to the extent necessary, any member of the Committee, acting
independently, shall be authorized to approve in advance any and all audit and
non-audit assignments awarded to independent auditors.
	 
	 	•	 	Review the performance and the remuneration of the independent auditors and
recommend to the Board of Directors the discharge of the independent auditors when
circumstances warrant.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that the audit function has
been effectively carried out and that any matter which the independent auditors wish to
bring to the attention of the Board of Directors has been addressed and that there are
no “unresolved differences” with the auditors. Be directly responsible for the
resolution of any disagreements between management and the independent auditors
regarding financial reporting matters.

Financial Reporting Processes and Risk Management

	 	•	 	Review the audit plan of the independent auditors for the current year, review the
integration of the external audit with the internal control program and review advice
from the external auditors relating to management and internal controls and the
Company’s responses to the suggestions made therein.
	 
	 	•	 	Monitor the Company’s internal accounting controls, informational gathering systems
and management reporting on internal control. In connection with fulfilling this
responsibility, the Committee shall receive a report on at least an annual basis from
the Company’s chief executive officer and chief financial officer in connection with
the such

 

 

	 	 	 	officers’ evaluation of internal control over financing reporting as to (1) all
significant deficiencies and material weaknesses in the design and operation of
internal control over financial reporting which are reasonably likely to adversely
affect the Company’s ability to record, process, summarize, and report financial
information; and (2) any fraud of which they are aware, whether or not material,
that involves a member of management or other employees who have a significant role
in the Company’s internal control over financial reporting. The Committee shall
direct the actions to be taken and/or make recommendations to the Board of Directors
of actions to be taken to the extent such disclosure indicates the finding of any
significant deficiencies in internal control over financial reporting or fraud.

	 	•	 	Review with management and the auditors the relevance and appropriateness of the
Company’s accounting principles and policies and the Company’s internal control over
financial reporting and review and approve all significant changes to such policies.
	 
	 	•	 	Obtain annually from the independent auditors, in connection with an audit report
and prior to the filing of such audit report, a report presenting the adequacy of the
internal audit and financial controls, specifically including (1) critical accounting
policies and practices to be used, (2) all material alternative treatments of financial
information within generally accepted accounting principles that have been discussed
with management, the ramifications of the use of these alternatives and the treatment
preferred by the independent auditors, and (3) material communications between
management and the independent auditor.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that the Company has
implemented appropriate systems of internal control over financial reporting and
monitor the annual review and evaluation by management of internal control over
financial reporting. The Committee shall also satisfy itself that the Company has
implemented appropriate systems of internal control over the safeguarding of the
Company’s assets and other “risk management” functions (including the identification of
significant risks and the establishment of appropriate procedures to manage those risks
and the monitoring of corporate performance in light of applicable risks) affecting the
Company’s assets, management, financial and business operations and the health and
safety of its employees and that these are operating effectively; make appropriate
recommendations to the Board of Directors in connection with the foregoing.
	 
	 	•	 	Review and approve the Company’s Investment and Treasury policies and monitor
compliance with such policies.
	 
	 	•	 	Review and approve all related party transactions for potential conflict of interest
situations on an ongoing basis. “Related party transactions” shall refer to
transactions required to be disclosed pursuant to applicable securities regulations and
stock exchange regulations or policies.

Legal and Regulatory Compliance

	 	•	 	The Committee has authority to engage outside advisors as it determines necessary to
carry out its duties.
	 
	 	•	 	Determine funding necessary for ordinary administrative expenses of the Committee
and for compensation of any outside advisors to be engaged by the Committee and notify
the Company of anticipated funding needs of the Committee.

 

 

	 	•	 	Satisfy itself, on behalf of the Board of Directors, that all material statutory
deductions have been withheld by the Company and remitted to the appropriate
authorities.
	 
	 	•	 	Review, with the Company’s principal external counsel, legal and regulatory matters
that could have a material impact on the Company’s financial statements.
	 
	 	•	 	Satisfy itself, on behalf of the Board of Directors, that all regulatory compliance
issues have been identified and addressed and identifying those that require further
work.
	 
	 	•	 	Establish procedures for:

	 	(a)	 	the receipt, retention and treatment of complaints received by
the Company regarding accounting, internal accounting controls, or auditing
matters;
	 
	 	(b)	 	the confidential, anonymous submission by employees of the
Company of concerns regarding questionable accounting or auditing matters
(commonly referred to as the “Whistleblowing Policy”); and
	 
	 	(c)	 	any other material matter.

	 	•	 	Cause the chief executive officer to investigate any allegations that any officer or
director of the Company, or any other person acting under the direction of any such
person, took any action to fraudulently influence, coerce, manipulate, or mislead any
independent public or certified accountant engaged in the performance of an audit of
the financial statements of the Company for the purpose of rendering such financial
statements materially misleading and, if such allegations prove to be correct, take or
recommend to the Board of Directors appropriate disciplinary action. Notwithstanding
the foregoing, if the person in question is the chief executive officer, the
investigation shall be undertaken by the Committee.

Budgets

	 	•	 	Assist the Board of Directors in the review and approval of operational, capital and
other budgets proposed by management.

General

	 	•	 	Perform any other activities consistent with this Charter, the Company’s By-laws and
governing law, as the Committee or the Board of Directors deems necessary or
appropriate.

 

 

Work Schedule of the Board and Committees — Specific Decisions

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	Q1 / April	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	(After Annual	 	Q1 / Extra	 	Q2 / July	 	Q2 / Extra	 	Q3 / October /	 	Q3 / Extra	 	Q4 / February	 	Q4 / Extra
	 	 	Meeting)	 	Meeting	 	 	 	Meeting	 	November	 	Meeting / December	 	 	 	Meeting
	Board

	 	Appointment of
officers
	 	 	 	 	 	 	 	Budget
	 	 	 	Financial statements	 	 
	 

	 	Appointment of
committees
	 	 	 	Reviews strategic

planning
	 	 	 	 	 	 	 	MD&A	 	 
	 

	 	Options of directors
	 	 	 	 	 	 	 	Reviews

communication plan
	 	 	 	Proxy Circular	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	Options (except

directors)
	 	Annual Information
Form — approval	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	Remuneration of
officers	 	 	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	Evaluation of
corporate
objectives	 	 	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	Corporate

objectives for the

upcoming year	 	 	 	 
	 
	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	AC

	 	Reviews Quarterly

Financial

Statements
	 	 	 	Reviews Quarterly

Financial

Statements
	 	 	 	Reviews Quarterly

Financial

Statements
	 	 	 	Recommends approval
of Financial
Statements	 	 
	 

	 	Reviews auditors’
report
	 	 	 	Reviews auditors’
report
	 	 	 	Reviews auditors’
report
	 	 	 	Reviews auditors’
report	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Reviews internal

control	 	 
	 

	 	 	 	 	 	 	 	 	 	Evaluates audit plan
	 	 	 	Report on pending
cases and litigation	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Reviews MD&A and AIF	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Auditors’ comments	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Evaluation of CFO	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Evaluation of auditors	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Choice of auditors	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Annual review of
mandate and its work	 	 
	HRCGC

	 	Recommends
formation of
committees
	 	 	 	 	 	 	 	 	 	Recommends
“options” (except
directors)	 	 	 	 
	 

	 	Appointment of
officers	 	 	 	 	 	 	 	 	 	 	 	 	 	 

 

 

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	Q1 / April	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	 	(After Annual	 	Q1 / Extra	 	Q2 / July	 	Q2 / Extra	 	Q3 / October /	 	Q3 / Extra	 	Q4 / February	 	Q4 / Extra
	 	 	Meeting)	 	Meeting	 	 	 	Meeting	 	November	 	Meeting / December	 	 	 	Meeting
	 

	 	Recommends the
method(s) of
remuneration of
directors
	 	 	 	 	 	 	 	 	 	Recommends
remuneration of
officers	 	 	 	 
	 

	 	Recommends
“options” for
directors
	 	 	 	 	 	 	 	 	 	Recommends
appointment of
officers	 	 	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Report on performance
of directors in
office	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Reviews corporate
governance rules —
recommendations	 	 
	 

	 	 	 	 	 	 	 	 	 	 	 	 	 	Evaluates performance
of Chairman of the
Board	 	 

Q1: January — February — March results approved at April Board meeting (end of April)

Q2: April — May — June results approved at July Board meeting (end of July)

Q3: July — August — September results approved at November Board meeting (end of October)

Q4: October — November — December results approved at January Board meeting (mid-February)

Note: In connection with abolition of Executive Committee.

 

 

Œ Performance Evaluation Criteria for the Directors and the Board

	•	 	Competence
	 
	•	 	Professionalism
	 
	•	 	Contribution to Board — expertise
	 
	•	 	Multidisciplinarity of Board — individual expertise
	 
	•	 	Commitment to Company development
	 
	•	 	Support provided to management, President and CEO
	 
	•	 	Attendance — Availability
	 
	•	 	Stance at meetings — involvement
	 
	•	 	Possible or potential conflicts of interest

� Orientation Program for New Directors

	•	 	Individual meetings with executive officers
	 
	•	 	Individual meeting with the President and CEO
	 
	•	 	Explanation of risk strategies and factors
	 
	•	 	Overview of internal and external environment
	 
	•	 	Discussion on the role of administration
	 
	•	 	Visit of facilities
	 
	•	 	Document Delivery

	 	•	 	information on the Company (annual report and other publications)
	 
	 	•	 	minutes of the previous fiscal year, if desired
	 
	 	•	 	company by-laws
	 
	 	•	 	shareholders’ agreement
	 
	 	•	 	information on insurance coverage
	 
	 	•	 	policies/plan governing the Board and/or senior executivesexv4w3

 

Exhibit 4.3

LABOPHARM INC.

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

	 	 	 	 	 
	
    
    Auditors’ Report

    	 	 	F-2	 
	
    
    Consolidated Financial Statements

    	 	 	 	 
	
    
    Consolidated Balance Sheets
    

    	 	 	F-3	 
	
    
    Consolidated Statements of Operations
    

    	 	 	F-4	 
	
    
    Consolidated Statements of Deficit
    

    	 	 	F-5	 
	
    
    Consolidated Statements of Cash Flows
    

    	 	 	F-6	 
	
    
    Notes to Consolidated Financial Statements
    

    	 	 	F-7	 

These consolidated financial statements are
presented in Canadian dollars.

F-1

 

AUDITORS’ REPORT

To the Directors of

Labopharm inc.

         
We have audited the consolidated balance sheets
of Labopharm inc. as at December 31, 2005 and 2004 and the
consolidated statements of loss, deficit and cash flows for the
years ended December 31, 2005 and December 31, 2004.
These financial statements are the responsibility of the
Company’s management. Our responsibility is to express an
opinion on these financial statements based on our audits.

         
We conducted our audits in accordance with
Canadian generally accepted auditing standards. Those standards
require that we plan and perform an audit to obtain reasonable
assurance whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation.

         
In our opinion, these consolidated financial
statements present fairly, in all material respects, the
financial position of the Company as at December 31, 2005
and 2004 and the results of its operations and its cash flows
for the years ended December 31, 2005 and December 31,
2004 in accordance with Canadian generally accepted accounting
principles.

 

		
	Montréal, Canada	(signed) Ernst & Young LLP.

		
	February 2, 2006	Chartered Accountants.

(except note 23, which is as at
April 17, 2006).

COMMENTS BY AUDITORS FOR U.S. READERS
ON

CANADA — U.S. REPORTING
DIFFERENCE

         
In the United States, reporting standards for
auditors require the addition of an explanatory paragraph
(following the opinion paragraph) when the financial statements
are affected by conditions and events that cast substantial
doubt on the Company’s ability to continue as a going
concern, such as those described in note 1 to the
consolidated financial statements. Our report to the directors
dated February 2, 2006 (except note 23, which is as at
April 17, 2006) is expressed in accordance with Canadian
reporting standards which do not permit a reference to such
events and conditions in the auditors’ report when these
are adequately disclosed in the financial statements.

 

		
	Montréal, Canada	(signed) Ernst & Young LLP.

		
	February 2, 2006	Chartered Accountants.

(except note 23, which is as at
April 17, 2006).

F-2

 

LABOPHARM INC.

CONSOLIDATED BALANCE SHEETS
(note 1)

	 	 	 	 	 	 	 	 	 
			
			As at December 31,
			

			2005		2004
			
		

			
			(thousands of
			Canadian dollars)
	
    
    ASSETS
    (note 11)

    	 	 	 	 	 	 	 	 
	
    
    Current

    	 	 	 	 	 	 	 	 
	
    
    Cash and cash equivalents
    

    	 	$	20,282	 	 	$	2,809	 
	
    
    Short-term investments (note 4)
    

    	 	 	14,611	 	 	 	20,814	 
	
    
    Accounts receivable (note 5)
    

    	 	 	532	 	 	 	967	 
	
    
    Research and development tax credits receivable
    (note 15)
    

    	 	 	875	 	 	 	800	 
	
    
    Income tax receivable
    

    	 	 	426	 	 	 	—	 
	
    
    Inventories (note 6)
    

    	 	 	2,188	 	 	 	—	 
	
    
    Prepaids and other assets
    

    	 	 	452	 	 	 	247	 
	 	 	 	
	 	 	 	
	 
	
    
    Total current assets

    	 	 	39,366	 	 	 	25,637	 
	 	 	 	
	 	 	 	
	 
	
    
    Restricted long-term investments
    (note 7)
    

    	 	 	1,271	 	 	 	1,282	 
	
    
    Property, plant and equipment (note 8)
    

    	 	 	10,280	 	 	 	10,961	 
	
    
    Intangible assets (note 9)
    

    	 	 	3,231	 	 	 	2,036	 
	
    
    Deferred financing costs
    

    	 	 	364	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	$	54,512	 	 	$	39,916	 
	 	 	 	
	 	 	 	
	 
	
    
    LIABILITIES

    	 	 	 	 	 	 	 	 
	
    
    Current

    	 	 	 	 	 	 	 	 
	
    
    Accounts payable and accrued liabilities
    

    	 	$	10,090	 	 	$	5,930	 
	
    
    Current portion of deferred revenue
    

    	 	 	9,067	 	 	 	266	 
	
    
    Current portion of obligations under capital
    leases (note 10)
    

    	 	 	83	 	 	 	134	 
	
    
    Current portion of long-term debt
    (note 11)
    

    	 	 	3,383	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	 	22,623	 	 	 	6,330	 
	 	 	 	
	 	 	 	
	 
	
    
    Deferred revenue
    

    	 	 	20,834	 	 	 	1,510	 
	
    
    Obligations under capital leases
    (note 10)
    

    	 	 	5,840	 	 	 	5,923	 
	
    
    Long-term debt (note 11)
    

    	 	 	7,818	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	 	57,115	 	 	 	13,763	 
	 	 	 	
	 	 	 	
	 
	
    
    Shareholders’ equity
    (deficiency)

    	 	 	 	 	 	 	 	 
	
    
    Common shares, no par value, unlimited authorized
    shares 43,673,863 and 42,510,630 issued as at December 31,
    2005 and 2004, respectively (note 12)
    

    	 	 	135,631	 	 	 	132,658	 
	
    
    Contributed surplus
    

    	 	 	6,350	 	 	 	4,745	 
	
    
    Deficit
    

    	 	 	(144,584	)	 	 	(111,250	)
	 	 	 	
	 	 	 	
	 
	
    
    Total shareholders’ equity
    (deficiency)

    	 	 	(2,603	)	 	 	26,153	 
	 	 	 	
	 	 	 	
	 
	 	 	$	54,512	 	 	$	39,916	 
	 	 	 	
	 	 	 	
	 

Commitments, Guarantees and Contingency (notes
13 and 14)

On behalf of the Board:

	 	 	 
	
    l

    Director
    	 	
    l

    Director
    

See accompanying notes

F-3

 

LABOPHARM INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(note 1)

	 	 	 	 	 	 	 	 	 	 
			
			For the year ended
			December 31,
			

			2005		2004
			
		

			
			(thousands of Canadian
			dollars, except share and
			per share amounts)
	
    
    REVENUE

    	 	 	 	 	 	 	 	 
	
    
    Product sales
    

    	 	$	1,269	 	 	$	—	 
	
    
    Cost of goods sold
    

    	 	 	758	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	
    
    Gross profit on product sales
    

    	 	 	511	 	 	 	—	 
	
    
    Other revenue

    	 	 	 	 	 	 	 	 
	
    
    Licensing
    

    	 	 	1,908	 	 	 	106	 
	
    
    Research and development contracts
    

    	 	 	61	 	 	 	1,288	 
	 	 	 	
	 	 	 	
	 
	 	 	 	2,480	 	 	 	1,394	 
	
    
    EXPENSES

    	 	 	 	 	 	 	 	 
	
    
    Research and development expenses
    

    	 	 	22,451	 	 	 	16,037	 
	
    
    Government assistance (note 15)
    

    	 	 	(2,713	)	 	 	(823	)
	 	 	 	
	 	 	 	
	 
	 	 	 	19,738	 	 	 	15,214	 
	
    
    Selling, general and administrative expenses
    

    	 	 	12,188	 	 	 	9,878	 
	
    
    Financial expenses (note 16)
    

    	 	 	1,937	 	 	 	864	 
	
    
    Depreciation and amortization
    

    	 	 	1,664	 	 	 	1,662	 
	
    
    Interest income
    

    	 	 	(557	)	 	 	(538	)
	
    
    Foreign exchange gain
    

    	 	 	(355	)	 	 	(57	)
	
    
    Expenses related to an incomplete financing
    initiative
    

    	 	 	—	 	 	 	1,509	 
	 	 	 	
	 	 	 	
	 
	 	 	 	34,615	 	 	 	28,532	 
	
    
    Loss before income taxes
    

    	 	 	(32,135	)	 	 	(27,138	)
	
    
    Income taxes (note 14):
    

    	 	 	 	 	 	 	 	 
	 	
    
    Current
    

    	 	 	1,199	 	 	 	41	 
	 	 	 	
	 	 	 	
	 
	
    
    Net loss

    	 	$	(33,334	)	 	$	(27,179	)
	 	 	 	
	 	 	 	
	 
	
    
    Net loss per share — basic and
    diluted

    	 	$	(0.78	)	 	$	(0.68	)
	 	 	 	
	 	 	 	
	 
	
    
    Weighted average number of shares
    outstanding

    	 	 	42,922,741	 	 	 	39,954,488	 
	 	 	 	
	 	 	 	
	 

See accompanying notes

F-4

 

LABOPHARM INC.

CONSOLIDATED STATEMENTS OF DEFICIT
(note 1)

	 	 	 	 	 	 	 	 	 
			
			For the year ended
			December 31,
			

			2005		2004
			
		

			
			(thousands of
			Canadian dollars)
	
    
    Balance, beginning of year (as previously
    reported)

    	 	$	(111,250	)	 	$	(81,095	)
	
    
    Adjustment for change in accounting policy
    (note 3)
    

    	 	 	—	 	 	 	(2,976	)
	 	 	 	
	 	 	 	
	 
	
    
    Balance, beginning of year
    (adjusted)

    	 	 	(111,250	)	 	 	(84,071	)
	
    
    Net loss
    

    	 	 	(33,334	)	 	 	(27,179	)
	 	 	 	
	 	 	 	
	 
	
    
    Balance, end of year

    	 	$	(144,584	)	 	$	(111,250	)
	 	 	 	
	 	 	 	
	 

See accompanying notes

F-5

 

LABOPHARM INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(note 1)

	 	 	 	 	 	 	 	 	 	 
			
			For the year ended
			December 31,
			

			2005		2004
			
		

			
			(thousands of
			Canadian dollars)
	
    
    OPERATING ACTIVITIES

    	 	 	 	 	 	 	 	 
	
    
    Net loss for the year
    

    	 	$	(33,334	)	 	$	(27,179	)
	
    
    Items not affecting cash:
    

    	 	 	 	 	 	 	 	 
	 	
    
    Depreciation of property, plant and equipment
    

    	 	 	1,524	 	 	 	1,520	 
	 	
    
    Amortization of intangible assets
    

    	 	 	140	 	 	 	142	 
	 	
    
    Financial expenses
    

    	 	 	271	 	 	 	—	 
	 	
    
    Amortization of deferred financing costs
    

    	 	 	110	 	 	 	—	 
	 	
    
    Unrealized foreign exchange gain
    

    	 	 	(232	)	 	 	—	 
	 	
    
    Stock-based compensation
    

    	 	 	1,754	 	 	 	1,775	 
	 	 	 	
	 	 	 	
	 
	 	 	 	(29,767	)	 	 	(23,742	)
	
    
    Net change in non-cash operating items
    (note 17)
    

    	 	 	28,727	 	 	 	660	 
	 	 	 	
	 	 	 	
	 
	 	 	 	(1,040	)	 	 	(23,082	)
	 	 	 	
	 	 	 	
	 
	
    
    INVESTING ACTIVITIES

    	 	 	 	 	 	 	 	 
	
    
    Acquisition of investments
    

    	 	 	(20,440	)	 	 	(43,547	)
	
    
    Disposals of investments
    

    	 	 	958	 	 	 	4,353	 
	
    
    Maturities of investments
    

    	 	 	25,685	 	 	 	37,106	 
	
    
    Acquisition of property, plant and equipment
    

    	 	 	(843	)	 	 	(1,000	)
	
    
    Acquisition of intangible assets
    

    	 	 	(173	)	 	 	(187	)
	 	 	 	
	 	 	 	
	 
	 	 	 	5,187	 	 	 	(3,275	)
	 	 	 	
	 	 	 	
	 
	
    
    FINANCING ACTIVITIES

    	 	 	 	 	 	 	 	 
	
    
    Repayment of capital lease obligations
    

    	 	 	(134	)	 	 	(171	)
	
    
    Proceeds from issuance of capital stock
    (note 12)
    

    	 	 	2,093	 	 	 	30,813	 
	
    
    Issuance costs of capital stock
    (note 12)
    

    	 	 	—	 	 	 	(2,196	)
	
    
    Proceeds from issuance of long-term debt
    

    	 	 	11,586	 	 	 	—	 
	
    
    Proceeds from issuance of warrants
    

    	 	 	731	 	 	 	—	 
	
    
    Deferred financing costs
    

    	 	 	(474	)	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	 	13,802	 	 	 	28,446	 
	 	 	 	
	 	 	 	
	 
	
    
    Foreign exchange loss on cash held in foreign
    currencies
    

    	 	 	(476	)	 	 	—	 
	
    
    Increase in cash and cash equivalents during
    the year

    	 	 	17,473	 	 	 	2,089	 
	
    
    Cash and cash equivalents, beginning of year
    

    	 	 	2,809	 	 	 	720	 
	 	 	 	
	 	 	 	
	 
	
    
    Cash and cash equivalents, end of
    year

    	 	$	20,282	 	 	$	2,809	 
	 	 	 	
	 	 	 	
	 
	
    
    Cash flows include the following
    items:

    	 	 	 	 	 	 	 	 
	
    
    Interest paid
    

    	 	$	1,434	 	 	$	863	 
	
    
    Income taxes paid (received)
    

    	 	$	427	 	 	$	(18	)
	 	 	 	
	 	 	 	
	 

See accompanying notes

F-6

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(thousands of Canadian dollars, except share and per share amounts)

 

		
	1. 	
    Description of Business and Going Concern
    Uncertainty

The Company, incorporated under the Companies
Act (Québec) is specialized in the development of drugs
using advanced controlled-release technologies and the
development of pharmaceutical products incorporating its
proprietary technologies.

The Company’s strategy is to develop
products internally in order to form strategic alliances or
enter into licensing agreements with national or international
pharmaceutical companies that have the necessary resources and
distribution networks to market and sell the pharmaceutical
products incorporating the Company’s proprietary
technologies. To date, the Company has financed its cash
requirements primarily through share issuances, a term loan,
investment tax credits, collaborative research contracts,
licensing and distribution agreements, interest income and
product sales. The future profitability of the Company is
dependent upon such factors as the success of the clinical
trials, the approval by regulatory authorities of products
developed by the Company, the ability of the Company to
successfully market, sell and distribute its products and the
ability of the Company to obtain the necessary financing to
complete its projects.

The Company has incurred significant operating
losses and cash outflows from operations and has incurred an
accumulated deficit of $144,584. As at December 31, 2005,
the Company’s committed cash obligations and expected level
of expenses for the upcoming twelve months exceed the committed
sources of funds and the Company’s cash and cash
equivalents on hand. The ability of the Company to continue as a
going concern is dependent upon raising additional financing
through borrowings or equity financing, receiving funds through
collaborative research contracts or product licensing
agreements, obtaining regulatory approval in various
jurisdictions, and achieving future profitable operations. The
outcome of these matters is dependent on a number of items
outside of the Company’s control. As a result, there is
significant uncertainty as to whether the Company will have the
ability to continue as a going concern.

The consolidated financial statements have been
prepared on a going concern basis, which assumes the Company
will continue in operation for the foreseeable future and will
be able to realize its assets and discharge its liabilities and
commitments in the ordinary course of business. These financial
statements do not include any adjustments to the amounts and
classification for assets and liabilities that may be necessary
should the Company not be successful in its effort to obtain
additional financing, to receive significant funds on signing
collaborative research contracts or by out licensing its
products or making significant product sales.

 

		
	2. 	
    Significant Accounting Policies

These financial statements have been prepared by
management in accordance with Canadian generally accepted
accounting principles. The most significant accounting policies
are summarized below. A reconciliation of significant
differences with generally accepted accounting principles in the
United States is presented in note 23.

Use of estimates

The preparation of financial statements in
conformity with generally accepted accounting principles
requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues
and expenses during the reporting periods. Actual results could
differ from those estimates and such differences could be
material.

F-7

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

 

		
	2. 	
    Significant Accounting
    Policies — (Continued)

Principles of consolidation

The consolidated financial statements include the
accounts of the Company and those of its wholly owned
subsidiaries, Labopharm Europe Limited, Labopharm (Barbados)
Limited, Labopharm Cyprus Limited and Labopharm USA, Inc.,
incorporated in 2005. All significant inter-company transactions
and balances have been eliminated upon consolidation.

Revenue recognition

The Company recognizes revenue from research and
development contracts, and licensing arrangements, which may
include multiple elements. Revenue arrangements with multiple
elements are reviewed in order to determine whether the multiple
elements can be divided into separate units of accounting, if
certain criteria are met. If separable, the consideration
received is allocated among the separate units of accounting
based on their respective fair values, and the applicable
revenue recognition criteria are applied to each of the separate
units. Otherwise, the applicable revenue recognition criteria
are applied to combined elements as a single unit of accounting.

Licensing revenues — Up-front
non-refundable licensing revenue is deferred and recognized on a
straight-line basis over the term which the Company maintains
substantive contractual obligations. Licensing revenue received
upon the achievement of milestones is recognized when the
underlying condition is met if it has stand-alone value to the
customer, the Company has no further obligations in relation to
that milestone and collectibility is reasonably assured.
Otherwise, it is recognized over the remaining term of the
underlying agreement. Amounts received in advance of recognition
are included in deferred revenue, as are amounts which are
refundable if underlying conditions are not met.

Product sales — Revenue is recognized
when the product is shipped to the Company’s customers,
provided the Company has not retained any significant risks of
ownership or future obligations with respect to the product
shipped and collection is reasonably assured. The Company’s
products are indirectly subject to pricing regulations in
certain markets.

Research and development contracts —
The Company recognizes revenues from various research agreements
as the contracted services are performed or when milestones are
achieved, in accordance with the terms of the specific
agreements. Up-front payments for the use of technology where
further services are to be provided or fees received on the
signing of research agreements are recognized over the period of
performance of the related activities. Amounts received in
advance of recognition are included in deferred revenue.

Cash and cash equivalents

Cash and cash equivalents consist of cash and all
highly liquid short-term investments that are readily
convertible to known amounts of cash and which are subject to an
insignificant risk of change in value. The Company considers
these highly liquid short-term investments with a maturity on
acquisition of less than three months to be cash equivalents.

F-8

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

 

		
	2. 	
    Significant Accounting
    Policies — (Continued)

Short-term and long-term investments

Short-term investments are recorded at the lower
of amortized cost or fair market value on a portfolio basis.
Long-term investments are accounted for at amortized cost.
Investments are written down to their fair market value based on
quoted market prices, when a decline in value is other than
temporary.

Inventories

Inventories are valued at the lower of cost,
which is determined on an average cost basis, and net realizable
value for finished goods and work-in-progress and replacement
cost for raw materials.

Property, plant and equipment

Property, plant and equipment are carried at cost
less related investment tax credits for research and development
equipment.

Assets acquired under capital leases are carried
at cost, being the present value of the minimum lease payments
after deduction of executory costs.

Depreciation of property, plant and equipment and
assets acquired under capital leases are calculated over their
estimated useful life using the following methods and rates:

	 	 	 	 	 
	
    
    Laboratory and plant equipment
    

    	 	
    Diminishing balance
    	 	
    20% to 30%
    
	
    
    Computer hardware and software
    

    	 	
    Diminishing balance
    	 	
    30%
    
	
    
    Furniture and office equipment
    

    	 	
    Straight-line
    	 	
    5 to 10 years
    
	
    
    Leasehold improvements
    

    	 	
    Straight-line over the term of the lease up to 10
    years
    
	
    
    Building and building improvements
    

    	 	
    Straight-line over the term of the lease up to 15
    years
    

Intangible assets

Intangible assets consist of patent and trademark
costs and intellectual property rights which consist of fees
paid to license technology or to acquire patents. The patent
costs include legal fees to obtain patents and patent
application fees.

Amortization of intangible assets is calculated
over their estimated useful life, which cannot exceed the life
of the underlying patents using the following methods
and rates:

	 	 	 	 	 
	
    
    Patents and trademarks
    

    	 	 	Straight-line up to 20 years	 
	
    
    Intellectual property rights
    

    	 	 	Straight-line up to 20 years	 

Deferred financing costs

Financing costs associated with the issuance of
debt are deferred and amortized over the term of the related
debt using the effective yield method.

F-9

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

 

		
	2. 	
    Significant Accounting
    Policies — (Continued)

Impairment of long-lived assets

Property, plant and equipment and other
long-lived assets are regularly reviewed for impairment whenever
events or changes in circumstances indicate that the carrying
value of an asset may not be recoverable. Impairment is assessed
by comparing the carrying amount of an asset to be held and used
with the sum of the undiscounted cash flows expected from its
use and disposal. If such assets are considered impaired, the
impairment loss to be recognized is measured by the amount by
which the carrying amount of the assets exceeds its fair value
generally determined on a discounted cash flow basis. Any
impairment results in a write-down of the asset and a charge to
income during the year.

Research and development expenses

Research expenses are charged to income in the
year of expenditure less related tax credits. Development costs
net of related tax credits are charged to income as incurred
unless a development project meets generally accepted accounting
principles in Canada for deferral and amortization. The Company
has not deferred any such development costs to date.

Government assistance

Grant amounts resulting from government
assistance programs, including investment tax credits on
research and development expenses, are reflected as reductions
to the cost of the assets or to the expenses to which they
relate at the time the assistance becomes receivable.

Foreign currency translation

The Company’s foreign subsidiaries are
considered to be integrated foreign entities and are accounted
for in accordance with the temporal method, as are transactions
in foreign currencies entered into by the Company. Monetary
assets and liabilities denominated in foreign currencies are
translated into Canadian dollars at the year-end exchange rate,
non-monetary assets and liabilities are translated at the
historical exchange rate, and revenue and expense items are
translated in Canadian dollars at rates of exchange in effect at
the related transaction dates. Exchange gains and losses arising
from these transactions are included as a charge to income
during the year.

Stock-based compensation plan

The Company has a stock-based compensation plan
and has applied the fair value based method to expense all
options awarded to employees and directors since
March 1, 2002. The fair value of stock options granted
is determined at the date of grant using the Black-Scholes
option pricing model, and expensed over the vesting period of
the options.

Net loss per share

The basic net loss per share is calculated using
the weighted average number of common shares outstanding during
the year.

The diluted net loss per share is calculated
based on the weighted average number of common shares
outstanding during the year, plus the effects of dilutive common
share equivalents such as options. This

F-10

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

 

		
	2. 	
    Significant Accounting
    Policies — (Continued)

method requires that the diluted net loss per
share be calculated using the treasury stock method, as if all
common share equivalents had been exercised at the beginning of
the reporting period, or period of issuance, as the case may be,
and that the funds obtained thereby were used to purchase common
shares of the Company at the volume weighted average trading
price of the common shares during the period.

Diluted loss per share is equal to the basic loss
per share since the effect of exercising 1,574,425 options
(2004 — 2,055,946) would be antidilutive for all
periods presented.

Income taxes

The Company follows the liability method of
accounting for income taxes. Under this method, future income
tax assets and liabilities are determined based on the
differences between the financial reporting and tax bases of
assets and liabilities and are measured using substantively
enacted tax rates and laws that are expected to be in effect in
the periods in which the future tax assets or liabilities are
expected to be realized or settled. A valuation allowance is
provided to the extent that it is more likely than not that
future income tax assets will not be realized.

Issuance costs of capital stock

The Company records issuance costs of capital
stock against capital stock.

Recent accounting pronouncements

Comprehensive Income and
Equity

In January 2005, the CICA released new Handbook
Section 1530, Comprehensive Income, and Section 3251,
Equity, effective for the annual and interim period of the
Company beginning on January 1, 2007.
Section 1530 establishes standards for reporting
comprehensive income. The section does not address issues of
recognition or measurement for comprehensive income and its
components. Section 3251 establishes standards for the
presentation of equity and changes in equity during the
reporting period. The requirements in this section are in
addition to Section 1530. We have not yet determined the
impact of the adoption of this standard on the presentation of
the consolidated results of operations or
financial position.

Financial Instruments —
Recognition and Measurement

In January 2005, the CICA released new Handbook
Section 3855, Financial Instruments — Recognition
and Measurement, effective for the annual and interim period of
the Company beginning on January 1, 2007. This new
section prescribes when a financial instrument is to be
recognized on the balance sheet and at what amount, sometimes
using fair value and other times using cost-based measures. It
also specifies how financial instrument gains and losses are to
be presented and defines financial instruments to include
accounts receivable and payable, loans, investments in debt and
equity securities, and derivative contracts. We have not yet
determined the impact of the adoption of this standard on the
consolidated results of operations or financial position.

F-11

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

 

		
	2. 	
    Significant Accounting
    Policies — (Continued)

Non-Monetary Transactions

In June 2005, the CICA released new Handbook
Section 3831, Non-monetary Transactions, effective for the
fiscal year beginning on January 1, 2006. This standard
requires all non-monetary transactions to be measured at fair
value unless they meet one of four very specific criteria.
Commercial substance replaces culmination of the earnings
process as the test for fair value measurement. A transaction
has commercial substance if it causes an identifiable and
measurable change in the economic circumstances of the entity.
Commercial substance is a function of the cash flows expected by
the reporting entity. The Company believes that the adoption of
this standard will not have a material impact on the
Company’s consolidated results of operations or financial
position.

Hedges

In April 2005, the CICA issued Section 3865
of the CICA Handbook entitled “Hedges”, effective for
the fiscal year beginning on January 1, 2007. This Section
establishes standards for when and how hedge accounting may be
applied. Hedging is an activity designed to modify an
entity’s exposure to one or more risks. Hedge accounting
modifies the normal basis for recognizing the gains, losses,
revenues and expenses associated with a hedged item or a hedging
item in an entity’s income statement. It ensures that
counterbalancing gains, losses, revenues and expenses are
recognized in the same period. The Company believes that the
adoption of this standard will not have a material impact on the
Company’s consolidated results of operations or financial
position.

3. Changes in Accounting Policy

In 2003, the Canadian Institute of Chartered
Accountants (“CICA”) amended its pronouncement
relating to stock-based compensation requiring companies to
measure and expense all equity instruments awarded to employees
and directors starting in fiscal years beginning on or after
January 1, 2004 in accordance with the fair value method.
The fair value of stock options to employees and directors is
determined at the date of grant using the Black-Scholes option
pricing model, and expensed over the vesting period of the
options. The transitional provisions provide for a prospective
treatment to this change in accounting policy for those
companies who adopt this new pronouncement in fiscal years
beginning before January 1, 2004 and a retroactive
treatment for those companies adopting on or after
January 1, 2004.

Effective January 1, 2004, the Company
adopted the retroactive treatment without restatement, for
options granted since March 1, 2002. Consequently, the
opening deficit and contributed surplus balances as at
January 1, 2004 increased by $2,976. The compensation
expense for the year ended December 31, 2005 was $1,754
(2004 — $1,775) of which $685 (2004 — $600)
was included in research and development expenses and $1,069
(2004 — $1,175) was included in selling, general and
administrative expenses. The counterpart has been recorded as
contributed surplus. Prior to January 1, 2004, no
compensation expense was recognized when stock options were
granted to employees and directors, however the Company provided
pro forma information as if the fair value method had been
applied.

F-12

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

4. Short-term Investments

Short-term investments are comprised of 9
investment grade instruments (21 as at December 31, 2004).
These investments have a maturity of less than one year and have
an average weighted yield of 3.05% (December 31,
2004 — 2.42%). The market value of short-term
investments held as at December 31, 2005 and 2004
approximates their carrying value. Short-term investments
include the following:

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Commercial paper
    

    	 	$	12,209	 	 	$	6,872	 
	
    
    Corporate bonds
    

    	 	 	2,402	 	 	 	6,719	 
	
    
    Government bonds
    

    	 	 	—	 	 	 	7,223	 
	 	 	 	
	 	 	 	
	 
	 	 	$	14,611	 	 	$	20,814	 
	 	 	 	
	 	 	 	
	 

5. Accounts Receivable

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Trade
    

    	 	$	42	 	 	$	329	 
	
    
    Sales taxes
    

    	 	 	386	 	 	 	436	 
	
    
    Interest on investments
    

    	 	 	104	 	 	 	196	 
	
    
    Other
    

    	 	 	—	 	 	 	6	 
	 	 	 	
	 	 	 	
	 
	 	 	$	532	 	 	$	967	 
	 	 	 	
	 	 	 	
	 

6. Inventories

As at December 31, 2005, the Company
has accumulated inventories comprised of raw materials totalling
$1,710 and intermediate finished goods (bulk tablets)
totalling $478.

7. Restricted Long-Term
Investments

Long-term investments are comprised of two debt
instruments (two as at December 31, 2004) maturing in
2006 with an average weighted yield of 2.9%
(December 31, 2004 — 2.0%). The market value
of the long-term investments held as at
December 31, 2005 approximates their carrying value.
These two investments collateralize letters of credit issued
with regard to lease obligations on behalf of the Company by its
bankers (note 13). Although these investments mature
in 2006, they will be renewed on an ongoing basis to maintain
the letters of credit.

F-13

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

8. Property, Plant and
Equipment

	 	 	 	 	 	 	 	 	 	 	 	 	 
							Net
					Accumulated		carrying
			Cost		depreciation		value
			
		
		

	
    
    2005

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Building and building improvements
    

    	 	$	8,044	 	 	$	1,409	 	 	$	6,635	 
	
    
    Laboratory and plant equipment
    

    	 	 	4,290	 	 	 	2,389	 	 	 	1,901	 
	
    
    Computer hardware and software
    

    	 	 	2,110	 	 	 	1,019	 	 	 	1,091	 
	
    
    Furniture and office equipment
    

    	 	 	1,090	 	 	 	518	 	 	 	572	 
	
    
    Leasehold improvements
    

    	 	 	106	 	 	 	25	 	 	 	81	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	15,640	 	 	$	5,360	 	 	$	10,280	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    2004

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Building and building improvements
    

    	 	$	8,030	 	 	$	871	 	 	$	7,159	 
	
    
    Laboratory equipment
    

    	 	 	3,862	 	 	 	1,945	 	 	 	1,917	 
	
    
    Computer hardware and software
    

    	 	 	1,872	 	 	 	726	 	 	 	1,146	 
	
    
    Furniture and office equipment
    

    	 	 	1,062	 	 	 	415	 	 	 	647	 
	
    
    Leasehold improvements
    

    	 	 	106	 	 	 	14	 	 	 	92	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	14,932	 	 	$	3,971	 	 	$	10,961	 
	 	 	 	
	 	 	 	
	 	 	 	
	 

Property, plant and equipment include the
following assets under capital leases:

	 	 	 	 	 	 	 	 	 	 	 	 	 
							Net
					Accumulated		carrying
			Cost		depreciation		value
			
		
		

	
    
    2005

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Building
    

    	 	$	5,970	 	 	$	1,061	 	 	$	4,909	 
	
    
    Laboratory equipment
    

    	 	 	243	 	 	 	130	 	 	 	113	 
	
    
    Office equipment
    

    	 	 	229	 	 	 	103	 	 	 	126	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	6,442	 	 	$	1,294	 	 	$	5,148	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    2004

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Building
    

    	 	$	5,970	 	 	$	663	 	 	$	5,307	 
	
    
    Laboratory equipment
    

    	 	 	243	 	 	 	101	 	 	 	142	 
	
    
    Office equipment
    

    	 	 	229	 	 	 	57	 	 	 	172	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	6,442	 	 	$	821	 	 	$	5,621	 
	 	 	 	
	 	 	 	
	 	 	 	
	 

Amortization expense of assets under capital
leases of $473 (2004 — $481) is included with
depreciation of property, plant and equipment.

The right to use the building and the building
improvements reverts to its owners in 2018 unless the Company
renews or extends the lease.

F-14

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

9. Intangible Assets

	 	 	 	 	 	 	 	 	 	 	 	 	 
							Net
					Accumulated		carrying
			Cost		amortization		value
			
		
		

	
    
    2005

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Intellectual property rights
    

    	 	$	500	 	 	$	271	 	 	$	229	 
	
    
    Patents and trademarks
    

    	 	 	3,720	 	 	 	718	 	 	 	3,002	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	4,220	 	 	$	989	 	 	$	3,231	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    2004

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Intellectual property rights
    

    	 	$	500	 	 	$	246	 	 	$	254	 
	
    
    Patents and trademarks
    

    	 	 	2,385	 	 	 	603	 	 	 	1,782	 
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	2,885	 	 	$	849	 	 	$	2,036	 
	 	 	 	
	 	 	 	
	 	 	 	
	 

 

		
	10. 	
    Capital Lease Obligations

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    Building, repayable in monthly instalments of $71
    until May 2008, $83 from June 2008 to May 2013, and $96
    from June 2013 to April 2018, including interest calculated at
    14.6%
    	 	$	12,765	 	 	$	13,615	 
	
    Various leases for office equipment, repayable in
    monthly instalments totalling $3 including interest ranging from
    8.0% to 9.9%, with maturity from February 2008 to March 2009
    	 	 	110	 	 	 	210	 
	 	 	 	
	 	 	 	
	 
	 	 	 	12,875	 	 	 	13,825	 
	
    
    Interest included in instalments
    

    	 	 	6,952	 	 	 	7,768	 
	 	 	 	
	 	 	 	
	 
	 	 	 	5,923	 	 	 	6,057	 
	
    
    Current portion
    

    	 	 	83	 	 	 	134	 
	 	 	 	
	 	 	 	
	 
	 	 	$	5,840	 	 	$	5,923	 
	 	 	 	
	 	 	 	
	 

Minimum lease payments under capital leases for
the next five years are as follows:

	 	 	 	 	 
	
    
    2006
    

    	 	$	889	 
	
    
    2007
    

    	 	 	889	 
	
    
    2008
    

    	 	 	975	 
	
    
    2009
    

    	 	 	1,002	 
	
    
    2010
    

    	 	 	1,000	 
	
    
    Thereafter
    

    	 	 	8,120	 

During 2005 no property, plant and equipment were
financed through capital leases (2004 — $13).

F-15

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	11. 	
    Long-Term Debt

	 	 	 	 	 
			2005
			

	
    Term loan, maturing on July 1, 2008 with
    interest payable monthly and repayable in 30 monthly
    payments of $452 including interest, commencing on
    February 1, 2006
    	 	$	11,660	 
	
    Less adjustment for the termination fee and the
    portion of the warrants not yet recognized as financial expenses
    	 	 	(459	)
	 	 	 	
	 
	
    
    Carrying value of long-term debt
    

    	 	$	11,201	 
	
    
    Current portion of long-term debt
    

    	 	 	3,383	 
	 	 	 	
	 
	 	 	$	7,818	 
	 	 	 	
	 

On June 28, 2005, the Company entered into a
US$10,000 term loan agreement bearing interest at 11.95%,
resulting in gross proceeds of $12,317. As part of the
agreement, the Company issued 543,104 warrants to purchase
common shares (note 12). Proceeds were allocated to
the long-term debt for $11,586 and the warrants for $731. As a
result of the value assigned to the warrants and the loan
termination fee of $408 (US$350) due on repayment, the effective
interest rate of the term loan is approximately 17%.

The financing costs related to the term loan
agreement amounted to $474 and were recorded as deferred
financing costs.

The term loan is collaterized by all of the
Company’s assets except for its intellectual property.

Minimum annual principal repayments of the
carrying value of the long-term debt during the next
twelve-month periods ending December 31, are as follows:

	 	 	 	 	 
	
    
    2006
    

    	 	$	3,383	 
	
    
    2007
    

    	 	 	4,423	 
	
    
    2008
    

    	 	 	3,395	 

12. Capital Stock

Authorized

Unlimited number of preferred shares,
non-participating, non-voting, without par value

Unlimited number of common shares, voting,
without par value

Issued

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    43,673,863 Common shares (December 31,
    2004 — 42,510,630)
    

    	 	$	135,631	 	 	$	132,658	 

Capital stock transactions

During 2005, 834,600
(2004 — 212,600) options were exercised for a
total cash consideration of $2,093 (2004 — $453).
In addition, capital stock was increased by $149
(2004 — $6) and contributed surplus reduced by
the same amount to record options exercised which were granted
after March 1, 2002. In addition, 328,633 shares were
issued on a cashless conversion of 543,104 warrants resulting in
a transfer of $731 from contributed surplus to share capital.

F-16

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

12. Capital Stock —
(Continued)

On May 26, 2004, the Company issued
6,122,449 common shares for consideration of $30,000. Share
issue expenses amounted to $2,196.

Warrants

On June 29, 2005, as part of the term loan
agreement described in note 11, the Company issued 543,104
warrants to purchase one common share per warrant, having an
exercise price of $2.71 each and expiring on June 29, 2010.
The Company valued the warrants using the Black-Scholes option
pricing model with the following weighted average assumptions:

	 	 	 
	
    
    Expected volatility
    

    	 	
    0.63
    
	
    
    Expected life
    

    	 	
    5.0 years
    
	
    
    Risk-free interest rate
    

    	 	
    3.16%
    
	
    
    Dividend yield
    

    	 	
    Nil
    

Proceeds from the term loan agreement were
allocated on a pro-rata basis to the long-term debt and the
warrants. The fair value attributed to the warrants
was $731.

During 2005, the 543,104 warrants were exercised
on a cashless basis for a total of 328,633 shares. As at
December 31, 2005, no warrants were outstanding
(2004 — nil).

During the year ended February 28, 2000, the
Company issued 200,000 warrants to purchase one common share per
warrant, to the former supplier of
Contramid®.
These warrants had an exercise price of $2.00 and an expiry date
of May 2004. During the year ended February 28, 2002,
10,000 warrants were exercised for a total of
10,000 shares for a cash consideration of $20. During 2004,
180,000 warrants were exercised for a total of
180,000 shares for a total cash consideration of $360 and
10,000 warrants expired unexercised.

Stock option plan

The Company established a stock option plan for
directors, executive officers, employees and consultants of the
Company. On April 20, 2005, the Company’s stock option
plan was amended in order to express the maximum number of
securities issuable thereunder as a percentage of the
Company’s issued and outstanding shares rather than a fixed
number. The maximum number of common shares that are issuable
under the plan shall not exceed 9.9% of the Company’s total
issued and outstanding shares at any time.

The maximum number of common shares that may be
optioned in favour of any individual will not exceed 5% of the
number of outstanding common shares. Under the stock option
plan, the price at which the common shares may be purchased will
not be lower than the closing price of the common shares on the
Toronto Stock Exchange on the grant date. Any options issued are
non-transferable.

All of the options that may be granted under the
plan are exercisable according to a schedule up to a maximum
period of ten years following the grant date thereof. The
outstanding options as at December 31, 2005, may be
exercised no later than December 2010. Options generally vest
over a three-year period except for options to Board of
Directors which vest immediately.

As of December 31, 2005, 4,323,712
securities are issuable under the plan, and 193,937 options are
available for grant.

F-17

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

12. Capital Stock —
(Continued)

The changes in the number of stock options
granted by the Company, and their weighted average exercise
prices are as follows:

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
					2005				2004
					
				

			#				#		
	
    
    Balance, beginning of year
    

    	 	 	3,363,475	 	 	$	5.01	 	 	 	3,415,025	 	 	$	4.87	 
	
    
    Granted
    

    	 	 	1,071,400	 	 	 	4.92	 	 	 	190,800	 	 	 	4.66	 
	
    
    Exercised
    

    	 	 	(834,600	)	 	 	2.51	 	 	 	(212,600	)	 	 	2.13	 
	
    
    Expired
    

    	 	 	(39,000	)	 	 	2.59	 	 	 	—	 	 	 	—	 
	
    
    Forfeited
    

    	 	 	(400	)	 	 	7.92	 	 	 	(29,750	)	 	 	7.36	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    Balance, end of year
    

    	 	 	3,560,875	 	 	$	5.59	 	 	 	3,363,475	 	 	$	5.01	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    Options eligible to be exercised
    

    	 	 	2,887,975	 	 	$	5.70	 	 	 	3,047,375	 	 	$	4.76	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 

Additional information concerning stock options
as at December 31, 2005 is as follows:

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
					
			Options outstanding		Options exercisable
			
		

					Weighted-				
					average		Weighted-				Weighted-
					remaining		average				average
			Number of		contractual		exercise		Number of		exercise
	Range of exercise price		options		life		price		options		price
	
		
		
		
		
		

	
    
    $2.16 to $3.94
    

    	 	 	1,476,025	 	 	 	2.70 years	 	 	$	3.07	 	 	 	1,167,625	 	 	$	2.99	 
	
    
    $4.10 to $6.61
    

    	 	 	986,700	 	 	 	3.58 years	 	 	$	5.79	 	 	 	645,600	 	 	$	5.35	 
	
    
    $7.00 to $10.29
    

    	 	 	1,098,150	 	 	 	1.88 years	 	 	$	8.83	 	 	 	1,074,750	 	 	$	8.86	 
	 	 	 	
	 	 	 	 	 	 	 	 	 	 	 	
	 	 	 	 	 
	 	 	 	3,560,875	 	 	 	 	 	 	 	 	 	 	 	2,887,975	 	 	 	 	 
	 	 	 	
	 	 	 	 	 	 	 	 	 	 	 	
	 	 	 	 	 

A compensation expense of $1,754
(2004 — $1,775) has been recognized during the
year ended December 31, 2005 for stock options granted to
employees and directors since March 1, 2002.

The fair value of options granted during the year
was estimated at the date of grant using the Black-Scholes
option pricing model with the following weighted average
assumptions:

	 	 	 	 	 	 	 	 	 
	For the year ended December 31,		2005		2004
	
		
		

	
    
    Expected volatility
    

    	 	 	0.67	 	 	 	0.72	 
	
    
    Expected life
    

    	 	 	4 years	 	 	 	4 years	 
	
    
    Risk-free interest rate
    

    	 	 	3.67%	 	 	 	3.65%	 
	
    
    Dividend yield
    

    	 	 	Nil	 	 	 	Nil	 

The weighted average grant date fair value of
stock options granted during the year ended December 31,
2005 using the above assumptions amounted to $2.65
(2004 — $2.63).

F-18

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

13. Commitments, Guarantees and
Contingency

(a) Commitments

The Company occupies certain facilities under
operating lease arrangements and leases certain equipment.
Estimated future minimum payments under these operating leases
for the years ending December 31 are as follows:

	 	 	 	 	 
	
    
    2006
    

    	 	$	82	 
	
    
    2007
    

    	 	 	64	 
	
    
    2008
    

    	 	 	60	 
	
    
    2009
    

    	 	 	58	 
	
    
    2010
    

    	 	 	58	 
	
    
    Thereafter
    

    	 	 	130	 
	 	 	 	
	 
	 	 	$	452	 
	 	 	 	
	 

Rental expenses for facilities and equipment
under operating leases totalled $128 in 2005 (2004 —
$84).

Letters of credit amounting to $1,271 were issued
to the lessors of the Company’s facilities as a collateral
for the Company’s performance of obligations under the
leases. These letters of credit are collateralized by specific
investments totalling $1,271 which have been classified as
long-term.

The Company has entered into long-term supply
agreements with third-party manufacturers in anticipation of the
commercialization of its products. These agreements include
clauses under which the Company would have to reimburse certain
equipment and set-up costs if minimum quantities are not
purchased or not purchased within the prescribed delay, and
clauses requiring the purchase of minimum quantities of product.
Management has estimated that the minimum commitments related to
these agreements would be approximately $267 for equipment and
set-up costs, and approximately $27,888 for the purchase of
bulk tablets.

(b) Guarantees

The Company periodically enters into research,
licensing, distribution or supply agreements with third parties
that include indemnification provisions that are customary in
the industry. These guarantees generally require the Company to
compensate the other party for certain damages and costs
incurred as a result of third-party intellectual property claims
or damages arising from these transactions. In some cases, the
maximum potential amount of future payments that could be
required under these indemnification provisions is unlimited.
These indemnification provisions generally survive termination
of the underlying agreement. The nature of the intellectual
property indemnification obligations prevents the Company from
making a reasonable estimate of the maximum potential amount it
could be required to pay. Historically, the Company has not made
any indemnification payments under such agreements and no amount
has been accrued in the accompanying consolidated financial
statements with respect to these indemnification obligations.

F-19

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

13. Commitments, Guarantees and
Contingency — (Continued)

(c) Contingency

In 1994, concurrently with the purchase of a
controlled-release technology, the Company acquired a right of
first refusal with respect to an improved technology for which
it agreed to pay royalties of 4% on net revenues generated from
the commercialization of the 1994 purchased technology. On
February 7, 2005, the Company was served with a motion to
institute legal proceedings in the Québec Superior Court.
The motion seeks payment of an unspecified amount of royalties
said to be outstanding since 1999. The Company considers
that, as at December 31, 2005, no amounts are owing.

14. Income Taxes

Income tax expense on loss from operations as
presented differs from the amount calculated by applying the
statutory income tax rate to loss before income taxes.

The reasons for this difference and the effect on
income tax expense are as follows:

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
							
			2005				
			
				
					
					2004
					

	
    
    Loss before income taxes:
    

    	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	
    Canadian operations
    	 	$	(1,007	)	 	 	 	 	 	$	(3,284	)	 	 	 	 
	 	
    Foreign operations
    	 	 	(31,128	)	 	 	 	 	 	 	(23,854	)	 	 	 	 
	 	 	 	
	 	 	 	 	 	 	 	
	 	 	 	 	 
	 	 	 	(32,135	)	 	 	 	 	 	 	(27,138	)	 	 	 	 
	
    
    Tax recovery at the Canadian statutory rate
    

    	 	 	9,961	 	 	 	31.0 %	 	 	 	8,413	 	 	 	31.0 %	 
	
    
    Change in income taxes arising from the following:
    

    	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
	 	
    Effect of foreign tax rate differential
    	 	 	(6,217	)	 	 	(19.3)	 	 	 	(2,974	)	 	 	(11.0)	 
	 	
    Non-deductible items
    	 	 	(497	)	 	 	(1.5)	 	 	 	(960	)	 	 	(3.5)	 
	 	
    Unrecognized tax benefits of losses carried
    forward and other differences
    	 	 	(5,044	)	 	 	(15.7)	 	 	 	(4,479	)	 	 	(16.5)	 
	 	
    Impact of changes in tax rates
    	 	 	970	 	 	 	3.0	 	 	 	—	 	 	 	—	 
	 	
    Other
    	 	 	(372	)	 	 	(1.2)	 	 	 	(41	)	 	 	(0.2)	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    Tax expense

    	 	$	(1,199	)	 	 	(3.7)%	 	 	$	(41	)	 	 	(0.2)%	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 

The Company created a Canadian Federal tax
expense and liability of $1,199 in order to utilize a
corresponding amount of non-refundable tax credits related to
research and development expenditures not previously recognized
in the financial statements and which would eventually expire.
The corresponding amount was recognized as government assistance
and a reduction of research and development expenses
(note 15) and offsets the Canadian Federal income
tax payable in the year.

F-20

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

14. Income Taxes —
(Continued)

The tax effect of temporary differences and net
operating losses that give rise to future income tax assets are
as follows:

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Future income tax liabilities

    	 	 	 	 	 	 	 	 
	
    
    Investment tax credits
    

    	 	$	(384	)	 	$	—	 
	 	 	 	
	 	 	 	
	 
	
    
    Total future income tax liabilities
    

    	 	 	(384	)	 	 	—	 
	 	 	 	
	 	 	 	
	 
	
    
    Future income tax assets

    	 	 	 	 	 	 	 	 
	
    
    Tax basis of capital assets in excess of carrying
    values
    

    	 	 	2,595	 	 	 	2,722	 
	
    
    Net operating losses carried forward of foreign
    entities
    

    	 	 	9,145	 	 	 	6,708	 
	
    
    Net operating losses carried forward of the
    Canadian entity
    

    	 	 	—	 	 	 	665	 
	
    
    Research and development expenditures
    

    	 	 	10,293	 	 	 	9,111	 
	
    
    Share issue costs
    

    	 	 	642	 	 	 	995	 
	 	 	 	
	 	 	 	
	 
	
    
    Total future income tax assets
    

    	 	 	22,675	 	 	 	20,201	 
	
    
    Valuation allowance
    

    	 	 	(22,291	)	 	 	(20,201	)
	 	 	 	
	 	 	 	
	 
	
    
    Net future income tax assets
    

    	 	 	—	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	
    
    Net future income tax liability
    

    	 	$	—	 	 	$	—	 
	 	 	 	
	 	 	 	
	 

During the year ended December 31, 2005, the
valuation allowance increased by $2,090.

The Company has accumulated loss carryforwards in
foreign jurisdictions which are available to reduce future
taxable income, the benefits of which have not been recognized
in these financial statements. These loss carryforwards expire
as follows:

	 	 	 	 	 
			Barbados
			

	
    
    2012
    

    	 	$	6,244	 
	
    
    2013
    

    	 	 	4,847	 
	
    
    2014
    

    	 	 	3,633	 
	 	 	 	
	 
	 	 	$	14,724	 
	 	 	 	
	 

In addition, the Company has $70,155 and $76 of
loss carryforwards in Ireland and Cyprus respectively that are
available to reduce taxable income in future years and have an
unlimited carryforward period, the benefit of which has not been
reflected in these financial statements.

The Company has approximately $30,818 of research
and development expenditures for Canadian Federal tax purposes
and $29,259 for Québec purposes that are available to
reduce taxable income in future years and have an unlimited
carryforward period, the benefit of which has not been reflected
in these financial statements. Research and development
expenditures are subject to audit by the taxation authorities
and accordingly, these amounts may vary.

The Company also has accumulated share issue
costs which have not been deducted for income tax purposes
amounting to approximately $1,986. The benefits of these
expenses have not been recorded in the financial statements.

F-21

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

14. Income Taxes —
(Continued)

During 2005, the Company was audited by the
Canada Revenue Agency (CRA) with respect to the 2002 sale,
to its foreign subsidiaries, of an undivided interest in certain
of its intellectual property rights. Subsequent to year end the
Company received a proposed adjustment from the CRA of the
amount for which the assets were sold. The proposed adjustment
would increase significantly the taxable income of the Company
for 2002. The Company believes that the proposed adjustment is
largely unfounded and it intends to vigorously oppose the
proposal and any subsequent assessment, should one arise.

The Company believes it has taken adequate
reserves to address this issue through a reduction in future tax
assets and a corresponding reduction in the 2005 valuation
allowance of $2,072. The ultimate resolution of this matter
could result in material adjustments to the amounts provided in
the accounts.

15. Government Assistance

The Company incurred research and development
expenditures which are eligible for investment tax credits. The
investment tax credits recorded are based on management’s
estimates of amounts expected to be recovered and are subject to
audit by the taxation authorities and, accordingly, these
amounts may vary. These amounts have been recorded as a
reduction of research and development expenditures as follows:

	 	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Research and development tax credits
    

    	 	 	 	 	 	 	 	 
	 	
    
    Non-refundable
    

    	 	$	1,199	 	 	$	—	 
	 	
    
    Refundable
    

    	 	 	1,514	 	 	 	823	 
	 	 	 	
	 	 	 	
	 
	 	 	$	2,713	 	 	$	823	 
	 	 	 	
	 	 	 	
	 

The Company has non-refundable tax credits
available amounting to $6,010 related to research and
development expenditures which may be utilized to reduce
Canadian Federal income taxes payable in the future years and
expire as follows:

	 	 	 	 	 
	
    
    2010
    

    	 	$	19	 
	
    
    2011
    

    	 	 	529	 
	
    
    2012
    

    	 	 	791	 
	
    
    2013
    

    	 	 	1,404	 
	
    
    2014
    

    	 	 	1,494	 
	
    
    2015
    

    	 	 	1,773	 
	 	 	 	
	 
	 	 	$	6,010	 
	 	 	 	
	 

The benefits of these non-refundable investment
tax credits have not been recognized in the financial statements.

F-22

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

16. Financial Expenses

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Interest on long-term debt
    

    	 	$	1,010	 	 	$	—	 
	
    
    Interest on capital lease obligations
    

    	 	 	817	 	 	 	864	 
	
    
    Amortization of deferred financing costs
    

    	 	 	110	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	$	1,937	 	 	$	864	 
	 	 	 	
	 	 	 	
	 

17. Net Change in Non-Cash Operating
Items

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Accounts receivable
    

    	 	$	355	 	 	$	328	 
	
    
    Research and development tax credits receivable
    

    	 	 	(75	)	 	 	100	 
	
    
    Income tax receivable
    

    	 	 	(425	)	 	 	—	 
	
    
    Inventories
    

    	 	 	(2,188	)	 	 	—	 
	
    
    Prepaids and other assets
    

    	 	 	(205	)	 	 	90	 
	
    
    Accounts payable and accrued liabilities
    

    	 	 	3,140	 	 	 	(1,157	)
	
    
    Deferred revenues
    

    	 	 	28,125	 	 	 	1,299	 
	 	 	 	
	 	 	 	
	 
	 	 	$	28,727	 	 	$	660	 
	 	 	 	
	 	 	 	
	 

18. Employee Benefit Plan

The Company has two defined contribution plans, a
contributory Canadian plan effective July 1, 2005 and a
non-contributory European plan effective December 2003. The
Company funded and charged to expense contributions of $108 and
$43 in 2005 and 2004, respectively.

19. Economic Dependence

The Company is dependent on two key raw material
suppliers, two contract manufacturers and two packagers. The
loss of any of these suppliers may have a materially adverse
effect on the Company’s financial position and results of
operations.

20. Financial Instruments

Fair value

Given their short-term maturity, the fair value
of cash and cash equivalents, accounts receivable, research and
development tax credits receivable, income tax receivable and
current accounts payable approximate the carrying value.

The fair value of the obligations under capital
leases, calculated at the present value of future contractual
payments of principal and interest and discounted at the current
market rate of interest available to the Company for debt
instruments with similar terms and maturity, approximates their
carrying values.

The fair value of the long-term debt, including
current portion approximates its carrying value. The Company
believes that the interest rates used to determine the carrying
value are similar to the rates which it could have obtained as
at the balance sheet date for loans with similar terms,
conditions and maturity dates.

F-23

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

20. Financial Instruments —
(Continued)

Credit risk

Financial instruments that potentially subject
the Company to significant concentrations of credit risk consist
principally of short-term and long-term investments. The Company
has investment policies that monitor the safety and preservation
of principal and investments are limited to $2,500 with a single
issuer.

Also, the Company provides credit to its clients
in the normal course of operations. It carries out on a
continuing basis, credit evaluations of its customers. As at
December 31, 2005, 100% (December 31,
2004 — 100%) of trade accounts receivable is due
from one customer (December 31, 2004 — one
customer). For the year ended December 31, 2005, 100%
(December 31, 2004 — 100%) of revenue from
research and development contracts was earned from one customer
(December 31, 2004 — two customers), located
in Europe.

Currency risk

A substantial portion of the Company’s
revenues from research contracts and licensing and distribution
agreements are denominated in U.S. dollars or Euros. This
results in financial risk due to fluctuations in the value of
the Canadian dollar relative to the U.S. dollar and Euro. The
Company does not use derivative financial instruments to reduce
its foreign exchange exposure, however, the Company has a
natural hedge for a portion of this risk, in that many of its
expenditures are in U.S. dollars and Euros. Fluctuations in
payments made for the Company’s services could cause
unanticipated fluctuations in the Company’s operating
results. The significant balances in foreign currencies at
December 31, 2005 are as follows:

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
					
			U.S. Dollars		Euros
			
		

			2005		2004		2005		2004
			
		
		
		

	
    
    Cash and cash equivalents
    

    	 	$	9,614	 	 	$	118	 	 	€	5,851	 	 	€	881	 
	
    
    Accounts receivables
    

    	 	 	143	 	 	 	—	 	 	 	30	 	 	 	213	 
	
    
    Restricted long-term investment
    

    	 	 	—	 	 	 	—	 	 	 	51	 	 	 	50	 
	
    
    Accounts payables and accrued liabilities
    

    	 	 	(2,704	)	 	 	(219	)	 	 	(616	)	 	 	(275	)
	
    
    Long-term debt
    

    	 	 	(10,000	)	 	 	—	 	 	 	—	 	 	 	—	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	 	 	$	(2,947	)	 	$	(101	)	 	€	5,316	 	 	€	869	 
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 

21. Segment Disclosure

The Company carries on business in Canada,
Barbados, the United States, and Ireland and substantially
all of the Company’s tangible assets are located in Canada.
All licensing and product revenue has been derived from the
business carried on in Ireland, by the Company’s subsidiary
Labopharm Europe Limited, and all other revenue has been derived
from business carried on in Canada. The intangible assets are
jointly owned

F-24

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

21. Segment Disclosure —
(Continued)

by the Company and its foreign subsidiaries. The
following table presents revenue by the customers’ domicile
and property, plant and equipment by location.

	 	 	 	 	 	 	 	 	 
			
			Total revenue
			

			2005		2004
			
		

	
    
    Europe
    

    	 	$	1,878	 	 	$	1,394	 
	
    
    United States
    

    	 	 	1,360	 	 	 	—	 
	 	 	 	
	 	 	 	
	 
	 	 	$	3,238	 	 	$	1,394	 
	 	 	 	
	 	 	 	
	 

	 	 	 	 	 	 	 	 	 
			
			Property, plant and
			equipment
			

			2005		2004
			
		

	
    
    Canada
    

    	 	$	9,912	 	 	$	10,762	 
	
    
    Europe
    

    	 	 	368	 	 	 	199	 
	 	 	 	
	 	 	 	
	 
	 	 	$	10,280	 	 	$	10,961	 
	 	 	 	
	 	 	 	
	 

22. Related Party Transaction

During 2005, in the normal course of business,
the Company paid consulting fees of $325 (2004 — $319)
to a company related to a director and recorded these as
selling, general and administrative expenses as incurred. These
transactions are measured at their exchange amount.

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States

These financial statements were prepared in
accordance with accounting principles generally accepted in
Canada (“Canadian GAAP”) and conform in all
material respects with U.S. generally accepted accounting
principles (“U.S. GAAP”) except as follows:

(a) Stock-based compensation

Under Canadian GAAP, the Company accounts for
stock-based compensation to employees and directors as described
in note 2. Under U.S. GAAP, the Company has similarly
elected to follow the fair value method in accordance with
FAS 123, Accounting for Stock-Based Compensation as
of May 1995. As such, all compensation expense is recorded
as a charge to income and a credit to contributed surplus.
However, compensation expense under U.S. GAAP takes into
account options and warrants granted prior to the effective date
of the Canadian GAAP requirements.

During the year ended
February 28, 2001, the Company granted
196,725 compensation options to its agent in connection
with the Company’s issuance of common shares. The options
had an exercise period of twenty-four months from
August 31, 2000, vested immediately and entitled the
holder to purchase common shares at an exercise price of $3.40
per share. Under Canadian GAAP no compensation cost was
recorded. For purposes of reconciliation to U.S. GAAP,
these options were accounted for under the fair value method on
the date of grant using the Black-Scholes option pricing model,
and an expense of $356 was recorded as a

F-25

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States — (Continued)

share issue cost against share capital, with a
corresponding credit to contributed surplus. During the year
ended February 28, 2002, 100,000 options were
exercised resulting in a transfer of $181 from contributed
surplus to share capital, and the remaining 96,725 options
expired unexercised in August 2002.

(b) Warrants

During the year ended
February 28, 2000, the Company issued
200,000 warrants to purchase one common share per warrant,
to the former supplier of
Contramid®
in partial settlement for the termination of an agreement. No
expense was recorded for the fair value of these warrants under
Canadian GAAP. For purposes of reconciliation to U.S. GAAP,
these warrants were accounted for under the fair value method on
the date of grant using the Black-Scholes option pricing model,
and an expense of $224 was recorded as a charge to operations in
fiscal 2000, with a corresponding credit to contributed surplus.
In 2002 and 2004, 190,000 warrants were exercised resulting
in a total transfer of $213 from contributed surplus to
capital stock.

(c) Patent and intellectual property
costs

Under Canadian GAAP, the Company capitalizes
certain patent costs and costs of acquiring intellectual
property as further described in note 2. Under
U.S. GAAP, such costs are classified as in-process research
and development and expensed as incurred until such time as the
underlying product is approved for commercialization. Amounts
included in the reconciliation of consolidated net loss and
comprehensive loss reflect an increase in the net loss for
amounts capitalized under Canadian GAAP but expensed under
U.S. GAAP, offset by a decrease to the net loss for the
related amortization expense.

On November 29, 2005, the Company acquired
certain patents which relate to a product approved for sale in
Europe and capitalized the purchase cost of $1,162 for U.S. and
Canadian GAAP purposes.

(d) Research and development
expenses

Under U.S. GAAP, research and development costs
are expensed as incurred and include salaries and benefits,
costs paid to third-party contractors to perform research,
develop and manufacture drug material, and a portion of
facilities cost. Clinical trial costs are a significant
component of research and development expenses and include costs
associated with third-party contractors. Under Canadian GAAP
certain development costs may be deferred.

(e) Available for sale
investment

Under U.S. GAAP, short-term investments are
classified as available-for-sale and carried at market values
with unrealized gains or losses reflected as a component of
accumulated other comprehensive income until the investments are
sold, at which time the realized gains and losses are included
in the results of operations. The reconciling differences
were insignificant in 2005 and 2004. Under Canadian GAAP
short-term investments are recorded at amortized cost unless
there is a decline in fair value which is other than temporary.

F-26

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States — (Continued)

(f) Comprehensive loss

Comprehensive loss includes all changes in
equity (deficiency) during the periods presented except
shareholder transactions. For the purpose of reporting under
U.S. GAAP, the components of comprehensive loss and total
comprehensive loss are reported in the consolidated statements
of changes in shareholders’ equity (deficiency), and below
net loss in the consolidated statements of operations and
deficit. For the periods presented, accumulated other
comprehensive loss equals net loss.

The effect of the above on the Company’s
consolidated financial statements is set out below:

Reconciliation of Consolidated Net Loss and
Comprehensive Loss

	 	 	 	 	 	 	 	 	 
			Year ended		Year ended
			December 31,		December 31,
			2005		2004
			
		

	
    
    Net loss under Canadian GAAP

    	 	$	(33,334	)	 	$	(27,179	)
	
    
    Adjustment for:
    

    	 	 	 	 	 	 	 	 
	
    
    Stock based compensation (a)
    

    	 	 	—	 	 	 	(217	)
	
    
    Patent and intellectual property costs (c)(d)
    

    	 	 	(33	)	 	 	(45	)
	
    
    Net loss and comprehensive loss under
    U.S. GAAP

    	 	$	(33,367	)	 	$	(27,441	)
	 	 	 	
	 	 	 	
	 
	
    
    Net loss per share under
    U.S. GAAP — basic and diluted

    	 	$	(0.78	)	 	$	(0.69	)

The weighted average number of common shares
outstanding for purposes of determining basic and diluted loss
per share are the same as those used for Canadian GAAP purposes.

The effects of any permanent or temporary timing
differences for tax purposes are not significant and therefore
have not been reflected in the reconciliation.

Reconciliation of Reported Amounts on
Consolidated Balance Sheets

Material variations in selected balance sheet
accounts under U.S. GAAP are as follows:

	 	 	 	 	 	 	 	 	 	 	 	 	 
			Canadian				U.S.
			GAAP		Adjustments		GAAP
			
		
		

	
    
    2005

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Intangible assets (c)(d)
    

    	 	$	3,231	 	 	$	(2,069	)	 	$	1,162	 
	
    
    Capital stock (a)(b)
    

    	 	 	135,631	 	 	 	2,939	 	 	 	138,570	 
	
    
    Contributed surplus (a)(b)
    

    	 	 	6,350	 	 	 	7,381	 	 	 	13,731	 
	
    
    Deficit
    

    	 	 	(144,584	)	 	 	(12,389	)	 	 	(156,973	)
	
    
    2004

    	 	 	 	 	 	 	 	 	 	 	 	 
	
    
    Intangible assets (c)(d)
    

    	 	 	2,036	 	 	 	(2,036	)	 	 	—	 
	
    
    Capital stock (a) (b)
    

    	 	 	132,658	 	 	 	1,706	 	 	 	134,364	 
	
    
    Contributed surplus (a)(b)
    

    	 	 	4,745	 	 	 	8,614	 	 	 	13,359	 
	
    
    Deficit
    

    	 	 	(111,250	)	 	 	(12,356	)	 	 	(123,606	)

F-27

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States — (Continued)

Reconciliation of Consolidated Cash Flow
Captions

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
					
			Year ended		Year ended
			December 31, 2005		December 31, 2004
			
		

			Canadian		U.S.		Canadian		U.S.
			GAAP		GAAP		GAAP		GAAP
			
		
		
		

	
    
    Operating activities (c)(d)
    

    	 	$	(1,040	)	 	$	(1,213	)	 	$	(23,082	)	 	$	(23,269	)
	
    
    Investing activities (c)(d)
    

    	 	 	5,187	 	 	 	5,360	 	 	 	(3,275	)	 	 	(3,088	)
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 

As at December 31, 2005 and 2004, cash and
cash equivalents are comprised of cash.

Additional disclosures required under U.S.
GAAP are as follows:

(i) Consolidated statement of changes in
shareholders’ equity (deficiency) in accordance with
U.S. GAAP:

	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 	 
									
			Outstanding common						
			shares						
			
		Contributed				
			Number				Surplus		Deficit		Total
			
				
		
		

	
    
    Balance, December 31, 2003

    	 	 	35,995,581	 	 	$	105,297	 	 	$	11,817	 	 	$	(96,165	)	 	$	20,949	 
	
    
    Share issuance
    

    	 	 	6,122,449	 	 	 	27,804	 	 	 	—	 	 	 	—	 	 	 	27,804	 
	
    
    Issued on the exercise of stock options
    

    	 	 	212,600	 	 	 	701	 	 	 	(248	)	 	 	—	 	 	 	453	 
	
    
    Issued on the exercise of warrants
    

    	 	 	180,000	 	 	 	562	 	 	 	(202	)	 	 	—	 	 	 	360	 
	
    
    Stock-based compensation
    

    	 	 	—	 	 	 	—	 	 	 	1,992	 	 	 	—	 	 	 	1,992	 
	
    
    Net loss
    

    	 	 	—	 	 	 	—	 	 	 	—	 	 	 	(27,441	)	 	 	(27,441	)
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    Balance, December 31, 2004

    	 	 	42,510,630	 	 	$	134,364	 	 	$	13,359	 	 	$	(123,606	)	 	$	24,117	 
	
    
    Issued on the exercise of stock options
    

    	 	 	834,600	 	 	 	3,475	 	 	 	(1,382	)	 	 	—	 	 	 	2,093	 
	
    
    Grant of warrants
    

    	 	 	—	 	 	 	—	 	 	 	731	 	 	 	—	 	 	 	731	 
	
    
    Issued on the exercise of warrants
    

    	 	 	328,633	 	 	 	731	 	 	 	(731	)	 	 	—	 	 	 	—	 
	
    
    Stock-based compensation
    

    	 	 	—	 	 	 	—	 	 	 	1,754	 	 	 	—	 	 	 	1,754	 
	
    
    Net loss
    

    	 	 	—	 	 	 	—	 	 	 	—	 	 	 	(33,367	)	 	 	(33,367	)
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 
	
    
    Balance, December 31, 2005

    	 	 	43,673,863	 	 	$	138,570	 	 	$	13,731	 	 	$	(156,973	)	 	$	(4,672	)
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 	 	 	
	 

(ii) Accounts payable and accrued
liabilities consist of the following:

	 	 	 	 	 	 	 	 	 
			2005		2004
			
		

	
    
    Trade payables
    

    	 	$	7,850	 	 	$	4,162	 
	
    
    Accrued payroll and related expenses
    

    	 	 	1,742	 	 	 	1,451	 
	
    
    Other
    

    	 	 	498	 	 	 	317	 
	 	 	 	
	 	 	 	
	 
	 	 	$	10,090	 	 	$	5,930	 
	 	 	 	
	 	 	 	
	 

F-28

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States — (Continued)

(iii)  Intangible assets

Under U.S. GAAP, the estimated amortization
expense for each of the next five succeeding fiscal years for
the capitalized costs of acquiring patents will amount
to $81.

(iv) Allowance for doubtful
accounts

The Company maintains an allowance for doubtful
accounts related to its accounts receivable. The Company reviews
its accounts receivable on a regular basis to determine if any
receivables have a high risk of being uncollectible, and include
these in its allowance. Based on the information available,
management believes the allowance for doubtful accounts is
appropriate; however, actual write-offs might exceed the
recorded allowance. The Company did not have an allowance for
doubtful accounts as of December 31, 2005 and 2004.

(v) Recent accounting pronouncements
under U.S. GAAP

In December 2004, the Financial Accounting
Standards Board issued SFAS 123(R) Share-Based
Payment, a revision to SFAS 123 Accounting for Stock
Based Compensation. SFAS 123(R) requires all
share-based payments to be recognized in the financial
statements based on their fair values using either a
modified-prospective or modified-retrospective transition
method. Accordingly, from the date of adoption of the revised
standard, the Company will be required to recognize compensation
expense for all share-based payments based on grant-date fair
value, including those granted, modified or settled prior to
December 1, 2002. Under U.S. GAAP, the Company had
already elected to follow the fair value method in accordance
with SFAS 123, and as such, SFAS 123(R) does not
represent a significant change in accounting policy for
the Company.

In November 2004, the FASB issued
SFAS No. 151, Inventory Costs, an amendment of
ARB No. 43, Chapter 4. This statement clarifies that
abnormal inventory costs such as costs of idle facilities,
excess freight and handling costs, and wasted material
(spoilage) are required to be recognized as current period
charges. In addition, the statement requires that allocation of
fixed production overhead to the costs of conversion be based on
the normal capacity of the production facilities. The provisions
of this statement became effective for inventory costs incurred
during fiscal years beginning after June 15, 2005. The
Company believes that the adoption of this statement will not
have a significant impact on the Company’s consolidated
results of operations or financial condition.

In December 2004, the FASB issued
SFAS No. 153, Exchanges of Non monetary Assets,
an amendment of APB Opinion No. 29. The amendments made by
SFAS 153 are based on the principle that exchanges of non
monetary assets should be measured based on the fair value of
the assets exchanged. Further, the amendments broaden the
exception for exchanges of non monetary assets that do not have
commercial substance. SFAS 153 is effective for non
monetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The Company believes that the
adoption of SFAS 153 will not have a material impact on the
Company’s consolidated results of operations or
financial position.

In May 2005, the FASB issued SFAS 154
Accounting Changes and Error Corrections. The statement
replaces APB Opinion No. 20, Accounting Changes and
SFAS No. 3, Reporting Accounting Changes in Interim
Financial Statements. SFAS 154 requires companies to apply
voluntary changes in principles retrospectively

F-29

 

LABOPHARM INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)

December 31, 2005

(thousands of Canadian dollars, except share and
per share amounts)

 

		
	23. 	
    Reconciliation of Significant Differences
    between Accounting Principles Generally Accepted in Canada and
    the United States — (Continued)

whenever practicable. SFAS 154 is effective
for accounting changes and correction of errors made in fiscal
years beginning after December 15, 2005. The Company
presently does not believe that the adoption of the provisions
of SFAS 154 will have a material impact on its financial
statements.

24. Comparative Figures

Certain comparative figures have been
reclassified to conform to the presentation adopted in the
current period.

F-30

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