Summary of CALLISTO PHARMACEUTICALS INC

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our consolidated financial statements and other financial information appearing elsewhere in this Annual Report on Form 10-K. In addition to historical information, the following discussion and other parts of this Annual Report contain forward-looking information that involves risks and uncertainties.

BUSINESS OVERVIEW

Callisto Pharmaceuticals, Inc. (which may be referred to as "Callisto", "the Company", "we" or "us") was incorporated under the laws of the State of Delaware in May 2003. We operate through two subsidiary companies: Synergy Pharmaceuticals Inc. and Callisto Research Labs, LLC, and we own two inactive subsidiaries, IgX, Ltd (Ireland) and Callisto Pharma, GmbH (Germany). Our principal offices are located at 420 Lexington Avenue, Suite 1609, New York, NY 10170.

We are a development stage biopharmaceutical company focused primarily on the development of drugs to treat neuroendocrine cancer (including advanced carcinoid cancer), rheumatoid arthritis ("RA"), acute leukemia and gastrointestinal ("GI") disorders and diseases. Our lead drug candidates are as follows:

º 1.
º SP-304, a guanylyl cyclase C ("GC-C") receptor agonist, to treat GI disorders, primarily chronic constipation ("CC") and constipation-predominant irritable bowel syndrome ("IBS-C"), currently being developed by our majority-owned subsidiary, Synergy Pharmaceuticals, Inc. ("Synergy").

º 2.
º Atiprimod, an orally administered drug with antiproliferative and antiangiogenic activity.

º 3.
º L-Annamycin, a novel compound from the anthracycline family of proven anti-cancer drugs, which has a novel therapeutic profile, including activity against drug resistant tumors and significantly reduced cardiotoxicity, or damage to the heart.

HISTORY

In March 2002, Callisto Pharmaceuticals, Inc. ("Old Callisto"), a non-public company, purchased 99.7% of the outstanding common shares of Webtronics, Inc., ("Webtronics") a public company for $400,000. Webtronics was incorporated in Florida on February 2, 2001 and had limited operations at December 31, 2002.

On April 30, 2003, pursuant to an Agreement and Plan of Merger dated March 10, 2003, as amended April 4, 2003, Synergy Acquisition Corp., a wholly-owned subsidiary of Webtronics merged into Synergy Pharmaceuticals, Inc. ("Synergy-DE") and Callisto Acquisition Corp., a wholly-owned subsidiary of Webtronics merged into Old Callisto (collectively, the "Merger"). As a result of the Merger, Old Callisto and Synergy-DE became wholly-owned subsidiaries of Webtronics. In connection with the Merger, Webtronics issued 17,318,994 shares of its common stock in exchange for outstanding Old Callisto common stock and an additional 4,395,684 shares in exchange for outstanding Synergy-DE common stock. In May 2003, Old Callisto changed its name to Callisto Research Labs, LLC ("Callisto Research") and Webtronics changed its name to Callisto Pharmaceuticals, Inc. and changed its state of incorporation from Florida to Delaware. Subsequently, 171,818 shares of common stock issued to former Synergy-DE shareholders were returned to us under the terms of certain indemnification agreements.

From inception through December 31, 2008, we have sustained cumulative net losses available to common stockholders of $90,987,267. Our losses have resulted primarily from expenditures incurred in connection with research and development activities, application and filing for regulatory approval of

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proposed products, stock-based compensation expense, patent filing and maintenance expenses, purchase of in-process research and development, outside accounting and legal services and regulatory, scientific and financial consulting fees, as well as deemed dividends attributable to the beneficial conversion rights of convertible preferred stock at issuance. From inception through December 31, 2008, we have not generated any revenue from operations, expect to incur additional losses to perform further research and development activities and do not currently have any commercial biopharmaceutical products, and do not expect to have such for several years, if at all.

Our product development efforts are thus in their early stages and we cannot make estimates of the costs or the time they will take to complete. The risk of completion of any program is high because of the many uncertainties involved in bringing new drugs to market including the long duration of clinical testing, the specific performance of proposed products under stringent clinical trial protocols, the extended regulatory approval and review cycles, our ability to raise additional capital, the nature and timing of research and development expenses and competing technologies being developed by organizations with significantly greater resources.

Recent Developments

On January 27, 2009, we announced that we were focusing all further development of Atiprimod towards the treatment of RA. We recognized that although the ongoing Phase II clinical trial of Atiprimod in advanced carcinoid cancer gave encouraging results, the data were not sufficiently demonstrative to warrant further development of Atiprimod in this indication. We announced, instead, our intention that based on Atiprimod's demonstrated favorable clinical safety profile, robustly supported by earlier studies of Atiprimod in RA patients, as well as by the recent oncology trials in advanced carcinoid cancer patients, where the drug was dosed at levels and frequencies considerably higher than anticipated for use in RA, we believe that Atiprimod holds significant promise as a new class of orally-administered, disease-modifying agent in RA.

On December 19, 2008, we entered into a Technology Assignment Agreement (the "Agreement") with AnorMED pursuant to which AnorMED transferred and assigned to us all of AnorMED's right, title and interest in and to all patents and patent applications with respect to Atiprimod in addition to all trade secrets, technical reports and data concerning Atiprimod and any analogs or derivatives in return for a cash payment of $650,000, which payment settled the upfront fees owed from December 31, 2007 Amended and Restated License Agreement. In addition the Agreement specified that the Amended and Restated License Agreement between us and AnorMED dated December 31, 2007, with respect to which AnorMED licensed to us certain patent rights and technology related to Atiprimod, was terminated with no additional amounts due.

On December 9, 2008, Synergy announced the completion of the Phase I clinical trial of SP-304 in healthy volunteers that was initiated in June, 2008. This first study was a double-blind, placebo-controlled, randomized single, oral, ascending dose trial performed in 71 healthy male and female volunteers. The primary objective of the Phase I clinical trial with SP-304 was to characterize the safety, tolerability, pharmacokinetic and pharmacodynamic effects of the drug in healthy volunteers. The data from the trial were included in an abstract accepted for presentation at the Digestive Disease Week conference that meets in Chicago in June, 2009. We plan to initiate a repeated-oral-dose trial of SP-304 in chronic constipation patients in late 2009 or early 2010.

On July 14, 2008, we entered into an Exchange Agreement dated July 11, 2008 ("Exchange Agreement"), as amended and effective on July 14, 2008, with Pawfect Foods, Inc. ("Pawfect"), Synergy Pharmaceuticals, Inc. ("Synergy-DE"), a majority-owned subsidiary of ours, and other holders of Synergy-DE common stock. According to the terms of the Exchange Agreement, Pawfect acquired 100% of the common stock of Synergy-DE, from us and the other holders of Synergy-DE, in exchange for 45,464,760 shares of Pawfect's common stock representing approximately 70% of Pawfect's

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outstanding common stock (the "Exchange Transaction"). We received 44,590,000 of the 45,464,760 shares of Pawfect's common stock exchanged for our ownership of Synergy-DE, and we are now the holder of 68% of Pawfect's outstanding common stock. The remaining 874,760 shares of Pawfect common stock exchanged for ownership of Synergy-DE were issued to certain executive officers of Synergy-DE who received their shares pursuant to a Repurchase Agreement with Synergy-DE dated July 3, 2008 and assumed by Pawfect. The fair value of each of the 874,760 shares was estimated on the grant date to be $0.60, which was based on the price paid by shareholders participating in Synergy's July 14, 2008 private placement. Stock based compensation expense of $524,856 related to these shares is being amortized over the vesting period of 2 years. In connection with the Exchange Transaction Pawfect received $3,025,000 less transaction costs of $73,087, yielding net proceeds of $2,951,913 from two private placements, which we have recorded as an increase in additional paid-in capital.

Pawfect was a development stage company selling pet food products utilizing the internet, with immaterial operations to date. On July 14, 2008, Pawfect discontinued its pet food business to focus all resources on continuing the development of drugs to treat GI disorders and diseases acquired in connection with the Exchange Agreement.

On July 21, 2008 Pawfect, amended its articles of incorporation, in the state of Florida, to effect the actions necessary to complete the transactions contemplated by the Exchange Agreement and changed its name to Synergy Pharmaceuticals, Inc. ("Synergy"). Synergy is now traded on the Over The Counter Bulletin Board under the symbol SGYP.OB.

On April 2, 2008, we filed an investigational new drug ("IND") application with the United States Food and Drug Administration ("FDA") relating to SP-304. On May 2, 2008, we received notice from the FDA that the proposed study was deemed safe to proceed and we initiated a Phase I clinical trial in volunteers on June 4, 2008.

On April 7, 2008, we received notice from the staff of the American Stock Exchange ("AMEX") of its intent to strike our common stock from the AMEX by filing a delisting application with the SEC for failure to regain compliance with Sections 1003(a)(i) and 1003(a)(ii) of the Company Guide and falling out of compliance with Section 1003(a)(iii) of the Company Guide with shareholders' equity of less than $6,000,000 and losses from continuing operations and/or net losses in four of our five most recent fiscal years. On July 14, 2008, our common stock was delisted from the AMEX and currently trades on the Over The Counter Bulletin Board under the symbol CLSP.OB.

SP-304 was developed by Synergy scientists based on structure-function studies performed in-house. A patent covering composition of matter and therapeutic applications of SP-304 was granted by the U.S. Patent and Trademark Office on May 9, 2006. SP-304 is an analog of uroguanylin, a natural GI hormone produced in the gut that is a key regulator of intestinal function. Uroguanylin works by activating the GC-C receptor on intestinal cells. The GC-C receptor, promotes fluid and ion transport in the GI tract. Under normal conditions, the receptor is activated by the natural hormones uroguanylin and guanylin. Activation of the receptor leads to the transport of chloride and bicarbonate into the intestine, and water is carried with these ions into the lumen of the intestine, thereby softening stool, and producing other pharmacologic effects that could potentially benefit patients with chronic constipation and IBS-C.

A practical, efficient and cost effective method for producing SP-304 on a commercial scale is currently being developed by two contract research organizations. At present we have multiple 100 gram-scale lots of SP-304, produced under current good manufacturing practices ("cGMP"), which are being used for non-clinical work to support further human studies.

SP-304 has also undergone pre-clinical animal studies as a treatment for GI inflammation in a collaborative study involving clinical gastroenterologist Dr. Scott Plevy of the University of North Carolina, Chapel Hill, NC. Recent results from his laboratory also showed that SP-304 was efficacious

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in animal models of ulcerative colitis ("UC"). A second generation GC-C receptor SP-333 is now in pre-clinical development and Synergy plans to file an IND and initiate a Phase I clinical trial in volunteers in 2010.

On November 7, 2006, we announced the initiation of a multi-center open-label Phase II clinical trial of Atiprimod for low-to-intermediate grade neuroendocrine cancers, primarily in advanced carcinoid cancer patients. On September 20, 2007, we announced that we had completed enrollment of the 40-patient Phase II clinical trial, and that patients had been on drug as along as 11 months. In October 2007, we announced the opening of a Phase II extension trial to permit those patients who had successfully completed a full year in the Phase II advanced carcinoid cancer trial to continue to receive Atiprimod therapy. We also indicated that we are no longer dosing patients in relapsed or refractory multiple myeloma and have no plans at present to continue evaluating the drug in this disease indication, instead focusing on the clinical development of Atiprimod to treat advanced carcinoid cancer. On May 16, 2008, we announced interim data from the company's ongoing open-label Phase II clinical trial of Atiprimod to treat low to intermediate grade neuroendocrine carcinoma (advanced carcinoid cancer). On January 27, 2009, we announced that we were focusing all further development of Atiprimod towards the treatment of rheumatoid RA. We recognized that although the ongoing Phase II clinical trial of Atiprimod in advanced carcinoid cancer gave encouraging results, the data were not sufficiently demonstrative to warrant further development of Atiprimod in this indication. We announced our belief that Atiprimod holds significant promise as a new class of orally-administered, disease-modifying agent in RA.

L-Annamycin was evaluated in two clinical trials: 1) a Phase I/IIa clinical trial in adult relapsed acute myelogenous leukemia ("AML") or refractory acute lymphocytic leukemia ("ALL") patients at three clinical sites in the U.S.; and
2) a Phase I clinical trial in children and young adults with relapsed or refractory ALL or AML. We established an MTD of 150 mg/m2/day given for 3 consecutive days in the adult trial and finished dosing of 10 patients at this MTD value. The clinical data, however, did not warrant further clinical evaluation of L-Annamycin as a single agent to treat relapsed or refractory adult acute leukemia patients. The Phase I trial of L-Annamycin in pediatric relapsed or refractory ALL or AML patients was initiated at a dose of 130 mg/m2/day. Due to the low number of patients with this disease, we were only able to enroll 3 patients in total, all at 130 mg/m2/day, and never achieved an MTD in children. Due to this poor enrollment plus the decision to suspend further development of L-Annamycin in adults, we have suspended any further work on L-Annamycin in acute leukemia at this time.

We will require additional capital to execute our plan. Worldwide economic conditions and the international equity and credit markets have significantly deteriorated and may remain depressed for the foreseeable future. These developments will make it more difficult for us to obtain additional equity or credit financing, when needed. We cannot be certain that funding will be available on acceptable terms, or at all. If we are unable to raise additional capital when required or on acceptable terms, we may have to (i) significantly delay, scale back or discontinue the development and/or commercialization of one or more of our product candidates, (ii) seek collaborators for our product candidates at an earlier stage than otherwise would be desirable and on terms that are less favorable than might otherwise be available and/or
(iii) relinquish or otherwise dispose of rights to technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves on unfavorable terms.

CRITICAL ACCOUNTING POLICIES

We prepare our financial statements in conformity with accounting principles generally accepted in the U.S. The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, including disclosure of contingent assets and contingent liabilities, at the date of

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the financial statements and the reported amounts of revenue and expenses during the reporting period. Because of the uncertainty of factors surrounding the estimates or assumptions used in the preparation of the consolidated financial statements, actual results may vary from these estimates.

Share-Based Payments

We rely heavily on incentive compensation in the form of stock options to recruit, retain and motivate directors, executive officers, employees and consultants. Incentive compensation in the form of stock options is designed to provide long-term incentives, develop and maintain an ownership stake and conserve cash during our development stage. Since inception through December 31, 2008 stock-based compensation expense has totaled $17,734,869 or 19% of our total accumulated deficit of $90,987,267.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard ("SFAS") No. 123 (Revised 2004), Share-Based Payments ("SFAS No. 123R"). SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for the award of equity instruments based on the fair value of the award at the date of grant. The expense is to be recognized over the period during which an employee is required to provide services in exchange for the award. SFAS No. 123R is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005 and accordingly we adopted SFAS No. 123R on January 1, 2006.

SFAS No. 123R did not change the way we account for non-employee stock-based compensation. We continue to account for shares of common stock, stock options and warrants issued to non-employees based on the fair value of the stock, stock option or warrant, if that value is more reliably measurable than the fair value of the consideration or services received. Stock-based compensation expense associated with these most of our non-employee option grants is being recorded in accordance with EITF 96-18 and accordingly (i) the measurement date will be when "performance commitment is completed" and accordingly the fair value of these options is being "marked to market" quarterly until the measurement date is determined.

Upon adoption of SFAS No. 123R, we selected the Black-Scholes option pricing model as the most appropriate model for determining the estimated fair value for stock-based awards. Use of a valuation model requires management to make certain assumptions with respect to selected model inputs. Expected volatility was calculated based on our historical volatility. Our stock price has fluctuated from $3.95 per share as of December 31, 2003 to $0.09 per share as of December 31, 2008. The expected term was determined based on the simplified method provided in Staff Accounting Bulletin ("SAB") No. 107, Share-Based Payment, ("SAB No. 107"). The risk-free interest rate is based on observed interest rate appropriate for the expected term of our stock options. Forfeitures are estimated, based on our historical experience, at the time of grant.

Research and Development

We do not currently have any commercial biopharmaceutical products, and do not expect to have such for several years, if at all and therefore our research and development costs are expensed as incurred. These include expenditures in connection with an in-house research and development laboratory, salaries and staff costs, application and filing for regulatory approval of our proposed products, purchase of in-process research and development, regulatory and scientific consulting fees, contract research and royalty payments to outside suppliers, facilities and universities as well as legal and professional fees associated with filing and maintaining our patent and license rights to our proposed products. While certain of our research and development costs may have future benefits, our policy of expensing all research and development expenditures is predicated on the fact that we have no history of successful commercialization of biopharmaceutical products to base any estimate of the number of future periods that would be benefited.

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RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2008 AND DECEMBER 31, 2007

We had no revenues during the 12 months ended December 31, 2008 and 2007 because we do not have any commercial biopharmaceutical products and we do not expect to have such products for several years, if at all.

Research and development expenses decreased $1,058,257 or 16%, to $5,449,721 for the 12 months ended December 31, 2008 from $6,507,978 for the 12 months ended December 31, 2007. This decrease in research and development expense was attributable to a decrease in Atiprimod and Annamycin clinical program expenses partially offset by an increase in SP-304 clinical program expenses. Expenses incurred on our Atiprimod program decreased $1,586,000 or 74% to $561,000 for the 12 months ended December 31, 2008 from $2,147,000 during the 12 months ended December 31, 2007. Clinical expenses incurred on our Annamycin program decreased $366,000 or 56% to $292,000 for the 12 months ended December 31, 2008 from $658,000 during the 12 months ended December 31, 2007. Our SP-304 program expenses incurred by our majority-owned subsidiary Synergy increased $1,730,000 or 76% to $4,018,000 for the 12 months ended December 31, 2008 from $2,288,000 during the 12 months ended December 31, 2007. Research and development expenses for non-clinical overhead, not allocated to specific programs, totaled $562,000 and $1,400,000 during the 12 months ended December 31, 2008 and 2007, respectively, a decrease of $838,000 or 60%, as we focused more of our research and development resources on established clinical programs and curtailed our non-clinical laboratory supplies and sponsored outside research. As a percent of our total research and development costs, these non-program specific non-clinical overhead expenses decreased to 10% from 22% of total research and development expenses during the 12 months ended December 31, 2008 and 2007, respectively.

General and administrative expenses for the 12 months ended December 31, 2008 were essentially unchanged at $4,311,767 from $4,317,288 for the 12 months ended December 31, 2007. Increased accounting, consulting and advisory expenses as a result of having two public reporting entities (Callisto and Synergy) during 2008, were offset by a decrease in legal and public relations expenses.

Net loss from operations was $9,731,488 for the 12 months ended December 31, 2008 which was $832,925 or 8% lower than the $10,564,413 reported in the comparable period of 2007. This decrease was attributable to lower research and development expenses discussed above combined with lower government grants income of $30,000 during the 12 months ended December 31, 2008 as compared to $260,853 received during the 12 months ended December 31, 2007. On April 1, 2005 we were awarded a biodefense partnership grant from the National Institute of Allergy and Infectious Diseases to develop a monoclonal antibody and vaccine against bacterial superantigen toxins over a two year period. Funding for this program was extended one year through April 2008. Because the bioterrorism program is not a core activity, we terminated in-house work on this program upon expiration of the research grant in April 2008

We record adjustments to the minority interests in Synergy for the allocable portion (32%) of losses to which the minority interest holders are entitled. The minority interest in Synergy as of the date of acquisition, July 14, 2008, was $663,765 after reflecting the net proceeds from the private placement. 32% of Synergy's net loss subsequent to the date of acquisition through December 31, 2008 was $1,151,577, excluding Synergy's charge for purchased in process research and development eliminated in consolidation. We suspended allocation of losses to the minority interest holders when the minority interest balance was reduced to zero. Any excess Synergy loss ($487,812) above the minority interest holder's balance was not charged to minority interests as the Synergy minority interest holders have no obligation to fund such losses.

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Net loss available to common stockholders for the 12 months ended December 31, 2008 was $9,655,471 compared to a net loss of $20,887,428 incurred for the 12 months ended December 31, 2007. The decreased net loss is the result of (i) lower operating expenses discussed above, (ii) the beneficial conversion feature discount related to the Series A and B preferred stock accreted as a dividend of $13,000,163 in the 12 months ended December 31, 2007 and (iii) a benefit in the 12 months ended December 31, 2007 relating to a change in the fair value of the Series B warrants of $2,591,005. We had no such items (ii) and
(iii) during 2008.

YEARS ENDED DECEMBER 31, 2007 AND DECEMBER 31, 2006

We had no revenues during the 12 months ended December 31, 2007 and 2006 because we do not have any commercial biopharmaceutical products and we do not expect to have such products for several years, if at all.

Research and development expenses increased $373,274, or 6%, to $6,507,978 for the 12 months ended December 31, 2007 from $6,134,704 for the 12 months ended December 31, 2006. This increase in research and development expense was attributable to significantly higher SP-304 and Atiprimod program expenses. Program expenses incurred with outside contract research organizations ("CROs"), include pre-clinical animal testing, drug formulation, tableting, hospital patient costs, blood testing, data collection, clinical monitoring and FDA consultants. Our SP-304 program expenses increased approximately $1,700,000, or 300%, to approximately $2,300,000 for the 12 months ended December 31, 2007 from approximately $600,000 during the 12 months ended December 31, 2006. Atiprimod program costs increased approximately $400,000, or 27%, to approximately $2,100,000 during the 12 months ended December 31, 2007 from $1,700,000 during the 12 months ended December 31, 2006. Partially offsetting these increased research expenditure were lower Annamycin program expenses of approximately $650,000 during the 12 months ended December 31, 2007, which was a 50% decrease from approximately $1,300,000 expensed during the 12 months ended December 31, 2006. During the 12 months ended December 31, 2006 we purchased and expensed a supply of Annamycin drug substance which was used in both our 2006 and 2007 clinical trials. Our Degrasyns program was also curtailed during the 12 months ended December 31, 2007, during which time we incurred only $12,593 on this pre-clinical program, as compared to $690,226 during the 12 months ended December 31, 2006.

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