Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management's beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as "projects," "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," "should," "would," "could," "will," "opportunity," "potential" or "may," variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act").

Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to: our ability to continue to develop and expand our diagnostic services business, our ability to expand and maintain a successful sales and marketing organization, our ability to maintain compliance with financial and other covenants under our credit facility, limitations on our ability to borrow funds under our credit facility based on our qualified accounts receivable and other liquidity factors, our ability to obtain annual renewals of or replacements for our credit facility, the effects of a going concern audit opinion on our operations, our ability to successfully transition our billing function in-house from a third party vendor, our ability to accurately forecast bad debt expense, our ability to remediate the material weaknesses in our internal control over financial reporting, the continuation of favorable third party payor reimbursement for laboratory tests, our ability to obtain additional financing on acceptable terms or at all, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in identifying and developing new diagnostic tests or novel markers, our ability to fund development of new diagnostic tests and novel markers and the amount of resources we determine to apply to novel marker development and commercialization, failure to obtain Food and Drug Administration clearance or approval for particular applications, our ability to compete with other technologies and with emerging competitors in novel cancer diagnostics and our dependence on third parties for collaboration in developing new tests, and those factors set forth under the captions "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Risk Factors" and "Financial Statements" in this Quarterly Report on Form 10-Q and disclosures made under the captions "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Risk Factors" and "Financial Statements and Supplementary Data" included in our Annual Report on Form 10-K for the year ended December 31, 2008. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied upon as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.

Overview and Outlook

We are an advanced oncology diagnostic services company, headquartered in Aliso Viejo, California. We combine innovative technologies, clinically meaningful diagnostic tests, and world-class pathology expertise to assess and characterize cancer. Our mission is to help improve the lives of those affected by cancer through translating cancer discoveries into better patient care.

Our strategic focus is on identifying high-quality and high-value opportunities to expand and differentiate our service offerings in a highly competitive market. An important aspect of our strategy involves the development of such opportunities by combining our medical expertise and available intellectual property with our sales and marketing team, resulting in the commercialization of novel oncology diagnostic tests (also referred to as "novel markers" or "biomarkers"). Novel oncology diagnostic tests detect characteristics of an individual's tumor or disease that, once identified and characterized, allow for more accurate prognosis, diagnosis, and treatment. Our strategy also includes the identification of complementary business partners and technologies. We believe that broader discovery and use of novel diagnostic tests will clarify and simplify critical decisions for healthcare providers and the biopharmaceutical industry. The growing demand for personalized medicine has generated a need for such novel diagnostic tests, creating a market widely expected by analysts to reach $3.0 billion by 2012.

Our goal is to position our company as the recognized industry leader within the oncology diagnostic testing market, including molecular marker development and molecular marker clinical validation services. We have deployed the best available testing platforms, which are connected to our internet-based portal, PATHSiTE,™ that delivers critical diagnostic and interpretative information onto the computer screens of community pathologists, oncologists, and pharmaceutical researchers.

In 2009, we are focused on four primary areas:

† Maintain financial discipline as we move closer towards profitability;

† Leverage our commercial channel to launch new tests and maintain our revenue growth trajectory;

† Expand our commercial efforts to reach new customers, while increasing the breadth and depth of services we provide to our existing customers; and

† Invest in high-value expansion opportunities that increase stockholder value.

Our Services

Overview

We provide a wide range of oncology diagnostic testing and consultative services which include technical laboratory services and professional interpretation by licensed physicians that specialize in pathology; such reports and analyses are provided to our customers through our internet-based portal, PATHSiTE.™

Our anatomic pathology services are focused on the most common types of solid tumors: breast, prostate, lung, and colon, representing over 80% of annual diagnosed cases in the United States. We also offer an extensive menu of hematopathology testing for leukemia and lymphoma. Our laboratory continues to expand its service offerings as new assays emerge. We also provide a complete complement of commercial services to biopharmaceutical companies and other research organizations, ranging from diagnostic testing services to the development of directed diagnostics through clinical trials.

New Tests Launched in 2009

During the second quarter of 2009, we launched the Clarient Insight® Dx Breast Cancer Profile ("Clarient Insight® Dx"), a prognostic test which has been clinically validated for women with early-stage, hormone-receptor-positive breast cancer. Clarient Insight® Dx uses a combination of pathology risk factors and molecular markers to categorize patients as either high or low risk for recurrence of breast cancer, utilizing a non-linear mathematical algorithm incorporating clinical and key pathologic variables into a continuous risk score. The main prognostic factors associated with breast cancer are the number of lymph nodes involved, tumor size, histological grade, and hormone receptor status, though some patients have a recurrence despite having a tumor with good prognostic features. Breast cancer has multiple clinical presentations, and the therapy for it should be chosen according to the patient's tumor characteristics, previous treatment, and performance status with the goal of improving survival without compromising their quality of life, and to this end, Clarient Insight® Dx provides physicians with meaningful data to treat their patients.

We also launched a new gene mutation test ("EGFR Mutation Test") during the second quarter of 2009 that can help physicians select the proper therapy for patients with non-small cell lung cancer ("NSCLC"). There are a number of drugs used for the treatment of NSCLC. We expect that our EGFR Mutation Test will provide pathologists and oncologists with the necessary data to best treat their patients, ensuring that unnecessary toxicities and treatment delays are avoided, and result in the reduction of the overall cost of therapy.

Test Methodologies

Our extensive menu of over 350 diagnostic tests used to assess and characterize cancer includes various methodologies which incorporate the latest laboratory technologies: immunohistochemistry ("IHC"), flow cytometry, molecular/PCR, fluorescent in situ hybridization ("FISH"), cytogenetics, and histology, which are described below:

IHC refers to the process of localizing proteins in cells of a tissue section and relies on the principle of antibodies binding specifically to antigens in biological tissues. IHC is widely used in the diagnosis of abnormal cells such as those found in cancerous tumors. Specific molecular markers are characteristic of particular cellular events such as proliferation or cell death (apoptosis). IHC is also used to understand the distribution and localization of biomarkers and differentially expressed proteins in various parts of biological tissue.

Flow cytometry is a technology that measures and analyzes multiple physical characteristics of single particles, usually cells, as they flow in a fluid stream through a beam of light. The properties measured include a particle's relative size, relative granularity or internal complexity, and relative fluorescence intensity. The use of flow cytometry assists a pathologist in diagnosing a wide variety of leukemia and lymphoma neoplasms. Flow cytometry is also used to monitor patients through therapy to determine whether the disease burden is increasing or decreasing, otherwise known as minimal residual disease monitoring.

Molecular/PCR is a molecular biological technique that involves the development of oligonucleotide probes for specific gene sequences and amplification of these sequences though repeated cycles of the polymerase-catalyzed reaction. The technique is extremely sensitive and rapid, and offers direct detection and visualization of gene sequences.

FISH is a molecular technique that can be used to detect and localize the presence or absence of specific DNA sequences on chromosomes. The technique uses fluorescent probes that bind to only those parts of the chromosome with which they show a high degree of sequence similarity. Fluorescence microscopy can be used to find out where the fluorescent probe binds to the chromosomes. FISH is often used for finding specific features in DNA for use in genetic counseling, medicine, and species identification. FISH can be used to help identify a number of gene alternations, such as amplification, deletions, and translocations.

Histology is the study of the microscopic structure of tissues. Through histology services, a pathologist attempts to identify the diagnosis of disease. Through structural and other changes in cells, tissues, and organs, pathologists can use a number of tools to establish a diagnosis of the type of disease suffered by the patient, a prognosis on the likely progression of the disease, and a determination as to which therapies are most likely to be effective in treating the patient. In addition to histology service, a number of molecular studies can now be run on these samples to gain further insight on prognostic and predictive indicators.

Cytogenetics involves genetic testing in hereditary cancer to assess a variety of genetic disorders and hematologic malignancies.

Employees

As of September 30, 2009, we, inclusive of Clarient Pathology Services, Inc. (defined in Note 1 to the Condensed Consolidated Financial Statements), had 340 employees: 187 in laboratory diagnostics, research and development, and support positions; 93 in executive, finance, information technology, billing, and administrative positions; and 60 in sales and marketing positions. We are not subject to any collective bargaining agreements, and we believe that our relationship with our employees is good. In addition to full-time employees, we utilize the services of various independent contractors, primarily for certain product development, marketing, and administrative activities.

Billing

Our net revenue is predominately derived from performing oncology diagnostic testing services which are billed to third parties (Medicare and private health insurers), clients (pathologists, hospitals, clinics), and patients.

Third-party billing

The majority of our net revenue is generated from patients who utilize health insurance coverage through Medicare or private health insurers.

Medicare reimbursement is dictated by Common Procedural Terminology ("CPT") billing codes under two distinct reimbursement schedules: a Physician Fee Schedule and a Clinical Fee Schedule. We have the requisite Medicare provider numbers for both schedules.

The relevant CPT billing codes under the Physician Fee Schedule distinguish between "Technical" diagnostic services (the performance of a diagnostic test), "Professional" services (the professional interpretation of a diagnostic test, typically performed by a licensed physician), and "Global" services (the combination of Technical and Professional services). The relevant CPT billing codes under the Clinical Fee Schedule are generally for Technical services. We perform Technical, Professional, and Global services under the Physician Fee Schedule, and Technical services under the Clinical Fee Schedule.

The amount that we are able to be reimbursed from private health insurers is based on several factors, including: the type of insurance coverage (for example, health maintenance organization or preferred provider organization), whether the services are considered to be in network or out of network by the health insurance provider, and the amount of any co-pays or deductibles for which the patient is responsible.

Client billing

We generally establish arrangements with our clients that allow us to bill them an agreed-upon amount for each type of service provided. It is generally our clients' responsibility to seek reimbursement from their patients' health insurance companies and/or the patients themselves.

Patient billing

We bill patients with health insurance co-payment obligations and deductibles (indirect billings), and billings to patients without health insurance coverage (direct billings).

Medicare Reimbursement Rates

Our laboratory diagnostic services are eligible for third-party reimbursement under well-established medical billing codes. These billing codes are known as Healthcare Common Procedure Coding Systems and incorporate CPT codes, providing the means by which Medicare/Medicaid and private health insurers identify certain medical services that are eligible for reimbursement. The Medicare/Medicaid reimbursement amounts are based on the relative value of medical services with associated CPT codes, as established by the Centers for Medicare & Medicaid Services ("CMS") with recommendations from the American Medical Association's Relative Value Update Committee.

The following summarizes the Medicare reimbursement rates under the Physician Fee Schedule for the most common CPT codes used in our laboratory services ("TC" modifier denotes Technical services, "26" modifier denotes Professional services, and no modifier denotes Global services). The below CPT codes were associated with a substantial portion of our revenue for the nine months ended September 30, 2008 and 2009.

                                                                                                 2009
                                                                                                Change
                  General Description of             2009                     2008               From
CPT Code                 Service              (1/1/09 - 12/31/09)      (1/1/08 - 12/31/08)       2008
88185            Flow cytometry (cell
                 surface, cytoplasmic, or
                 nuclear marker)             $                  59    $                  52         13.5 %
88342 - TC       IHC (including tissue
                 immunoperoxidase)           $                  72    $                  69          4.3 %
88342 - 26       IHC (including tissue
                 immunoperoxidase)           $                  44    $                  44            -
88342            IHC (including tissue
                 immunoperoxidase)           $                 116    $                 113          2.7 %
88361 - TC       IHC (computer assisted)     $                 116    $                 123         (5.7 )%
88361 - 26       IHC (computer assisted)     $                  62    $                  62            -
88361            IHC (computer assisted)     $                 178    $                 186         (4.3 )%
88368 - TC       FISH (manual)               $                 182    $                 158         15.2 %
88368 - 26       FISH (manual)               $                  70    $                  71         (1.4 )%
88368            FISH (manual)               $                 251    $                 229          9.6 %
88367 - TC       FISH (computer assisted)    $                 222    $                 204          8.8 %
88367 - 26       FISH (computer assisted)    $                  66    $                  65          1.5 %
88367            FISH (computer assisted)    $                 288    $                 269          7.1 %
83891            PCR - Isolation or
                 extraction of highly
                 purified NA                 $                   6    $                   6            -
83896            PCR- NA probe               $                   6    $                   6            -
83898            PCR - Amp of patient NA,
                 each NA sequence            $                  24    $                  23          4.4 %
83907            PCR - Lysis of cells
                 prior to NA extraction
                 (FFPE Only)                 $                  20    $                  19          5.3 %
83914            PCR - Mutation
                 identification              $                  24    $                  23          4.4 %
83912 - 26       PCR - Interpretation and
                 report                      $                  19    $                  19            -
88381 - 26       PCR - Microdissection,
                 manual                      $                 257    $                 257            -

We work with relevant medical societies and other constituents to encourage appropriate reimbursement levels from Medicare and other payors (which may base their reimbursement amount on Medicare rates) that fairly reflect the costs of developing specialized laboratory diagnostic services and the related benefits. The type of services that we perform are widely recognized for providing net healthcare savings as physicians are empowered with diagnostic and interpretive information to more responsively treat their patients.

Characteristics of Our Net Revenue and Expenses

Net revenue

Net revenue is derived from billing governmental and private health insurers, clients, and patients for the services that we provide. We report revenue net of "contractual allowances" which is defined and discussed within the "Critical Accounting Policies and Estimates" section below. Bad debt expense is recorded as an operating expense, and is a key component of our overall operating performance.

Cost of services

Cost of services includes compensation (including stock-based compensation) and benefits of laboratory personnel, laboratory support personnel, and pathology personnel. Cost of services also includes depreciation expense of laboratory equipment, laboratory supplies expense, allocated facilities-related expenses, and certain direct costs such as shipping. See Note 14 to the Condensed Consolidated Financial Statements for a discussion of certain prior year adjustments of expense classifications between cost of services and operating expenses.

Sales and marketing

Sales and marketing expenses primarily consist of the compensation and benefits of our sales force and sales support, and marketing personnel. It also includes costs attributable to marketing our services to community pathology practices, hospitals, and clinics.

General and administrative

General and administrative expenses primarily include compensation (including stock-based compensation) and benefits for personnel that support our general operations such as: information technology, executive management, billing and collection, client services, financial accounting, purchasing, and human resources. General and administrative expenses also include allocated facilities-related expenses, insurance, recruiting, legal, audit, and other professional services.

Bad debt

Bad debt consists of estimated uncollectible accounts, or portions thereof, recorded during the period. The process of evaluating the required allowance for doubtful account, and resulting bad debt expense, at each period end involves an evaluation of historical collection experience to aged receivable balances by payor class, and also involves our significant assumptions and judgment for those receivables we consider unlikely to be collected.

Research and development

Research and development expenses consist of compensation and benefits for research and development personnel, certain laboratory supplies, certain information technology personnel, research and development consultants, and allocated facility-related costs. Our research and development activities primarily relate to the development and validation of diagnostic tests in connection with our specialized oncology diagnostic services, as well as the development of technology to electronically deliver such services to our customers.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenue and expenses for the periods presented.

Management believes that the following estimates are the most critical to understand and evaluate our reported financial results, which require management's most difficult, subjective, or complex judgments, resulting from the need to make estimates that are inherently uncertain.

Revenue recognition

Net revenue for our diagnostic services is recognized at the time of completion of discreet diagnostic tests which comprise a patient encounter at a specific date of service (commonly referred to as an "accession"). Our services are billed to various payors, including Medicare, private health insurance companies, healthcare institutions, and patients. We utilize published fee schedules from CMS for recognized revenue for amounts billed to Medicare for our services. We report revenue for our services from contracted payors, including certain private health insurance companies and healthcare institutions, based on the contracted rate (which is generally based on the CMS published fee schedule) or in certain instances, our estimate of such rate.

The difference between the amount billed and the amount recognized as revenue is the result of standard discounts (commonly referred to as "contractual allowances"). We report net revenue from non-contracted payors, including certain private health insurance companies, based on the amount expected to be approved for payment for our services. Subsequent revenue adjustments for non-contracted payors are recognized in the period realized. Patient revenue is divided into two classes: direct bill and indirect bill. The amount recognized as net revenue for direct bill patients is based on a standard multiple of the CMS published fee schedule. The amount recognized as net revenue for indirect bill patients is based on their co-pay or deductible obligation with their primary insurance payor.

Allowance for doubtful accounts and bad debt expense

An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from our various payor groups. The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments. Specifically, the allowance for doubtful accounts is adjusted periodically, and is principally based upon an evaluation of historical collection experience of accounts receivable by age for our various payor classes. After appropriate collection efforts, accounts receivable are written off and deducted from the allowance for doubtful accounts. Additions to the allowance for doubtful accounts are charged to bad debt expense. The payment realization cycle for certain governmental and managed care payors can be lengthy, involving denial, appeal, and adjudication processes, and is subject to periodic adjustments that may be significant.

During the third quarter of 2009, we refined our model for estimating an appropriate allowance for doubtful accounts at period end, utilizing historical payment information by payor class and receivable age, which was not previously available to us in sufficient form and content. Nonetheless, due to a combination of objective and subjective factors in our previous model for estimating an appropriate allowance for doubtful accounts, our reported net accounts receivable of $24.6 million as of September 30, 2009 would not have been materially different had the previous model been applied in the third quarter of 2009.

Stock-based compensation

We record compensation expense related to stock-based awards, including stock options and restricted stock, based on the fair value of the award using the Black-Scholes option-pricing model. Stock-based compensation expense recognized during the period is based on the value of the portion of the stock-based awards . . .