"Management's Discussion and Analysis of Financial Condition and Results of Operations" should be read in connection with our accompanying Consolidated Financial Statements (including the notes thereto) appearing elsewhere herein.

We are a biotechnology company developing Surfactant Replacement Therapies (SRT) for respiratory disorders and diseases. Our proprietary technology produces a peptide-containing synthetic surfactant that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for survival and normal respiratory function. We believe that our proprietary technology makes it possible, for the first time, to develop a series of SRT to treat conditions for which there are few or no approved therapies available for patients in the Neonatal Intensive Care Unit (NICU), Pediatric Intensive Care Unit (PICU), Intensive Care Unit (ICU) and other hospital settings.

Our SRT pipeline is focused initially on the most significant respiratory conditions prevalent in the NICU and PICU. We have filed with the U.S. Food and Drug Administration (FDA) a New Drug Application (NDA) for our initial product, Surfaxin® (lucinactant) for the prevention of Respiratory Distress Syndrome (RDS) in premature infants. The FDA has established April 17, 2009 as its target action date to complete its review of this NDA. (See"Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations.") We are also developing Surfaxin for other neonatal and pediatric respiratory conditions and disorders, such as Acute Respiratory Failure (ARF), for which we are conducting a Phase 2 clinical trial in children up to two years of age, and Bronchopulmonary Dysplasia (BPD), a debilitating and chronic lung disease typically affecting premature infants who have suffered RDS. Aerosurf™ is our proprietary SRT in aerosolized form and is being developed for the treatment of RDS in premature infants. Aerosurf has the potential to obviate the need for endotracheal intubation and conventional mechanical ventilation and holds the promise to significantly expand the use of SRT in respiratory medicine.

We also believe that our SRT will potentially address a variety of debilitating respiratory conditions such as Acute Lung Injury (ALI), cystic fibrosis (CF), chronic obstructive pulmonary disease (COPD), and asthma, that affect pediatric, young adult and adult patients in the ICU and other hospital settings.

We have implemented a business strategy that includes:

· focusing primarily on efforts intended to potentially gain regulatory approval to market and sell Surfaxin for the prevention of RDS in premature infants in the United States, and, as we work towards this milestone, conserving our financial resources;

· selective investment in our SRT pipeline programs, including life-cycle development of Surfaxin for other respiratory conditions prevalent in the NICU and PICU, new SRT formulation development, and Aerosurf for neonatal and pediatric conditions;

· taking actions to establish our own commercial organization specialized in neonatal and pediatric indications to prepare for and execute the launch of Surfaxin in the United States;

· seeking collaboration agreements and strategic partnerships in the international and domestic markets for the development and potential commercialization of our SRT pipeline, including Surfaxin and Aerosurf, although there can be no assurance that we will succeed in entering into such an arrangement;

· continued investment in our quality systems and manufacturing capabilities, including our manufacturing operations in Totowa, New Jersey and our recently-completed analytical laboratories in Warrington, Pennsylvania. We plan to manufacture sufficient drug product to meet the anticipated pre-clinical, clinical, formulation development and potential future commercial requirements of Surfaxin, Aerosurf and our other SRT product candidates. To support our formulation development activities, we plan to enter into arrangements with one or more contract manufacturing organizations. For our aerosolized SRT, we plan to collaborate with engineering device experts and use contract manufacturers to produce aerosol devices and related components to meet our development and potential future commercial requirements. Our long-term manufacturing strategy includes potentially entering into arrangements with contract manufacturing organizations, expanding our existing facilities or building or acquiring additional manufacturing capabilities for the production and development of our proprietary SRT drug and combination drug-device combination products; and

· seeking investments of additional capital, including potentially from business alliances, commercial and development partnerships, equity financings and other similar opportunities, although there can be no assurance that we will identify or enter into any specific alliances or transactions.

Since our inception, we have incurred significant losses and, as of September 30, 2008, we had an accumulated deficit of $318.9 million (including historical results of predecessor companies). The majority of our expenditures to date have been for research and development activities. (See"Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations.")

Historically, we have funded our operations with working capital provided principally through public and private equity financings, debt arrangements and strategic collaborations. As of September 30, 2008, we had: (i) cash and marketable securities of $31.5 million; (ii) approximately 17.2 million shares potentially available for issuance, up to an aggregate of approximately $56.9 million, under a May 2008 Committed Equity Financing Facility (2008 CEFF) with Kingsbridge Capital Limited (Kingsbridge), subject to certain conditions, including that the volume weighted-average price of our common stock (VWAP) on each trading day must be at least equal to the greater of $1.15 or 90% of the closing price of our common stock on the trading day immediately preceding the draw down period (see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facility"); (iii) approximately 4.5 million shares potentially available for issuance, up to an aggregate of approximately $34.3 million, under an April 2006 Committed Equity Financing Facility with Kingsbridge (2006 CEFF), subject to certain conditions, including that the VWAP on each trading day must be at least equal to the greater of $2.00 or 85% of the closing price of our common stock on the trading day immediately preceding the draw down period (see our most recent Annual Report on Form 10-K, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facility");
(iv) approximately $10.0 million outstanding ($8.5 million principal and $1.5 million of accrued interest as of September 30, 2008) on a loan from PharmaBio Development Inc. d/b/a NovaQuest (PharmaBio), the strategic investment group of Quintiles Transnational Corp., the principal amount of which is due and payable, together with all accrued and unpaid interest on April 30, 2010;
(v) $3.8 million outstanding under our equipment financing facility with GE Business Financial Services Inc. (GE), and (vi) $0.5 million outstanding under an equipment loan from the Commonwealth of Pennsylvania, Department of Community and Economic Development, Machinery and Equipment Loan Fund (MELF). See"Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."

Research and development expenses for the three and nine months ended September 30, 2008 were $6.7 million and $21.4 million, respectively. Research and development expenses for the three and nine months ended September 30, 2007 were $6.2 million and $18.4 million, respectively. These costs are charged to operations as incurred and are tracked by category rather than by project. Research and development costs consist primarily of expenses associated with our manufacturing operations, formulation development, development of aerosolized SRT, and research, clinical, regulatory and other direct preclinical and clinical projects.

These cost categories typically include the following expenses:

Manufacturing Development

Manufacturing development primarily reflects costs to: (i) maintain our manufacturing operations in Totowa, New Jersey and our quality assurance and analytical chemistry capabilities in Totowa and at our recently completed analytical and development laboratories at our headquarters in Warrington, Pennsylvania, to assure adequate production of clinical and potential commercial drug supply for our SRT programs, including Surfaxin, if approved, in conformance with current good manufacturing practices (cGMP) (these costs include employee expenses, depreciation, costs of drug substances, quality control and assurance activities and analytical services); (ii) design, develop, manufacture and assemble aerosolization systems to administer Aerosurf, including the initial prototype version and the next-generation version of our novel capillary aerosolization system, and (iii) develop new formulations of our SRT.

Development Operations (unallocated)

Development operations include (i) clinical, regulatory and biostatistics activities for the management of our clinical trial programs in accordance with current good clinical practices (cGCP) and (ii) medical affairs capabilities, including medical science liaisons, to provide scientific and medical education support in connection with the potential commercial launch of Surfaxin and other products in our SRT pipeline. These costs include personnel, supplies, facilities, fees to consultants, other related costs of clinical trials and management, clinical quality control and regulatory compliance activities, data management and biostatistics.

Direct Pre-Clinical and Clinical Program Expenses

Direct pre-clinical and clinical program expenses include (i) pre-clinical activities prior to initiation of any potential human clinical trials and (ii) activities associated with conducting human clinical trials, including patient enrollment costs, external site costs, costs of clinical drug supply and related external costs such as contract research consultant fees and expenses, and (iii) activities associated with obtaining data and other information included in our Complete Responses to the April 2006 and May 2008 Approvable Letters.

The following summarizes our research and development expenses by each of the foregoing categories for the three and nine months ended September 30, 2008 and 2007:

                                         Three Months Ended          Nine Months Ended
( in thousands)                            September 30,               September 30,
Research and Development Expenses:        2008           2007          2008         2007

Manufacturing development            $     3,286    $     3,520   $    12,656   $    9,902
Development operations
(unallocated)                              1,910          1,724         5,900        5,251
Direct pre-clinical and clinical
program expenses                           1,528            940         2,837        3,247
Total Research & Development
Expenses                             $     6,724    $     6,184   $    21,393   $   18,400

Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, the nature, timing of completion, and ultimate cost of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty. Results from clinical trials may not be favorable and data from clinical trials are subject to varying interpretation and may be deemed insufficient by the regulatory bodies reviewing applications for marketing approvals. As such, clinical development and regulatory programs are subject to risks and changes that may significantly impact cost projections and timelines.

Currently, none of our drug product candidates are available for commercial sale. All of our potential products are in regulatory review or clinical or pre-clinical development. The status and anticipated completion date of each of our lead SRT programs are discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations." Successful completion of development of any of our SRT is contingent on numerous risks, uncertainties and other factors, some of which are described in detail in the "Risk Factors" section contained in our most recent Annual Report on Form 10-K.

Chrysalis Technologies, a Division of Philip Morris USA Inc.

In March 2008, we restructured our December 9, 2005 Strategic Alliance Agreement (Original Alliance Agreement) with Philip Morris USA Inc., d/b/a Chrysalis Technologies (Chrysalis), which had been created to unite two complementary respiratory technologies - our peptide-containing synthetic surfactant technology with Chrysalis' novel capillary aerosolization technology - to deliver therapeutics to the deep lung.

Under the Original Alliance Agreement, Chrysalis was primarily responsible for development activities related to its proprietary capillary aerosolization technology (the Chrysalis Technology) and we were responsible for aerosolized drug formulations, clinical and regulatory activities, and the manufacturing and commercialization of the combination drug-device products using the Chrysalis Technology (Licensed Products). Under the restructuring, we entered into an Amended and Restated License Agreement dated March 28, 2008 (U.S. License Agreement) with Chrysalis to amend and restate the Original Alliance Agreement in the United States. As Chrysalis has assigned to Philip Morris Products S.A. (PMPSA) all rights in and to the Chrysalis Technology outside of the United States (International Rights), effective March 28, 2008, we also entered into a License Agreement with PMPSA with respect to the International Rights (International License Agreement, and together with the U.S. License Agreement, the License Agreements) on substantially the same terms and conditions as the U.S. License Agreement.

We hold an exclusive license in the United States under the U.S. License Agreement and an exclusive license to the International Rights under the PMPSA License Agreement in and to the Chrysalis Technology for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions (the foregoing uses in each territory, Exclusive Field). In addition, under the U.S. License Agreement, we hold a license to use the Chrysalis Technology with other drugs to treat specified target indications in specified target populations. Our exclusive license under each License Agreement now includes, in addition to the rights we previously had, the right to develop and have developed Licensed Products in the Exclusive Field in the respective territory.

In accordance with the terms of the U.S. License Agreement, Chrysalis agreed to provide continuing development support to us through June 30, 2008 and also agreed to provide financial support for our future development activities in the amount of $4.5 million, of which $2.0 million became payable upon execution of the modified agreement in March 2008 and $2.5 million became payable upon completion of a technology transfer to us (in scope sufficient to permit us to practice the Chrysalis Technology) in June 2008.

Under the Original Alliance Agreement, we were obligated to pay Chrysalis royalties based on a multi-tiered royalty structure (that escalated upon attaining collaboration product revenues greater than $500 million and $1 billion). Under the License Agreements, we are now obligated to pay royalties at a rate equal to a low single-digit percent of sales of products sold in the Exclusive Field in the respective territories. In connection with the exclusive undertakings of Chrysalis and PMPSA not to exploit the Chrysalis Technology in the Exclusive Field, we are obligated to pay royalties on all product sales, including sales of any aerosol devices and related components sold by us in the Exclusive Field that are based on aerosolization technology other than the Chrysalis Technology. In addition, we have agreed in the future to pay minimum royalties, but are entitled to a future reduction of royalties in an amount equal to the excess of any minimum royalty paid over royalties actually earned under the License Agreements.

Under the License Agreements, we generally own the intellectual property that we create or reduce to practice in the performance of the License Agreements or exercise of the licenses granted thereunder, except such inventions that relate primarily, in each instance, to the Chrysalis Technology (Chrysalis Technology Improvements). We are obligated to assign to Chrysalis and PMPSA all such Chrysalis Technology Improvements and all such inventions are then made subject to our rights under each License Agreement. The License Agreements also contain provisions related to the calculation and payment of royalties, record-keeping and audit rights, and prosecution of patents, and include customary representations, warranties and indemnities. Each License Agreement, unless terminated earlier will expire as follows as to each Licensed Product in each country in the respective territory, on a country-by-country basis, upon the latest of: (a) the tenth anniversary of the date of the first commercial sale of the Licensed Product; (b) the date on which the sale of such Licensed Product ceases to be covered by a claim of an issued and unexpired patent in such country, or (c) the date a generic form of the product is introduced in such country. The License Agreements may be terminated, by Chrysalis or PMPSA, as appropriate, in the event that we fail to make the payment of the minimum royalties, as provided therein, or by us, in whole or in part, in the early years following the effective date, upon payment of a termination fee. In addition, either party to each License Agreement may terminate upon a material breach by the other party (subject to a specified cure period).

We have incurred substantial losses since inception and expect to continue to make significant investments for product research, development, manufacturing, sales and marketing and general administrative activities. We will need to generate significant revenues from product sales, related royalties and transfer prices to achieve and maintain profitability.

Through September 30, 2008, we had no revenues from any product sales, and had not achieved profitability on a quarterly or annual basis. Our ability to achieve profitability depends upon, among other things, our ability to develop products, obtain regulatory approval for products under development and enter into collaboration and other agreements for product development, manufacturing and commercialization. In addition, our results are dependent upon the performance of our strategic partners and suppliers. Moreover, we may never achieve significant revenues or profitable operations from the sale of any of our products or technologies.

Through September 30, 2008, we had not generated taxable income. At December 31, 2007, net operating losses available to offset future taxable income for Federal tax purposes were approximately $258.7 million. In addition, we had a research and development tax credit carryforward of $6.1 million at December 31, 2007. The Tax Reform Act of 1986 (the "Act") provides for a limitation on the annual use of net operating loss and research and development tax credit carry-forwards following certain "ownership changes" (as defined by the Act) that could limit our ability to utilize these carry-forwards. As a result of, among other things, past financings, we are considered to have experienced various such ownership changes. Accordingly, our ability to utilize the foregoing carry-forwards may be limited. Additionally, because tax laws limit the time periods during which these carry-forwards may be applied against future taxes, we may not be able to take full advantage of these carry-forwards for federal and state income tax purposes. The Federal net operating loss and research and development tax credit carryforwards expire beginning in 2008 through 2027. In 2008, $0.8 million of Federal net operating losses and $18,124 of research and development tax credit carryforwards expire.

Over the next 12 to 24 months, we plan to undertake a variety of initiatives that are discussed below.

Research and Development

We will continue to focus our research, development and regulatory activities on advancing our pipeline of potential SRT for respiratory diseases. The drug development, clinical trial and regulatory process is lengthy, expensive and uncertain and subject to numerous risks including, without limitation, the applicable risks discussed herein and those contained in the "Risk Factors" section in our most recent Annual Report on Form 10-K. Also see"Management's Discussion and Analysis of Financial Condition and Results of Operations - Research and Development."

Our major research and development projects include:

SRT for Neonatal and Pediatric Indications

In order to address the most prevalent respiratory disorders affecting infants in the NICU and PICU, we are conducting several therapeutic programs that target respiratory conditions that have been cited as some of the most significant unmet medical needs in the neonatal and pediatric community.

Surfaxin for the Prevention of RDS in Premature Infants

On May 1, 2008, the date under the Prescription Drug User Fee Act (PDUFA) on which the FDA was to complete its review of our NDA for Surfaxin for the prevention of RDS in premature infants, we received a third Approvable Letter for this NDA. Most notably, this Approvable Letter did not contain a requirement for additional clinical trials. On October 17, 2008, we submitted our Complete Response to this Approvable Letter. The FDA designated our Complete Response as a Class 2 resubmission and has established April 17, 2009 as its target action date under PDUFA to complete its review of our Surfaxin NDA.

Prior to receiving the May 2008 Approvable Letter, we believe that we had made significant progress towards gaining regulatory approval for Surfaxin. Specifically, (i) as of March 2008, we had submitted to the FDA 12-month stability data on our Surfaxin process validation batches, (ii) also in March 2008, the FDA completed a pre-approval inspection (PAI) of our manufacturing operations at Totowa, New Jersey, and thereafter issued an Establishment Inspection Report (EIR) indicating an approval recommendation, and (iii) on April 30, 2008, as part of our NDA review, we completed labeling discussions with the FDA and agreed to a proposed Surfaxin package insert setting forth prescribing information, although the package insert will not be considered final until the FDA approves our NDA.

The May 2008 Approvable Letter included, among other things, requests (i) to further tighten or justify one acceptance criterion for the biological activity test that we previously had implemented for Surfaxin release and stability testing (Biological Activity Test), (ii) to further tighten or justify acceptance criteria for lipid drug substance impurities, (iii) to further tighten or justify 2 of the 21 physical and chemical drug product acceptance criteria that we had proposed in our October 2007 Complete Response to the April 2006 Approvable Letter, and (iv) to submit certain specified equipment and aseptic process-related validation reports. To gain clarification of certain items identified in this Approvable Letter, on May 14, we submitted an information package to the FDA and requested a meeting, which occurred by teleconference on June 18, 2008.

Based on our assessment of the May 2008 Approvable Letter, after consulting with our regulatory experts, and the our June 2008 teleconference with the FDA, with the exception of two items, we believed that we could respond to the Approvable Letter using readily available data. With respect to the two remaining items, we agreed with the FDA to provide additional confirmatory data and related information as follows:

(i) Surfaxin Biological Activity Test

A few years ago, based on discussions with the FDA, we qualified and validated the Biological Activity Test in accordance with current Good Manufacturing Practices (cGMP) and implemented it for Surfaxin release and stability testing. In addition, as agreed at a December 2006 clarification meeting with the FDA, we generated data in a well-characterized RDS animal model at a Surfaxin dose level that was the same dose used in the Surfaxin Phase 3 clinical trials (the 2007 Study). The Biological Activity Test data and the 2007 Study results supported the comparability of Surfaxin drug product used in our Surfaxin Phase 3 clinical trials to the Surfaxin drug product to be manufactured for commercial use. In addition, these data were used to propose final acceptance criteria for the Biological Activity Test and were provided to, and reviewed by, the FDA prior to the May 2008 Approvable Letter.

At the June 18, 2008 meeting, the FDA asked us to conduct an additional test with respect to the Biological Activity Test using a different dose level than historically employed for Surfaxin release and stability testing. In addition, in a side by side experiment, we conducted a study using the same RDS animal model and dose as was used in the 2007 Study. We believe that the data generated supports determination of final acceptance criteria for the Biological Activity Test, the proposed shelf life for Surfaxin and further confirms the comparability of Surfaxin drug product used in our Surfaxin Phase 3 clinical trials to the Surfaxin drug product to be manufactured for commercial use. This information was included in our recent Complete Response.

(ii) Specifications for Lipid-Related Impurities in Surfaxin Active Pharmaceutical Ingredients

Surfaxin is comprised of four active pharmaceutical ingredients (APIs); a novel peptide, a fatty acid and two phospholipids. To gain final marketing authorization by the FDA, the FDA indicated that our proposed specifications for lipid-related impurities in the two individual phospholipids must also satisfy guidance issued by the International Conference of Harmonization (ICH). The ICH generally designates threshold limits for impurities present in an API and also provides guidance for justifying specifications that exceed the designated threshold limits.

At the June 18 meeting with the FDA, we discussed justifying impurity levels for certain lipid-related impurities that exceeded the ICH designated threshold limits based upon their being present in the human lung at levels equal to or greater than those that exist in Surfaxin. The FDA requested information about the levels of these lipid-related impurities specific to the neonatal lung. In addition to reviewing the scientific literature to satisfy the FDA's request, we also consulted with lipid-experts and our phospholipids suppliers to determine whether the lipid-related impurities in question can be reduced to the ICH . . .