We have incurred substantial losses since inception due to investments in research and development, manufacturing and potential commercialization activities and we expect to continue to incur substantial losses over the next several years. Historically, we have funded our business operations through various sources, including public and private securities offerings, draw downs under our Committed Equity Financing Facilities (CEFFs), capital equipment and financing and debt facilities, and strategic alliances. We expect to continue to fund our business operations through a combination of these sources, as well as sales revenue from our product candidates, if approved.

Following receipt of the April 2009 FDA Complete Response Letter for Surfaxin, we made fundamental changes in our business strategy. We are actively assessing various strategic and financial alternatives to secure necessary capital to advance our KL4 respiratory pipeline programs to maximize shareholder value.
Although we are presently actively engaged in discussions with potential strategic and financial partners, there can be no assurance that any strategic alliance or other financing transaction will be successfully concluded.

Our capital requirements will depend upon many factors, including the success of our product development and commercialization plans. Currently, we are focused on developing our lead KL4 surfactant products, Surfaxin LS, Aerosurf and Surfaxin, to address the most significant respiratory conditions affecting pediatric populations. However, there can be no assurance that our research and development projects will be successful, that products developed will obtain necessary regulatory approval, that any approved product will be commercially viable, that any CEFF will be available for future financings, or that we will be able to obtain additional capital when needed on acceptable terms, if at all. Even if we succeed in raising additional capital and developing and subsequently commercializing product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

As of September 30, 2009, we had cash and cash equivalents of $17.7 million. Also as of September 30, 2009, under our two CEFFs, we may potentially raise (subject to certain conditions, including minimum stock price and volume limitations) up to an aggregate of $73.8 million. In May 2009, we completed a registered direct public offering resulting in gross proceeds of $11.3 million ($10.5 million net). Through September 30, 2009 we raised an aggregate of $6.6 million from seven draw-downs under our CEFFs in 2009. In October 2009, we raised an additional $4.3 million from three draw-downs under our CEFFs. However, as of November 4, 2009, the May 2008 CEFF was unavailable because our stock price was below the minimum price required to utilize it. Also, as of September 30, 2009, our $10.4 million loan with Novaquest (formerly PharmaBio Development Inc.), a strategic investment group of Quintiles Transnational Corp., is classified as a current liability, payable in April 2010. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facilities, and "- Financings Pursuant to Common Stock Offerings."

Until we are able to secure a strategic alliance or complete a financing transaction to generate required capital, we have taken steps to conserve our financial resources, predominantly by curtailing investments in our pipeline programs. Following receipt in April 2009 of the Complete Response Letter for Surfaxin, we implemented cost containment measures and reduced our workforce from 115 to 91 employees. The workforce reduction was focused primarily in our commercial and corporate administrative groups. We have retained the core capabilities that we need to support development of our KL4 surfactant technology, including our quality, manufacturing and research and development resources. We incurred a one-time charge of approximately $0.6 million in the quarter ending June 30, 2009 related to the workforce reduction (see Note 5 - Commercial Strategy and Cost Containment Measures).

The accompanying interim unaudited consolidated financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. Our ability to continue as a going concern is dependent on our ability to raise additional capital, to fund our research and development and commercial programs and meet our obligations on a timely basis. If we are unable to successfully raise sufficient additional capital, through strategic and collaborative ventures with potential partners and/or future debt and equity financings, we will likely not have sufficient cash flows and liquidity to fund our business operations, which could significantly limit our ability to continue as a going concern. In addition, as of September 30, 2009, we have authorized capital available for issuance (and not otherwise reserved) of approximately 500,000 shares of common stock. We have presented to our stockholders, for approval at our Annual Meeting of Stockholders on December 7, 2009, a proposal to increase our authorized shares by 200 million from 180 million to 380 million. If this proposal is not approved, we may be unable to undertake additional financings without first seeking stockholder approval, a process that would require a special meeting of stockholders, is time-consuming and expensive and could impair our ability to efficiently raise capital when needed, if at all. In that case, we may be forced to further limit development of many, if not all, of our programs. If we are unable to raise the necessary capital, we may be forced to curtail all of our activities and, ultimately, potentially cease operations. Even if we are able to raise additional capital, such financings may only be available on unattractive terms, or could result in significant dilution of stockholders' interests and, in such event, the market price of our common stock may decline. Our balance sheet does not include any adjustments relating to recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue in existence.

Note 3 - Accounting Policies and Recent Accounting Pronouncements

Accounting policies

There have been no changes to our critical accounting policies since December 31, 2008. For more information on critical accounting policies, refer to our Annual Report on Form 10-K for the year ended December 31, 2008. Readers are encouraged to review these disclosures in conjunction with the review of this Form 10-Q.

Net loss per common share

Basic net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding for the periods. As of September 30, 2009 and 2008, 30.9 million and 22.0 million shares of common stock, respectively, were potentially issuable upon the exercise of certain stock options and warrants and vesting of restricted stock awards. Due to our net loss, these potentially issuable shares were not included in the calculation of diluted net loss per share as the effect would be anti-dilutive, therefore basic and dilutive net loss per share are the same.

Comprehensive loss

Comprehensive loss consists of net loss plus the changes in unrealized gains and losses on available-for-sale securities. Comprehensive loss for the three and nine months ended September 30, 2009 and 2008 are as follows:

                                               For the three months ended           For the nine months ended
(in thousands)                                       September 30,                        September 30,
                                               2009                 2008              2009               2008

Net loss                                   $      (7,191 )     $      (10,639 )   $     (24,099 )     $  (30,568 )
Change in unrealized (losses)/gains on
marketable securities                                  -                    3                (1 )            (32 )
Comprehensive loss                         $      (7,191 )     $      (10,636 )   $     (24,100 )     $  (30,600 )

Recent accounting pronouncements

In June 2009, the Financial Accounting Standards Board (FASB) issued the Accounting Standards Codification™ (the Codification). The Codification now is the single source of authoritative accounting principles recognized by FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with Generally Accepted Accounting Principles ("GAAP"), in the United States. The Codification became effective for interim and annual periods ending after September 15, 2009. All other accounting literature not included in the Codification will be nonauthoritative, except for additional authoritative rules and interpretive releases issued by the SEC. The Codification is not intended to change GAAP; instead it reorganizes the thousands of US GAAP pronouncements into approximately 90 Accounting Topics. The Company's adoption of the Codification did not have an impact on our consolidated financial statements.

In May 2009, FASB issued new guidance for accounting for subsequent events. The new guidance, which is now part of Accounting Standards Codification (ASC) Topic 855, Subsequent Events, is consistent with existing auditing standards in its definition of subsequent events, but requires disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. There are two types of subsequent events: (1) events that provide additional evidence about conditions that existed at the balance sheet date, and are recognized in the financial statements, and (2) events that provide evidence about conditions that did not exist at the balance sheet date, but arose before the financial statements are issued or are available to be issued, and are not recognized at the balance sheet date. The adoption of the new guidance had no impact on our consolidated financial statements. We evaluated all events or transactions that occurred after September 30, 2009 up through November 9, 2009, the date these financial statements were issued and filed with the SEC. During this period we did not have any material recognized subsequent events, however, there were three nonrecognized subsequent events described in Note 10.

In December 2007, FASB issued new guidance for accounting for collaborative arrangements. The new guidance, which is now part of ASC Topic 808, Collaborative Arrangements, is effective for fiscal years beginning after December 15, 2008. The scope of the new guidance is limited to collaborative arrangements where no separate legal entity exists and in which the parties are active participants and are exposed to significant risks and rewards that depend on the success of the activity. The new guidance requires certain income statement presentation of transactions with third parties and of payments between parties to the arrangement, along with disclosure about the nature and purpose of the arrangement. The adoption of the new guidance on January 1, 2009 did not have a material impact on our consolidated financial statements.

In December 2007, FASB issued new guidance for accounting for business combinations. The new guidance, which is now part of ASC topic 805, Business Combinations, is effective for financial statements issued for fiscal years beginning on or after December 15, 2008. The new guidance establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree, and the goodwill acquired in the business combination. ASC Topic 805 also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. We adopted the new guidance on January 1, 2009, which had no immediate impact on our financial statements; however it may have an impact on the accounting for any potential future business combinations.

Note 4 - Revenue from Collaborative Arrangement and Grants

We did not earn any revenue during the three and nine months ended September 30, 2009.

In March 2008, we restructured our strategic alliance agreement with Philip Morris USA Inc. d/b/a Chrysalis Technologies (Chrysalis). See our Annual Report on Form 10-K for the year ended December 31, 2008 - Note 12 to our Consolidated Financial Statements. Under the modified agreement, Chrysalis agreed to pay us $4.5 million to support future development of our Capillary Aerosolization Technology, of which $2.0 million became payable upon execution of the revised agreement in March 2008 and $2.5 million became payable upon completion of a technology transfer to us in June 2008.

Note 5 - Commercial Strategy and Cost Containment Measures

In April 2009, following receipt of the Complete Response Letter for Surfaxin for the prevention of RDS in premature infants, we reviewed all aspects of our business with an immediate intention to conserve cash. As a result of this review, we implemented a fundamental change in our business strategy. We are no longer planning to establish our own specialty pulmonary organization to commercialize our potential pediatric products, including Surfaxin, in the United States. To secure capital and advance our KL4 surfactant pipeline programs, we are now seeking to reduce our financial burden by entering into strategic alliances in all markets, including the United States, to support our research and development programs and, if approved, to commercialize our products.

In addition, we implemented cost containment measures and reduced our workforce from 115 to 91 employees, focused primarily on commercial and corporate personnel. We continue to maintain our core capabilities to support development of our KL4 surfactant technology, including quality, manufacturing and research and development resources. We incurred a charge of $0.6 million in the second quarter of 2009 associated with staff reductions and the close-out of certain contractual arrangements, which is included within the appropriate line items on the Statement of Operations ($0.4 million in general and administrative expenses and $0.2 million in research and development expenses). As of September 30, 2009, payments totaling $0.6 million had been made related to these items and $0.1 million were unpaid.

                                          Severance         Termination of
                                         and Benefits         Commercial
   (in thousands)                          Related             Programs         Total

   Q2 2009 Charge                       $          554     $             74     $  628
   Payments / Adjustments                         (450 )                  -       (450 )
   Liability as of June 30, 2009        $          104     $             74     $  178
   Payments / Adjustments                          (97 )                 (4 )     (101 )
   Liability as of September 30, 2009   $            7     $             70     $   77

Note 6 - Stockholders' Equity

May 2009 Registered Direct Public Offering

On May 13, 2009, we completed a registered direct public offering that resulted in gross proceeds of $11.3 million ($10.5 million net proceeds) from the issuance of 14.0 million shares of our common stock and warrants to purchase seven million shares of common stock. The shares were sold to select institutional investors at a price of $0.81 for each share of common stock, together with a related warrant to purchase 0.5 shares of common stock. The warrants are exercisable for a period of five years at an exercise price of $1.15 per share. Lazard Capital Markets LLC acted as the exclusive placement agent for the offering and received a fee of 6% of the gross proceeds of the offering and reimbursement of certain expenses incurred by it in connection with the offering. Under the Placement Agent Agreement, we agreed not to draw down on our CEFFs for a period of 30 days after the offering, and, for the 60 days following that date, agreed to an aggregate draw down limit of 2% of our outstanding common stock, and also agreed not to sell, for a period of 90 days following the entry into the definitive agreements, any of our common stock other than in connection with the offering, pursuant to employee benefit plans, or in connection with strategic alliances involving us and a strategic partner. In addition, each of our directors and select executive officers agreed to 90 day lock-up provisions with regard to future sales of our common stock, which expired on August 16, 2009. The common stock issued and issuable by exercise of the warrants in connection with this offering are covered by the universal shelf registration statement on Form S-3 (No. 333-151654) (2008 Universal Shelf).

Committed Equity Financing Facilities

As of September 30, 2009, we had two CEFFs that we entered into on December 12, 2008 (December 2008 CEFF) and May 22, 2008 (May 2008 CEFF) that allow us to raise capital for a period of three years ending February 6, 2011 and June 18, 2011, respectively, at the time and in amounts deemed suitable to us. A third CEFF expired on May 12, 2009. Under the December 2008 CEFF, as of September 30, 2009, we had 11.1 million shares potentially available for issuance (up to a maximum of $21.4 million), provided that the volume weighted-average price of our common stock on each trading day (VWAP) must be at least equal to the greater of (i) $.60 or (ii) 90% of the closing price of our common stock on the trading day immediately preceding the draw down period (Minimum VWAP). Under the May 2008 CEFF, as of September 30, 2009, we had approximately 13.3 million shares potentially available for issuance (up to a maximum of $52.3 million), provided that the VWAP on each trading day must be at least the greater of $1.15 or the Minimum VWAP. Use of each CEFF is subject to certain other covenants and conditions, including aggregate share and dollar limitations for each draw down. See our Annual Report on Form 10-K for the year ended December 31, 2008 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Committed Equity Financing Facility (CEFF)"). We anticipate using our CEFFs (at such times our stock price is at a level above the CEFF minimum price requirement) to support our working capital needs and maintain cash availability into 2010.

Financings pursuant to the CEFF

On January 2, 2009, we completed a financing that was initiated in 2008 under the May 2008 CEFF, resulting in gross proceeds of $0.5 million from the issuance of 478,783 shares of our common stock at an average price per share, after the applicable discount, of $1.04.

On January 16, 2009, we completed a financing under the May 2008 CEFF resulting in gross proceeds of approximately $0.4 million from the issuance of 419,065 shares of our common stock at an average price per share, after the applicable discount, of $1.04.

On February 18, 2009, we completed a financing under the May 2008 CEFF resulting in gross proceeds of approximately $1.0 million from the issuance of 857,356 shares of our common stock at an average price per share, after the applicable discount, of $1.17.

On March 31, 2009, we completed a financing under the May 2008 CEFF resulting in gross proceeds of approximately $1.1 million from the issuance of 1,015,127 shares of our common stock at an average price per share, after the applicable discount, of $1.08.

On April 8, 2009, we completed a financing under the December 2008 CEFF resulting in gross proceeds of approximately $1.0 million from the issuance of 806,457 shares of our common stock at an average price per share, after the applicable discount, of $1.24.

On May 7, 2009, we completed a financing under the December 2008 CEFF resulting in gross proceeds of approximately $1.0 million from the issuance of 1,272,917 shares of our common stock at an average price per share, after the applicable discount, of $0.79.

On September 23, 2009, we completed a financing under the December 2008 CEFF resulting in gross proceeds of approximately $1.6 million from the issuance of 1,793,258 shares of our common stock at an average price per share, after the applicable discount, of $0.88.

On October 13, 2009, we completed a financing under the May 2008 CEFF resulting in gross proceeds of approximately $0.6 million from the issuance of 558,689 shares of our common stock at an average price per share, after the applicable discount, of $1.09.

On October 13, 2009, we completed a financing under the December 2008 CEFF resulting in gross proceeds of approximately $1.8 million from the issuance of 1,908,956 shares of our common stock at an average price per share, after the applicable discount, of $0.94.

On October 21, 2009, we completed a financing under the December 2008 CEFF resulting in gross proceeds of approximately $1.9 million from the issuance of 2,100,790 shares of our common stock at an average price per share, after the applicable discount, of $0.90.

Note 7 - Fair Value of Financial Instruments

We adopted the provisions of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements.

Under ASC Topic 820, fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:

· Level 1 - Quoted prices in active markets for identical assets and liabilities. Level 1 is generally considered the most reliable measurement of fair value under ASC 820.

· Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

· Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Fair Value on a Recurring Basis

Due to their short-term maturity, the carrying amounts of cash, money markets
and accounts payable approximate their fair values. The table below categorized
assets measured at fair value on a recurring basis based upon the lowest level
of significant input (Level 1) to the valuations as of September 30, 2009.

                                              Fair Value                    Fair value measurement using
                                             September 30,          Level 1             Level 2            Level 3
Assets                                           2009
Money Markets and Certificates of Deposit   $        14,688     $        14,688       $          -       $          -
Restricted Cash                                         600                 600                  -                  -
Total                                       $        15,288     $        15,288       $          -       $          -

Note 8 - Stock Options and Stock-Based Employee Compensation

We use the Black-Scholes option-pricing model to determine the fair value of stock options and amortize the stock-based compensation expense over the requisite service periods of the stock options. The fair value of stock options is affected by our stock price and several subjective variables included the Black-Scholes option-pricing model, such as the expected stock price volatility over the term of the option, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model, which incorporates the assumptions used for the three and nine month periods noted in the following table:

                                       September 30,      September 30,
                                            2009              2008

             Expected volatility            92%               77%
             Expected term             4 and 5 years      4 and 5 years
             Risk-free interest rate   1.17% - 1.35%          3.5%
             Expected dividends               -                 -

The total employee stock-based compensation for the three and nine months ended September 30, 2009 and 2008 was as follows:

        (in thousands)               Three Months Ended          Nine Months Ended
                                        September 30,              September 30,
                                     2009           2008          2009         2008
        Research & Development     $     84       $    389     $      530     $ 1,081
        General & Administrative        344            764          1,711       2,310
                 Total             $    428       $  1,153     $    2,241     $ 3,391

As of September 30, 2009, there was $2.8 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Amended and Restated 1998 Stock Incentive Plan (1998 Plan) and the 2007 Long-Term Incentive Plan. That cost is expected to be recognized over a weighted-average vesting period of 1.5 years.

Note 9 - Contractual Obligations and Commitments

Effective August 13, 2009, Dr. Robert J. Capetola resigned his positions as our President and Chief Executive Officer and as a member of our Board of Directors (Board). The Board elected Mr. W. Thomas Amick, Chairman of the Board, to serve as Chief Executive Officer on an interim basis. We entered into a separation agreement and general release (Separation Agreement) with Dr. Capetola providing for (i) an upfront severance payment of $250,000, and (ii) periodic payments in an amount equal to his base salary (calculated at a rate of $490,000 per annum), in accordance with our payroll practices and less required withholdings. The periodic payments will end the earlier of (x) May 3, 2010 or (y) the date, if ever, that a Corporate Transaction (as defined below) occurs. In addition, Dr. Capetola will be entitled to (A) continuation of medical benefits and insurance coverage for a period of 24 or 27 months, depending upon circumstances, and (B) accelerated vesting of all outstanding restricted shares and options, which shall remain exercisable to the end of their stated terms. The Separation . . .