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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

OR

[ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER 1-10113

-----------------

HALSEY DRUG CO., INC.
(Exact name of registrant as specified in its charter)

NEW YORK 11-0853640
(State or other Jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

695 N. PERRYVILLE ROAD, CRIMSON BUILDING NO. 2, UNIT 4
ROCKFORD, ILLINOIS 61107
(Address of Principal Executive Offices) (Zip Code)

(815) 399-2060
(Registrant's telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last
report.)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes [X] No [ ]

As of November 16, 2003 the registrant had 21,601,704 shares of Common
Stock, $.01 par value, outstanding.

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HALSEY DRUG CO., INC. & SUBSIDIARIES

INDEX



PAGE
----

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements
Condensed Consolidated Balance Sheets-
September 30, 2003 (Unaudited) and December 31, 2002 ................................... 3

Condensed Consolidated Statements of
Operations (Unaudited) - Nine and three months ended September 30, 2003
and September 30, 2002 ................................................................. 5

Condensed Consolidated Statements of Cash
Flows (Unaudited) - Nine months ended September 30, 2003
and September 30, 2002 ................................................................. 6

Consolidated Statement of Stockholders'
Deficit (Unaudited) - Nine months ended September 30, 2003 ............................. 8

Notes to Condensed Consolidated Financial Statements ................................... 9

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .................................................... 17

Item 4. Controls and Procedures................................................................. 24

PART II. OTHER INFORMATION

Item 2. Changes in Securities................................................................... 24
Item 6. Exhibits and Reports on Form 8-K........................................................ 25

SIGNATURES ........................................................................................ 26

CERTIFICATIONS ........................................................................................ 28


2



PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS



(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(IN THOUSANDS)

ASSETS
CURRENT ASSETS
Cash ............................................................................. $ 889 $ 9,211
Accounts Receivable - trade, net of
allowances for doubtful accounts of $16 and $14
at September 30, 2003 and December 31, 2002, respectively ..................... 553 610
Inventories ...................................................................... 2,638 2,285
Prepaid expenses and other current assets ........................................ 758 394
------- -------

Total current assets ........................................................ 4,838 12,500

PROPERTY, PLANT & EQUIPMENT, NET .................................................... 6,167 5,367

DEFERRED PRIVATE OFFERING COSTS,
net of accumulated amortization of $606 and $9
at September 30, 2003 and December 31, 2002, respectively .................... 1,015 1,032

OTHER ASSETS AND DEPOSITS ........................................................... 366 465
------- -------

$12,386 $19,364
======= =======


The accompanying notes are an integral part of these statements.

3



HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS



(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------ ------------
(IN THOUSANDS, EXCEPT SHARE DATA)

LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
TERM NOTE PAYABLE............................................. $ 21,401 $ --
CONVERTIBLE SUBORDINATED DEBENTURES........................... 84,439 --
Less: debt discount......................................... (61,703) --
------------ -------------
22,736 --

Current maturities of notes payable and capital lease
obligations.............................................. 50 33
Accounts payable........................................... 2,753 3,119
Accrued expenses........................................... 3,929 3,115
Department of Justice Settlement........................... 300 300
------------ ------------

Total current liabilities............................... 51,169 6,567

TERM NOTE PAYABLE............................................. -- 21,401

CONVERTIBLE SUBORDINATED DEBENTURES........................... -- 77,118
Less: debt discount......................................... -- (73,955)
------------ ------------
3,163

CAPITAL LEASE OBLIGATIONS..................................... 101 40

DEPARTMENT OF JUSTICE SETTLEMENT.............................. 216 461

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' DEFICIT
Common stock - $.01 par value; authorized 80,000,000
shares; issued and outstanding, 21,224,398 shares
and 21,035,323 shares at September 30, 2003 and
December 31, 2002, respectively......................... 212 211
Additional paid-in capital................................. 154,970 148,611
Accumulated deficit........................................ (194,282) (161,090)
------------ ------------

(39,100) (12,268)
------------ ------------
$ 12,386 $ 19,364
============ ============


The accompanying notes are an integral part of these statements.

4



HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)



SEPTEMBER 30,
-------------
FOR THE NINE MONTHS ENDED FOR THE THREE MONTHS ENDED
------------------------------- -------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------

Net product revenues $ 4,210 $ 6,152 $ 1,478 $ 2,013

Cost of manufacturing 7,405 9,372 2,267 3,118
Research and development 955 1,161 339 404
Selling, general and administrative expenses 6,114 5,472 2,197 1,957
Plant shutdown costs -- (120) -- --
------------ ------------ ------------ ------------

Loss from operations (10,264) (9,733) (3,325) (3,466)

Other income (expense)
Interest expense (4,436) (3,408) (1,532) (1,235)
Interest income 22 10 1 3
Amortization of deferred debt discount and
private offering costs (18,050) (7,562) (6,367) (3,187)
Other (464) 5 (367) 16
------------ ------------ ------------ ------------

NET LOSS $ (33,192) $ (20,688) $ (11,590) $ (7,869)
============ ============ ============ ============

Basic and diluted loss per share $ (1.57) $ (1.37) $ (0.55) $ (0.52)
============ ============ ============ ============

Weighted average number of outstanding shares 21,196,131 15,065,240 21,222,993 15,065,240
============ ============ ============ ============


The accompanying notes are an integral part of these statements.

5



HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



NINE MONTHS ENDED
SEPTEMBER 30
------------
2003 2002
-------- --------
(IN THOUSANDS, EXCEPT SHARE DATA)

Cash flows from operating activities

Net loss ............................................................................ $(33,192) $(20,688)
-------- --------

Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization .................................................... 607 641
Amortization of deferred debt discount and private
offering costs ................................................................... 18,050 7,562
Amortization of deferred product acquisition costs ............................... 33 27
Debentures for interest ......................................................... 2,331 1,633
Loss on disposal of assets ....................................................... 10 12
Increase in fair value of warrants ............................................... 457 --
Changes in assets and liabilities
Accounts receivable ........................................................... (1,521) (1,739)
Inventories ................................................................... (353) 304
Prepaid expenses and other current assets ..................................... (364) (453)
Other assets and deposits ..................................................... 66 140
Accounts payable .............................................................. (18) 531
Accrued expenses .............................................................. 2,056 2,080
-------- --------

Total adjustments ............................................................ 21,354 10,738
-------- --------

Net cash used in operating activities ........................................... (11,838) (9,950)
-------- --------

Cash flows from investing activities

Capital expenditures ............................................................. (1,306) (267)
Net proceeds from sale of assets ................................................. -- 16
-------- --------

Net cash used in investing activities ......................................... (1,306) (251)
-------- --------

Cash flows from financing activities

Proceeds from issuance of debentures ............................................. 5,100 --
Proceeds from issuance of notes payable .......................................... -- 10,000
Payments to Department of Justice ................................................ (245) (233)
Payments on notes payable and capital lease obligations .......................... (33) --
-------- --------

Net cash provided by financing activities ................................... 4,822 9,767
-------- --------

NET DECREASE IN CASH ............................................................. (8,322) (434)


6





Cash at beginning of period ......................................................... 9,211 442
-------- --------

Cash at end of period ............................................................... $ 889 $ 8
======== ========

Cash paid for interest .............................................................. $ 405 $ 32
======== ========


Supplemental disclosures of noncash investing and financing activities for the
nine months ended September 30, 2003:

1. The Company has repaid $1,578 of indebtedness in the form of product
deliveries.

2. The Company issued 645,000 warrants with an estimated relative fair
value of $581 for the lending commitment in the form of debentures.

3. The Company issued 189,075 shares of common stock upon the conversion
of $110 of Debentures.

4. Equipment financed through capital leases aggregated approximately
$111.

5. The Company issued 150,000 warrants with an estimated relative fair
value of $112 in connection with the termination of an employment
agreement.

The accompanying notes are an integral part of these statements.

7



HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)

NINE MONTHS ENDED SEPTEMBER 30, 2003

(IN THOUSANDS, EXCEPT SHARE DATA)

(UNAUDITED)



COMMON STOCK
$.01 PAR VALUE ADDITIONAL
-------------- PAID-IN ACCUMULATED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
---------- -------- ---------- ----------- ----------

Balance January 1, 2003............... 21,035,323 $ 211 $ 148,611 $ (161,090) $ (12,268)

Net loss for the nine
months ended September 30, 2003.... (33,192) (33,192)

Conversion of debentures.............. 189,075 1 109 110

Increase in fair value of warrants.... 457 457

Issuance of warrants for commitment... 581 581

Issuance of warrants in connection
with the termination of an
employment agreement.................. 112 112

Intrinsic value of beneficial
conversion features in connection
with the issuance of subordinated
debentures............................ 5,100 5,100
---------- -------- --------- ---------- ----------

Balance at September 30, 2003......... 21,224,398 $ 212 $ 154,970 $ (194,282) $ (39,100)
========== ======== ========= ========== ==========


The accompanying notes are an integral part of this statement.

8


HALSEY DRUG CO., INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 1 - BASIS OF PRESENTATION AND LIQUIDITY MATTERS

The accompanying unaudited condensed consolidated financial statements
of Halsey Drug Co., Inc. and subsidiaries (the "Company") have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Rule 10-01 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles in the United States for
complete financial statements. In the opinion of management, all adjustments,
consisting of normal recurring accrual adjustments, considered necessary to
present fairly the financial position, results of operations and changes in cash
flows for the three and nine months ended September 30, 2003, assuming the
Company will continue as a going concern, have been made. The results of
operations for the three and nine month periods ended September 30, 2003 are not
necessarily indicative of the results that may be expected for the full year
ended December 31, 2003. The unaudited condensed consolidated financial
statements should be read in conjunction with the consolidated financial
statements and footnotes thereto for the year ended December 31, 2002 included
in the Company's Annual Report on Form 10-K filed with the Securities and
Exchange Commission.

At September 30, 2003 the Company had cash and cash equivalents of
$889,000 as compared to $9,211,000 at December 31, 2002. The Company had a
working capital deficit at September 30, 2003 of $46,331,000, after the
reclassification of outstanding indebtedness to current as such debt is in
default, and an accumulated deficit of $194,282,000. The Company incurred a net
loss of $33,192,000 during the nine months ended September 30, 2003.

On December 20, 2002, the Company consummated a private offering of
securities for an approximate aggregate purchase price of $26,394,000 (the "2002
Debenture Offering"). The securities issued in the Offering consisted of 5%
convertible senior secured debentures (the "2002 Debentures"). Of the
$26,394,000 in 2002 Debentures issued in the 2002 Debenture Offering,
approximately $15,894,000 of the 2002 Debentures were issued in exchange for the
surrender of a like amount of principal and accrued interest outstanding under
Company's 10% convertible promissory notes issued pursuant to various working
capital bridge loan transactions with Galen Partners III, L.P., Galen
International III, L.P., Galen Employee Fund III, L.P. (collectively, "Galen")
and certain other lenders, during the period from August 15, 2001 through and
including December 20, 2002. The 2002 Debentures, issued at par, will become due
and payable as to principal on March 31, 2006. Interest on the principal amount
of the 2002 Debentures, at the rate of 5% per annum, is payable on a quarterly
basis. Interest on the 2002 Debentures will be substantially paid by the
Company's issuance of a debenture instrument substantial by identical to the
2002 Debentures issued in the 2002 Debenture Offering, in the principal amount
equal to the accrued interest for each quarterly period. The 2002 Debentures
were issued pursuant to a certain Debenture Purchase Agreement dated December
20, 2002 (the "2002 Debenture Purchase Agreement") by and among the Company,
Care Capital Investments II, LP ("Care Capital"), Essex Woodlands Health
Ventures V, L.P. ("Essex"), Galen and each of the purchasers listed on the
signature page thereto.

In connection with various strategic alliance transactions with Watson,
$17,500,000 was advanced to the Company under a term loan (the "Watson Term
Loan"). The Watson Term Loan is secured by a first lien on all of the Company's
assets, senior to the lien securing all other Company indebtedness, and carried
a floating rate of interest equal to prime plus two percent and had an original
maturity date of March 31, 2003. As part of the Company's 2002 Debenture
Offering, the Watson Term Loan was amended to (1) extend the maturity date to
March 31, 2006, (2) increase the interest rate to prime plus four and one half
percent and (3) increase the principal amount to $21,401,331 to reflect the
inclusion of approximately $3.9 million owed by the Company to Watson under the
Core Products Supply Agreement between the parties. The interest rate at
September 30, 2003 and December 31, 2002 was 8.25% and 8.75%, respectively. In
consideration of the amendment to the Watson Term Loan, the Company issued to
Watson a common stock purchase warrant ("Watson Warrant") exercisable for
10,700,665 shares of the Company's common stock at an exercise price of $.34 per
share. The warrant has a term expiring December 31, 2009. The fair value of the
Watson Warrant on the date of grant of $11,985,745, as calculated using the
Black-Scholes option-pricing model, was charged to earnings on the date of

9



grant as a loss on the extinguishment of debt. As of September 30, 2003, Watson
had advanced to the Company $21,401,331 under the Watson Term Loan, representing
the entire amount available under such loan facility.

As of November 13, 2003 the Company was in default under the Watson
Term Loan for failure to pay the interest payment due October 1, 2003. Such
default permits Watson to accelerate the indebtedness under the Watson Term Loan
and to enforce its rights against the Company's assets, which secure the loan.
The Company's default under the Watson Term Loan also results in a default under
the terms of the Company's outstanding 1998 Debentures, 1999 Debentures and 2002
Debentures. Such indebtedness has been classified as current liabilities in the
accompanying consolidated balance sheet at September 30, 2003. The Company is in
active discussions with Watson to restructure the Watson Term Loan and/or
satisfy its obligations thereunder. The exercise by Watson or the holders of the
Company's outstanding Debentures of their respective rights and remedies under
the Watson Term Loan and the Debentures Purchase Agreements would have a
material adverse effect on the Company's financial condition and results of
operations and could require the Company to seek relief under applicable
bankruptcy laws.

The development and commercialization of active pharmaceutical
ingredients ("APIs") and finished dosage products incorporating the Company's
opiate synthesis and finished dosage formulation technologies are subject to
various factors, many of which are outside the Company's control. Specifically,
only a limited portion of such technologies have been tested in laboratory
settings, none have been tested in clinical settings, and all of such
technologies will need to be successfully scaled up to commercial scale to be
commercially viable, of which no assurance can be given. Additionally, the
Company must satisfy, and continue to maintain compliance with, the DEA's and
FDA's requirements for the maintenance of its controlled substances
manufacturing registrations (the "Manufacturing Registration") and the issuance
and maintenance of the DEA raw material import registration (the "Import
Registration"). The process of seeking the Import Registration and contesting
opposition proceedings, as well as the continuing development of the Company's
opiate synthesis and finished dosage formulation technologies, are intended to
continue through 2004. The Company is currently unable to provide any assurance
that such technologies can be scaled up to commercial scale or that they will be
commercially viable. Moreover, no assurance can be given that the Company will
succeed in obtaining the Import Registration. The Company is committing the
majority of its resources, and available capital to the development of the
opiate synthesis and finished dosage formulation technologies and to the receipt
of the Import Registration. The failure of the Company to successfully develop
the opiate synthesis and finished dosage formulation technologies, or to obtain
the Import Registration will have a material adverse effect on the Company's
operations and financial condition. The Company's cash flow and limited sources
of available financing make it uncertain that the Company will have sufficient
capital to continue to fund operations or to otherwise complete the development
of the opiate synthesis and finished dosage formulation technologies, to obtain
required DEA and FDA approvals and to fund the capital improvements necessary
for the manufacture of APIs and finished dosage products incorporating such
technologies.

As of November 13, 2003, Care Capital, Essex Woodlands and Galen
Partners (collectively, the "Majority 2002 Debentureholders") had collectively
advanced an aggregate of $6,600,000 to the Company pursuant to a Letter of
Support issued by the Majority 2002 Debentureholders dated May 5, 2003 in order
to fund the Company's operating losses and capital requirements (the "Letter of
Support Advances"). The Letter of Support Advances were made in accordance with
the terms of 2002 Debenture Purchase Agreement resulting in the Company's
issuance of 2002 Debentures in an aggregate principal amount of $6,600,000
having a maturity date of March 31, 2006 After giving effect to the Letter of
Support Advances made through November 13, 2003, there remains $2,000,000
potentially available for advance to the Company by the Majority 2002
Debentureholders under the Letter of Support. No assurance can be given,
however, that all or any portion of the $2 million balance provided for in the
Letter of Support will be advanced to the Company by the Majority 2002
Debentureholders.

The Company believes that, assuming the remaining funding provided
under the Letter of Support is advanced to the Company, of which no assurance
can be given, such amount, combined with cash flow from operations, will be
sufficient to satisfy the Company's working capital requirements only through
January 1, 2004. In the event no further advances are made to the Company by the
Majority 2002 Debentureholders under the Letter of Support, the Company's
current cash position combined with cash flow from operations will be sufficient
to fund operations only through December 1, 2003. Except for the potential
receipt of the $2,000,000 available under the Letter of Support, the Company has
no other available sources of financing to fund continued operating losses and
working capital requirements.

10


Subsequent to September 30, 2003, the Company initiated a restructuring of its
operations which includes the closure or divestment of its operation in Congers,
New York, the discontinuance of the manufacture and sale of finished dosage
generic products and substantially reducing activities at its active ingredient
facility in Culver, Indiana. The Company estimates that the restructuring will
be completed over the next 50 to 80 days and result in a workforce reduction of
approximately 100 employees, leaving approximately 16 employees to be engaged in
the Company's research and development activities relating to opiate APIs and
finished dosage products incorporating the Company's opiate synthesis and
finished dosage formulation technologies. The Company is not able to estimate
the amount of any impairment charges related to its restructuring plan including
but not limited to, its Fixed Assets, inventory, or other associated costs.

Although the Company is currently in active discussions with the
Majority 2002 Debentureholders to obtain additional financing to fund the
restructuring of its operations and to fund the Company's operations during
2004, no assurance can be given that such funding will be provided, or that
there is available to the Company other sources of financing in the absence of
funding by the Majority 2002 Debentureholders. In the absence of continued
funding by the Majority 2002 Debentureholders or an alternative third-party
investment, the Company will be required to further scale back or terminate
operations, and/or seek protection under applicable bankruptcy laws.

Even assuming the Company is successful in securing additional sources
of financing to fund the Company's operations, there can be assurance that the
Company's development efforts relating to its API opiate synthesis or finished
dosage formulation technologies will result in commercial scale technologies, or
that if such technologies are capable of being scaled up, that they will result
in commercially viable products. The Company is also unable to provide any
assurance that it will succeed in its application to the DEA for the Import
Registration. The Company's failure to scale up and commercialize its API opiate
synthesis and finished dosage formulation technologies or to obtain the Import
Registration will have a material adverse impact on the Company's financial
condition and results of operations.

NOTE 2 - STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation using the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related Interpretations ("APB
No. 25") and has adopted the disclosure provisions of Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based Compensation --
Transition and Disclosure, an amendment of FASB Statement No. 123." Under APB
No. 25, when the exercise price of the Company's employee stock options equals
the market price of the underlying stock on the date of grant, no compensation
expense is recognized. Accordingly, no compensation expense has been recognized
in the consolidated financial statements in connection with employee stock
option grants.

The following table illustrates the effect on net income and earnings per share
had the Company applied the fair value recognition provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," to stock-based employee compensation.



FOR THE NINE MONTHS ENDED FOR THE THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
IN THOUSANDS, EXCEPT PER SHARE DATA

Net loss, as reported $ (33,192) $ (20,688) $ (11,590) $ (7,869)
Deduct: Total stock-based employee compensation
expense determined under the fair value-based
method for all awards (554) (772) (172) (258)
------------ ------------ ------------ ------------

Pro forma net loss $ (33,746) $ (21,460) $ (11,762) $ (8,127)
============ ============ ============ ============
Loss per share:
Basic and diluted - as reported $ (1.57) $ (1.37) $ (.55) $ (.52)
============ ============ ============ ============
Basic and diluted - pro forma $ (1.59) $ (1.42) $ (.55) $ (.54)
============ ============ ============ ============


Pro forma compensation expense may not be indicative of future
disclosures because it does not take into effect pro forma compensation expense
related to grants before 1995. For purposes of estimating the fair value of each
option on the date of grant, the Company utilized the Black-Scholes
option-pricing model.

11



The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.

NOTE 3 - EARNINGS (LOSS) PER SHARE

The computation of basic earnings (loss) per share of common stock is
based upon the weighted average number of common shares outstanding during the
period. Diluted earnings per share is based on basic earnings per share adjusted
for the effect of other potentially dilutive securities. Excluded from the 2003
and 2002 computations are approximately 239,305,000 and 63,582,000,
respectively, of outstanding warrants, options and the effect of convertible
debentures and convertible bridge loans outstanding, as such inclusion which
would be antidilutive

NOTE 4 - NEW ACCOUNTING PRONOUNCEMENTS

In November 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" ("FIN No. 45"). FIN No. 45
requires that upon issuance of a guarantee, a guarantor must recognize a
liability for the fair value of an obligation assumed under a guarantee. FIN No.
45 also requires additional disclosures by a guarantor in its interim and annual
financial statements about the obligations associated with guarantees issued.
The recognition provisions of FIN No. 45 are effective for any guarantees issued
or modified after December 31, 2002. The disclosure requirements are effective
for financial statements of interim or annual periods ending after December 15,
2002. The adoption of FIN No. 45 did not have a material impact on the Company's
financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation -- Transition and Disclosure, an amendment of FASB
Statement No. 123." SFAS No. 148 amends SFAS No. 123, "Accounting for
Stock-Based Compensation," ("SFAS No. 148") to provide alternative methods of
transition for an entity that voluntarily changes to the fair value-based method
of accounting for stock-based employee compensation. It also amends the
disclosure provisions of that Statement to require prominent disclosure about
the effects on reported net income of an entity's accounting policy decisions
with respect to stock-based employee compensation. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in APB Opinion No. 25 and related interpretations as provided
for under SFAS No. 148. Accordingly, compensation expense is only recognized
when the market value of the Company's stock at the date of the grant exceeds
the amount an employee must pay to acquire the stock. The adoption of SFAS No.
148 did not have a material impact on the Company's financial position or
results of operations.

In January 2003, the FASB issued FASB Interpretation No. 46
"Consolidation of Variable Interest Entities" ("FIN No. 46") In general, a
variable interest entity is a corporation, partnership, trust, or any other
legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. A
variable interest entity often holds financial assets, including loans or
receivables, real estate or other property. A variable interest entity may be
essentially passive or it may engage in activities on behalf of another company.
Until now, a company generally has included another entity in its consolidated
financial statements only if it controlled the entity through voting interests.
FIN No. 46 changes that by requiring a variable interest entity to be
consolidated by a company if that company is subject to a majority of the risk
of loss from the variable interest entity's activities or entitled to receive a
majority of the entity's residual returns or both. FIN No. 46's consolidation
requirements apply immediately to variable interest entities created or acquired
after January 31, 2003. The consolidation requirements apply to older entities
in the first fiscal year or interim period ending after December 15, 2003.
Certain of the disclosure requirements apply to all financial statements issued
after January 31, 2003,

12



regardless of when the variable interest entity was established. The Company has
adopted FIN No. 46 effective January 31, 2003. The adoption of FIN No. 46 did
not have a material impact on the Company's financial position or results of
operations.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," ("SFAS No. 149"), which
amends and clarifies financial accounting and reporting for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities under SFAS No. 133. SFAS No. 149 is
effective for contracts entered into or modified after June 30, 2003 except for
the provisions that were cleared by the FASB in prior pronouncements. The
adoption of SFAS No. 149 did not have a material impact on the Company's
financial position or results of operations.

In May 2003, the FASB issued "SFAS No. 150", "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"). This statement establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. In accordance
with the standard, financial instruments that embody obligations for the issuer
are required to be classified as liabilities. This Statement shall be effective
for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of SFAS No. 150 did not have a material impact
on the Company's financial position or results of operations.

NOTE 5 - STRATEGIC ALLIANCE WITH WATSON PHARMACEUTICALS

On March 29, 2000, the Company completed various strategic alliance
transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions
provided for Watson's purchase of a certain pending abbreviated new drug
application ("ANDA") from the Company for $13,500,000, for Watson's rights to
negotiate for Halsey to manufacture and supply certain identified future
products to be developed by Halsey, for Watson's marketing and sale of the
Company's core products and for Watson's extension of a $17,500,000 term loan to
the Company (See Note 8).

As part of the strategic alliance transactions, the Company and Watson
completed a manufacturing and supply agreement providing for Watson's marketing
and sale of the Company's existing core products portfolio (the "Core Products
Supply Agreement"). The Core Products Supply Agreement obligated Watson to
purchase a minimum amount of approximately $3,060,000 per quarter (the "Minimum
Purchase Amount") in core products from the Company, through September 30, 2001
(the "Minimum Purchase Period"). At the expiration of the initial Minimum
Purchase Period, if Watson did not continue to satisfy the Minimum Purchase
Amount, the Company would then be able to market and sell the core products on
its own or through a third party. On August 8, 2001, the Company and Watson
executed an amendment to the Core Products Supply Agreement providing (i) for a
reduction of the Minimum Purchase Amount from $3,060,000 to $1,500,000 per
quarter, (ii) for an extension of the Minimum Purchase Period from the quarter
ended September 30, 2001 to the quarter ended September 30, 2002, (iii) for
Watson to recover previous advance payments made under the Core Products Supply
Agreement in the form of the Company's provision of products having a purchase
price of up to $750,000 per quarter (such credit amount to be in excess of
Watson's $1,500,000 minimum quarterly purchase obligation), and (iv) for the
Company's repayment to Watson of any remaining advance payments made by Watson
under the Core Products Supply Agreement (and which amount has not been
recovered by product deliveries by the Company to Watson). As part of the
completion of the 2002 Debenture Offering (See Note 1), on December 20, 2002,
the Company and Watson further amended the Core Products Supply Agreement to
provide for the Company's satisfaction of its outstanding payment obligations to
Watson of $3,901,331 under such Agreement by the capitalization of such payment
obligation as part of the principal under the term loan with Watson (the "Watson
Term Loan") (See Note 8). As a result, the Watson Term Loan was amended to
increase the principal amount of the Watson Term Loan from $17,500,000 to
$21,401,331. In addition, the maturity date of Watson Term Loan was extended
from March 31, 2003 to March 31, 2006.

In March 2003, the Company notified Watson that the Company intended to
commence selling the core products independent of, and in addition to, Watson's
efforts as provided for under the Core Products Agreement.

13



As of November 16, 2003, the Company was in default under the Watson
Term Loan for failure to pay the interest payment due October 1, 2003. Such
default permits Watson to accelerate the indebtedness under the Watson Term Loan
and to enforce its rights against the Company's assets which secure the loan.
See "Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources."

NOTE 6 - INVENTORIES

Inventories consist of the following:



SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
(IN THOUSANDS)

Finished Goods......................... $ 1,454 $ --
Work in Process........................ 650 831
Raw Materials.......................... 534 1,454
------------ ------------
$ 2,638 $ 2,285
============ ============


NOTE 7 - CONVERTIBLE SUBORDINATED DEBENTURES

Convertible Subordinated Debentures consist of the following:



SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
(IN THOUSANDS)

1998 Debentures........................ $ 31,093 $ 30,215
1999 Debentures........................ 21,237 20,509
2002 Debentures........................ 32,109 26,394

84,439 77,118
Less: Debt discount.................... (61,703) (73,955)
------------ ------------

$ 22,736 $ 3,163
============ ============


As of November 16, 2003 the Company was in default under the Watson
Term Loan for failure to pay the interest payment due October 1, 2003. Such
default permits Watson to accelerate the indebtedness under the Watson Term Loan
and to enforce its rights against the Company's assets, which secure the loan.
The Company's default under the Watson Term Loan also results in a default under
the terms of the Company's outstanding 1998 Debentures, 1999 Debentures and 2002
Debentures. Such indebtedness has been classified as current liabilities in the
accompanying consolidated balance sheet at September 30, 2003. The Company is in
active discussions with Watson to restructure the Watson Term Loan and/or
satisfy its obligations thereunder. The exercise by Watson or the holders of the
Company's outstanding Debentures of their respective rights and remedies under
the Watson Term Loan and the Debentures Purchase Agreements would have a
material adverse effect on the Company's financial condition and results of
operations and could require the Company to seek relief under applicable
bankruptcy laws.

During the nine months ended September 30, 2003, the Company issued
$7,431,000 in new debentures of which $2,331,000 was issued as payment of
accrued interest in the same amount of these debentures and $5,100,000 was
issued under the Letter of Support Advances. The Debentures issued under the
Letter of Support Advances are convertible into 15,000,000 shares of the
Company's common stock at a conversion price of $.34. As the conversion price of
such debentures was less than the fair market value of the Company's common
stock on the date of issue, $5,100,000 of beneficial conversion features were
determined to exist. The $5,100,000 of beneficial conversion features are being
amortized to interest expense monthly through the maturity date of the debt,
which is March 31, 2006. During the nine months ended September 30, 2002, the
Company issued $2,331,000 in new debentures as payment of accrued interest in
the same amount of these debentures.

14



Such debentures are convertible into 2,602,000 shares of the Company's common
stock at various conversion prices of $1.02, $.925, and $.803.

As a result of the issuance of the new debentures under the Letter of
Support Advances, certain existing warrants agreements were modified as a result
of dilution adjustment provisions contained therein. During the nine months
ended September 30, 2003, the Company recorded a charge to earnings as other
expense of $457,000 related to the increase in the fair value of the warrants,
as calculated using the Black - Scholes option-pricing model, as a result of the
modification of terms of the warrant agreement.

During the nine months ended September 30, 2003, debentures in the
principal amount of $110,000 were converted into 189,075 shares of the Company's
common stock.

Related-Party Transactions

Current members of the Company's management and Board of Directors hold
certain of the 1998 Debentures and 1999 Debentures. The aggregate principal
amount of such debentures was approximately $174,000 and $170,000 at September
30, 2003 and December 31, 2002, respectively. Interest expense on these
debentures was approximately $6,500 and $5,800, for the nine months ended
September 30, 2003 and 2002, respectively, of which approximately $4,700 for
each nine-month period was paid through the issuance of like debentures.
Interest expense on these debentures was approximately $2,200 and $2,000, for
the three months ended September 30, 2003 and 2002, respectively, of which
approximately $1,600 for each three month period was paid through the issuance
of like debentures.

NOTE 8 - TERM NOTE PAYABLE

In connection with various strategic alliance transactions (See Note
5), Watson advanced $17,500,000 to the Company under the Watson Term Loan. The
loan is secured by a first lien on all of the Company's assets, senior to the
lien securing all other Company indebtedness, and carries a floating rate of
interest equal to prime plus two percent and had an original maturity date of
March 31, 2003. As part of the Company's 2002 Debenture Offering, the Watson
Term Loan was amended to (1) extend the maturity date to March 31, 2006, (2)
increase the interest rate to prime plus four and one half percent and (3)
increase the principal amount to $21,401,331 to reflect the inclusion of the
Company's payment obligations under the Core Products Supply Agreement between
Watson and the Company. The interest rate at September 30, 2003 was 8.25% and at
December 31, 2002 was 8.75%. In consideration of the amendment to the Watson
Term Loan, the Company issued to Watson a common stock purchase warrant ("Watson
Warrant") exercisable for 10,700,665 shares of the Company's common stock at an
exercise price of $.34 per share. The warrant has a term expiring December 31,
2009. The fair value of the Watson Warrant on the date of grant, as calculated
using the Black-Scholes option-pricing model, of $11,985,745 was charged to
earnings on the date of grant as a loss on the extinguishment of debt. As of
September 30, 2003, Watson has advanced $21,401,331 to the Company under the
Watson Term Loan.

As of November 13, 2003, the Company was in default under the Watson
Term Loan for failure to pay the interest payment due October 1, 2003. Such
default permits Watson to accelerate the indebtedness under the Watson Term Loan
and to enforce its rights against the Company's assets which secure the loan.
See "Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources."

NOTE 9 - COMMITMENTS AND CONTINGENCIES

Employment contracts

15



In May 2003, an employment agreement between the Company and the
Company's former Chief Executive Officer was terminated. Pursuant to provisions
of a negotiated separation agreement, the Company has accrued for a total value
of approximately $500,000 to such employee including a $400,00 promissory note
plus the estimated the value of benefits provided by the Company to such former
employee. The promissory note is payable in quarterly installments commencing
October 16, 2003. The separation agreement also granted a warrant to this
individual for the purchase of up to 150,000 shares of the Company's common
stock at an exercise price of .34 per share. The fair value of the warrant of
$112,000, as calculated using the Black-Scholes option pricing model, has been
charged to operations during the three months ended September 30, 2003. The
warrant has a seven-year term and has a cashless exercise clause providing that
upon the exercise of the warrant, such individual can receive common shares for
the equivalent amount of appreciated value of the warrant at the time of
exercise. As of November 13, 2003, the Company has not commenced payments
relating to the promissory note to such individual under this separation
agreement. (See Legal Proceedings).

In August 2003, the Company entered into an employment agreement with a
new Chief Executive Officer . The agreement provides for, among other things:
(i) an annual base salary of $300,000, and (ii) an aggregate of 5,500,000
options to purchase the Company's stock at an exercise price of $0.34 per common
share that vest 1,000,000 option shares on March 31, 2004 and the balance
thereafter at a rate of 500,000 per calendar quarter, beginning June 30, 2004
which an exercise term expiring in ten years. The stock option is subject to the
shareholders approval to modify the Company's 1998 Stock Option Plan to (i)
increase the number of shares reserved for issuance and (ii) authorize issuance
of stock options having an exercise price less than fair market value of the
common stock of the Company on the date of issuance. The employment agreement
term is for a two year period which automatically renews for successive one-year
periods unless either the Company or the employee provides 90 days' notice of
non-renewal.

Legal Proceedings

Beginning in 1992, actions were commenced against the Company and
numerous other pharmaceutical manufacturers, in connection with the alleged
exposure to diethylstilbestrol ("DES"). The Company's insurance carrier assumed
the defense of all such matters, and the carrier has settled a substantial
number. Currently, several actions remain pending with the Company as a
defendant in the Pennsylvania Court of Common Pleas, Philadelphia Division, and
the insurance carrier is defending each action. The Company and its legal
counsel do not believe any of such actions will have a material impact on the
Company's financial condition. The ultimate outcome of these lawsuits cannot be
determined at this time, and accordingly, no adjustment has been made to the
condensed consolidated financial statements.

In May 2003, the Company was notified that the Company, as well as
numerous other pharmaceutical manufacturers and distributors, was a named
defendant in a lawsuit involving a product liability claim. The claim has been
submitted and accepted by Company's insurance carrier for defense. The final
outcome of this lawsuit cannot be determined at this time, and accordingly, no
adjustment has been made to the condensed consolidated financial statements.

The Company is named as a defendant in an action entitled Alfred Kohn
v. Halsey Drug Co. in the Supreme Court of New York, Bronx County. The Plaintiff
seeks damages of $1 million for breach of an alleged oral contract to pay a
finder's fee for a business transaction involving the Company. Discovery in this
action has been completed. The Company has filed for summary judgment in this
action. In the event the Company is unsuccessful in its motion for summary
judgment, a trial on this action will follow. The Company does not believe this
action will have a material impact on the Company's financial condition. The
ultimate outcome of this lawsuit cannot be determined at this time, and
accordingly, no adjustment has been made to the condensed consolidated financial
statements.

In November 2003, the Company received a summons and complaint filed in
Illinois by the Company's former Chief Executive Officer. The complaint alleges,
among other things, that the Company has defaulted in its payment obligation
under the terms of a $400,000 promissory note issued to such former employee
under a Separation Agreement between the parties. The Company intends to file an
answer to the complaint and defend this matter. No adjustment has been made to
the consolidated financial statements for this matter.

16



In addition, the Company is a party to legal matters arising in the
general conduct of business. The ultimate outcome of such matters is not
expected to have a material adverse effect on the Company's results of
operations or financial position.

Indemnifications

Each of the purchase agreements for the 1998 Debentures, 1999
Debentures and the 2002 Debentures, contain provisions by which the Company is
obligated to indemnify the purchasers of the debentures for any losses, claims,
damages, liabilities, obligations, penalties, awards, judgments, expenses,
disbursements, arising out of or resulting from the breach of any
representation, warranty, or agreement, of the Company related to purchase of
the debentures. These indemnification obligations do not include a limit, or
maximum potential future payments, nor are there any recourse provisions or
collateral that may offset the cost. As of September 30, 2003, the fair value of
the liability for any obligation arising as a result of these indemnification
agreements is $0.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCE CONDITION AND RESULTS OF
OPERATIONS

NINE MONTHS ENDED SEPTEMBER 30, 2003 VS. NINE MONTHS ENDED SEPTEMBER 30, 2002

NET PRODUCT REVENUES

The Company's net product revenues for the nine months ended September
30, 2003 of $4,210,000 represents a decrease of $1,942,000 (32%) as compared to
net revenues for the nine months ended September 30, 2002 of $6,152,000. The
decrease in net product revenues is a result of decreased purchases by the
Company's primary customer, Watson Pharmaceuticals. During the first quarter
2003, the Company initiated steps to reestablish internal sales efforts so as to
become less dependent upon a single customer. Net product revenues from this
strategy have been slow to materialize and the Company expects minimal revenues
from this strategy for the remainder of 2003. (See Liquidity and Capital
Resources below.)

COST OF MANUFACTURING

For the nine months ended September 30, 2003, cost of manufacturing
decreased $1,967,000 as compared to the nine months ended September 30, 2002. As
a percentage of sales, cost of manufacturing was 176% and 152% for the nine
months ended September 30, 2003 and 2002, respectively. The decrease of
$1,967,000 was a result of reduced net product revenues as noted above. As a
percent of sales, cost of manufacturing increased 24% because of higher material
costs (13% of the increase) and unabsorbed fixed quality control department
expenses (11% of the increase).

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses as a percentage of sales
for the nine months ended September 30, 2003 and 2002 were 145% and 89%,
respectively. Overall these expenses in the first nine months of 2003 increased
$642,000 or 12% from the same period in 2002. The increase is a result of
increases in payroll and payroll related costs of $481,000, Company insurance
premiums of $200,000, accounts receivable bad debt expense of $350,000, DEA
consulting of $48,000 and agency recruiting fees of $100,000 offset by
reductions in legal expenditures of $144,000 and product marketing expenses of
$393,000 during the nine month period ended September 30, 2003.

RESEARCH AND DEVELOPMENT EXPENSES

The Company currently conducts research and development activities at
each of its Congers, New York and Culver, Indiana facilities. The Company's
research and development activities consist primarily of the development of the
Company's opiate synthesis technologies, including the development of opiate
APIs, as well as new generic drug product development efforts and manufacturing
process improvements. Development activities are primarily directed at
developing generic drug formulations, reviewing and testing such formulations
for equivalence to brand name products and additional testing in areas

17



such as bioavailability, bioequivalence and shelf-life. During 2003, the
Company's research and development efforts have been focused on finished dosage
formulation technology, finished dosage generic products and opiate API
manufacturing process technology. Research and development expenses decreased
$206,000 from the same period in 2002. The decrease is a result of reductions in
wages and wage related costs of $35,000, consulting of $100,000, subscriptions
of $11,000, product submission expenses of $40,000 and agency recruiting fees of
$20,000. Research and development expenses as a percentage of sales for the nine
months ended September 30, 2003 and 2002 were 23% and 19%, respectively.

NET LOSS

For the nine months ended September 30, 2003, the Company had net loss
of $33,192,000 as compared to a net loss of $20,688,000 for the nine months
ended September 30, 2002. Included in net loss for the nine months ended
September 30, 2003, was interest expense of $4,436,000 and amortization of
deferred debt discount and private offering costs of $18,050,000, as compared to
$3,408,000 and $7,562,000, respectively, over the same period in 2002. Also
included in net loss for the nine months ended September 30, 2003, was a charge
to earnings of $457,000 related to the increase in fair value of warrants, as
calculated using the Black-Scholes option-pricing model, as a result of the
modification of terms from the issuance of debentures.

THREE MONTHS ENDED SEPTEMBER 30, 2003 VS. THREE MONTHS ENDED SEPTEMBER 30, 2002

NET PRODUCT REVENUES

The Company's net product revenues for the three months ended September
30, 2003 of $1,478,000 represents a decrease of $535,000 (27%) as compared to
net revenues for the three months ended September 30, 2002 of $2,013,000. The
decrease in net product revenues is a result of decreased purchases by the
Company's primary customer, Watson Pharmaceuticals. During the first quarter
2003, the Company initiated steps to reestablish internal sales efforts so as to
become less dependent upon a single customer. Net product revenues from this
strategy have been slow to materialize and the Company expects minimal revenues
from this strategy for the remainder of 2003.

COST OF MANUFACTURING

For the three months ended September 30, 2003, cost of manufacturing
decreased $851,000 as compared to the three months ended September 30, 2002. As
a percentage of sales, cost of manufacturing was 153% and 155% for the three
months ended September 30, 2003 and 2002, respectively. The decrease was a
result of reduced net product revenues as noted above.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses as a percentage of sales
for the three months ended September 30, 2003 and 2002 were 149% and 97%,
respectively. Overall, these expenses for the three month period ended September
30, 2003 increased $240,000 or 12% from the same period in 2002. The increase is
a result of increases in legal expenses of $100,000, Company insurance premiums
of $48,000, and accounts receivable bad debt expense of $350,000, offset by
reductions in product marketing expenses of $194,000 and payroll and payroll
related costs of $64,000 during the three month period ended September 30, 2003.

RESEARCH AND DEVELOPMENT EXPENSES

The Company currently conducts research and development activities at
each of its Congers, New York and Culver, Indiana facilities. The Company's
research and development activities consist primarily of the development of the
Company's opiate synthesis technologies, including the development of
manufacturing processes for opiate APIs, new generic drug product development
efforts and opiate API manufacturing process improvements. Development
activities are primarily directed at developing generic drug formulations,
reviewing and testing such formulations for equivalence to brand name products
and additional testing in areas such as bioavailability, bioequivalence and
shelf-life. During 2003, the Company's research and development efforts have
been focused on finished dosage formulation technology, finished dosage generic
products and opiate API manufacturing

18



process technology. Research and development expenses decreased $65,000 from the
same period in 2002. The decrease is a result of reductions in wages and wage
related costs. Research and development expenses as a percentage of sales for
the three months ended September 30, 2003 and 2002 was 23% and 20%,
respectively.

NET LOSS

For the three months ended September 30, 2003, the Company had net loss
of $11,590,000 as compared to a net loss of $7,869,000 for the three months
ended September 30, 2002. Included in net loss for the three months ended
September 30, 2003, was interest expense of $1,532,000 and amortization of
deferred debt discount and private offering costs of $6,368,000, as compared to
$1,235,000 and $3,187,000, respectively, over the same period in 2002. Also
included in net loss for the three months ended September 30, 2003, was a charge
to earnings of $365,000 related to the increase in fair value of warrants, as
calculated using the Black-Scholes option-pricing model, as a result of the
modification of terms from the issuance of debentures.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2003 the Company had cash and cash equivalents of
$889,000 as compared to $9,211,000 at December 31, 2002. The Company had a
working capital deficit at September 30, 2003 of $46,331,000, after the
reclassification of outstanding indebtedness to current as such debt is in
default, and working capital at December 31, 2002 of $5,933,000.

On December 20, 2002, the Company consummated a private offering of
securities for an approximate aggregate purchase price of $26,394,000 (the "2002
Debenture Offering"). The securities issued in the 2002 Debenture Offering
consisted of 5% convertible senior secured debentures (the "2002 Debentures").
Of the $26,394,000 in 2002 Debentures issued in the 2002 Debenture Offering,
approximately $15,894,000 of the 2002 Debentures were issued in exchange for the
surrender of a like amount of principal and accrued interest outstanding under
Company's 10% convertible promissory notes issued pursuant to various working
capital bridge loan transactions with Galen and certain other lenders, during
the period from August 15, 2001 through and including December 20, 2002. The
2002 Debentures, issued at par, will become due and payable as to principal on
March 31, 2006. The 2002 Debentures were issued pursuant to a certain Debenture
Purchase Agreement dated December 20, 2002 (the "Purchase Agreement") by and
among the Company, Care Capital Investments II, LP ("Care Capital"), Essex
Woodlands Health Ventures V, L.P. ("Essex"), Galen and each of the purchasers
listed on the signature page thereto.

The Debentures issued to each of Care Capital and Essex are convertible
at any time after issuance into shares of the Company's Common Stock. The 2002
Debentures issued to Galen and the other investors in the 2002 Debenture
Offering (excluding Care Capital and Essex) are convertible at any time after
the approval of the Company's shareholders and debentureholders of an amendment
to the Company's Certificate of Incorporation to increase its authorized shares
of Common Stock from 80,000,000 shares to such number of shares as shall provide
sufficient authorized shares to permit the conversion of the 2002 Debentures and
the Company's other outstanding convertible securities. Subject to the
foregoing, the 2002 Debentures are convertible into shares of Common Stock at a
price per share (the "Conversion Price") of $.34. Until such time as the Company
completes a Subsequent Material Offering (as defined below) the Conversion Price
is subject to adjustment, from time to time, to equal the consideration per
share received by the Company for its Common Stock, or the conversion/exercise
price per share of the Company's Common Stock issuable under rights or option
for the purchase of, or stock or other securities convertible into, Common Stock
("Convertible Securities"), if lower than the then applicable Conversion Price.
Following the Company's completion of a Subsequent Material Offering, the
Conversion Price is subject to adjustment from time to time on a
weighted-average dilution basis. A "Subsequent Material Offering" is the grant
or issuance of Common Stock or Convertible Securities by the Company during any
six (6) month period for an aggregate gross consideration of at least
$10,000,000. Assuming the conversion of the 2002 Debentures at the initial
Conversion Price of $.34 per share, the 2002 Debentures are convertible into an
aggregate of approximately 77,629,000 shares of Common Stock.

The Purchase Agreement provides that, subject to the receipt of
shareholder approval to amend the Company's Certificate of Incorporation, the
holders of the 2002 Debentures shall have the right to vote as part of a single
class with

19


all holders of the Company's Common Stock on all matters to be voted upon by
such stockholders. Each 2002 Debentureholder shall have such number of votes as
shall equal the number of votes he would have had if such holder converted the
entire outstanding principal amount of his 2002 Debenture into shares of Common
Stock immediately prior to the record date relating to such vote; provided,
however, that any 2002 Debentures initially held by Care Capital shall, for so
long as they are held by Care Capital, have no voting rights.

The 2002 Debentures are secured by a lien on all assets of the Company,
tangible and intangible. In addition, each of Houba, Inc. and Axiom
Pharmaceutical Corporation, each a wholly-owned subsidiary of the Company, has
executed in favor of the holders of the 2002 Debentures an unconditional
agreement of guarantee of the Company's obligations under the Purchase
Agreement. Each guarantee is secured by all assets of such subsidiary, and, in
the case of Houba, Inc., by a mortgage lien on its Culver, Indiana real estate.
In addition, the Company has pledged the stock of each such subsidiary to the
holders of the 2002 Debentures to further secured its obligations under the
Purchase Agreement.

In accordance with the terms of a Subordination Agreement dated
December 20, 2002 between the Company, the holders of the 2002 Debentures, the
holders of the Existing Debentures and Watson Pharmaceuticals, Inc. ("Watson"),
the liens on the Company's and its subsidiaries' assets as well as the payment
priority of the 2002 Debenture are (i) subordinate to the Company's lien and
payment obligations in favor of Watson under the Watson Term Loan (as defined
below), and (ii) senior to the Company's lien and payment obligations in favor
of holders of the Existing Debentures in the aggregate principal amount of
approximately $50,724,000.

In connection with various strategic alliance transactions with Watson,
$17,500,000 was advanced to the Company under a term loan (the "Watson Term
Loan"). The Watson Term Loan is secured by a first lien on all of the Company's
assets, senior to the lien securing all other Company indebtedness, and carried
a floating rate of interest equal to prime plus two percent and had an original
maturity date of March 31, 2003. As part of the Company's 2002 Debenture
Offering, the Watson Term Loan was amended to (1) extend the maturity date to
March 31, 2006, (2) increase the interest rate to prime plus four and one half
percent and (3) increase the principal amount to $21,401,331 to reflect the
inclusion of approximately $3.9 million owed by the Company to Watson under the
Core Products Supply Agreement between the parties. The interest rate at
September 30, 2003 and December 31, 2002 was 8.25% and 8.75%, respectively. In
consideration of the amendment to the Watson Term Loan, the Company issued to
Watson a common stock purchase warrant ("Watson Warrant") exercisable for
10,700,665 shares of the Company's common stock at an exercise price of $.34 per
share. The warrant has a term expiring December 31, 2009. The fair value of the
Watson Warrant on the date of grant of $11,985,745, as calculated using the
Black-Scholes option-pricing model, was charged to earnings on the date of grant
as a loss on the extinguishment of debt. As of September 30, 2003, Watson had
advanced to the Company $21,401,331 under the Watson Term Loan, representing the
entire amount available under such loan facility.

As of November 13, 2003 the Company was in default under the Watson
Term Loan for failure to pay the interest payment due October 1, 2003. Such
default permits Watson to accelerate the indebtedness under the Watson Term Loan
and to enforce its rights against the Company's assets, which secure the loan.
The Company's default under the Watson Term Loan also results in a default under
the terms of the Company's outstanding 1998 Debentures, 1999 Debentures and 2002
Debentures. Such indebtedness has been classified as current liabilities in the
accompanying consolidated balance sheet at September 30, 2003. The Company is in
active discussions with Watson to restructure the Watson Term Loan and/or
satisfy its obligations thereunder. The exercise by Watson or the holders of the
Company's outstanding Debentures of their respective rights and remedies under
the Watson Term Loan and the Debentures Purchase Agreements would have a
material adverse effect on the Company's financial condition and results of
operations and could require the Company to seek relief under applicable
bankruptcy laws.

The development and commercialization of APIs and finished dosage
products incorporating the Company's opiate synthesis and finished dosage
formulation technologies are subject to various factors, many of which are
outside the Company's control. Specifically, only a limited portion of such
technologies have been tested in laboratory settings, none have been tested in
clinical settings, and all of such technologies will need to be successfully
scaled up to commercial scale to be commercially viable, of which no assurance
can be given. Additionally, the Company must satisfy, and continue to maintain
compliance with, the DEA's and FDA's requirements for the maintenance of
controlled substances manufacturing registrations (the "Manufacturing
Registration") and the issuance and maintenance of the DEA raw material import
registration (the "Import Registration"). The process of

20


seeking the Import Registration and contesting opposition proceedings, as well
as the continuing development of the Company's opiate synthesis and finished
dosage formulation technologies, are intended to continue through 2004. The
Company is currently unable to provide any assurance that such technologies can
be scaled up to commercial scale or that they will be commercially viable.
Moreover, no assurance can be given that the Company will succeed in obtaining
the Import Registration. The Company is committing the majority of its
resources, and available capital to the development of the opiate synthesis and
finished dosage formulation technologies and to the receipt of the Import
Registration. The failure of the Company to successfully develop the opiate
synthesis and finished dosage technologies, or to obtain the Import Registration
will have a material adverse effect on the Company's operations and financial
condition. The Company's cash flow and limited sources of available financing
make it uncertain that the Company will have sufficient capital to continue to
fund operations or to otherwise complete the development of the opiate synthesis
and finished dosage technologies, to obtain required DEA and FDA approvals and
to fund the capital improvements necessary for the manufacture of opiate APIs
and finished dosage products incorporating such technologies.

At the Company's request, on May 5, 2003, the Company received a letter
executed by each of Care Capital, Galen Partners and Essex Woodlands (the
"Majority 2002 Debentureholders") advising that the Majority 2002
Debentureholders would provide funding to meet the Company's 2003 capital
requirements, up to an aggregate amount not to exceed $8.6 million (the "Letter
of Support"). The Letter of Support further provides that the terms of any
funding provided by the Majority 2002 Debentureholders would be subject to
negotiation between the Company and the Majority 2002 Debentureholders at the
time of any funding. In consideration for the issuance of the Letter of Support,
the Company authorized the issuance of warrants to the Majority 2002
Debentureholders exercisable for an aggregate of 645,000 shares of the Company's
Common Stock at an exercise price of $.34 per share (which is equivalent to the
conversion price of the 2002 Debentures), subject to downward adjustment to
equal the consideration per share received by the Company for its Common Stock,
or the conversion/exercise price per share of the Company's Common Stock
issuable under convertible securities, in a third part investment if lower than
the exercise price of the warrants.

As of November 13, 2003, the Majority 2002 Debentureholders had
advanced an aggregate of $6,600,000 to the Company under the Letter of Support
to fund the Company's operating losses and capital requirements (the "Letter of
Support Advances"). The Letter of Support Advances were made in accordance with
the terms of 2002 Debenture Purchase Agreement resulting in the Company's
issuance of 2002 Debentures in an aggregate principal amount of $6,600,000
having a maturity date of March 31, 2006. After giving effect to the Letter of
Support Advances made through November 13, 2003, there remains $2,000,000
potentially available for advance to the Company by the Majority 2002
Debentureholders under the Letter of Support. No assurance can be given,
however, that all or any portion of the $2 million balance provided for in the
Letter of Support will be advanced to the Company by the Majority 2002
Debentureholders.

The Company believes that, assuming the remaining funding provided for
under the Letter of Support is advanced to the Company, of which no assurance
can be given, such amount, combined with cash flow from operations, will be
sufficient to satisfy the Company's working capital requirements only through
January 1, 2004. In the event no further advances are made to the Company by the
Majority 2002 Debentureholders under the Letter of Support, the Company's
current cash position combined with cash flow from operations would be
sufficient to fund operations only through December 1, 2003. Except for the
potential receipt of the remaining $2,000,000 available under the Letter of
Support, the Company has no other available sources of financing to fund
continued operating losses and working capital requirements. Subsequent to
September 30, 2003, the Company has initiated a restructuring of its operations
which includes the closure or divestment of its operations in Congers, New York,
the discontinuance of the manufacture and sale of finished dosage generic
products and substantially reducing activities at its active ingredients
facility in Culver, Indiana. The Company estimates that the restructuring will
be completed over the 50 to 80 days and result in a workforce reduction of
approximately 100 employees, leaving approximately 16 employees to be engaged in
the Company's research and development activities relating to API opiate and
finished dosage products incorporating the Company's opiate synthesis and
finished dosage formulation technologies.

Although the Company is currently in active discussions with the
Majority 2002 Debentureholders to obtain additional financing to fund the
restructuring of its operations and to fund the Company's operations during
2004, no assurance can be given that such funding will be provided, or that
there is available to the Company other sources of financing in the absence of
funding by the Majority 2002 Debentureholders. In the absence of continued
funding by the Majority 2002 Debentureholders or an alternative third-party
investment, the Company will be required to

21


further scale back or terminate operations and/or seek protection under
applicable bankruptcy laws.

Even assuming the Company is successful in securing additional sources
of financing to fund the Company operations, there can be no assurance that the
Company's development efforts relating to its API opiate synthesis or finished
dosage formulation technologies will result in commercial scale technologies, or
that if such technologies are capable of being scaled up, that they will result
in commercially viable products. The Company is also unable to provide any
assurance that it will succeed in its application through DEA for the Import
Registration. The Company's failure to scale up and commercialize its API opiate
synthesis and finished dosage formulation technologies or to obtain the Import
Registration will have a material adverse impact on the Company's financial
condition and results of operations.

CRITICAL ACCOUNTING POLICIES

Financial Reporting Release No. 60, which was released by the
Securities and Exchange Commission ("SEC") in December 2001, requires all
companies to include a discussion of critical accounting policies or methods
used in the preparation of financial statements. Note A of the Notes to
Consolidated Financial Statements, as contained in the Company's Annual Report
on Form 10-K, includes a summary of the Company's significant accounting
policies and methods used in the preparation of the financial statements. In
preparing these financial statements, the Company has made its best estimates
and judgments of certain amounts included in the financial statements, giving
due consideration to materiality. The application of these accounting policies
involves the exercise of judgment and use of assumptions as to future
uncertainties and, as a result, actual results could differ from these
estimates. The Company does not believe there is a great likelihood that
materially different amounts would be reported under different conditions or
using different assumptions. The Company's critical accounting policies are as
follows:

Revenue Recognition

The Company recognizes revenue at the time a product is shipped to
customers. The Company established sales provisions for estimated chargebacks,
discounts, rebates, returns, pricing adjustments and other sales allowances
concurrently with the recognition of revenue. The sales provisions are
established based upon consideration of a variety of factors, including but not
limited to, actual return and historical experience by product type, the number
and timing of competitive products approved for sale, the expected market for
the product, estimated customer inventory levels by product, price declines and
current and projected economic conditions and levels of competition. Actual
product return, chargebacks and other sales allowances incurred are, however,
dependent upon future events. Management continually monitors the factors that
influence sales allowance estimates and make adjustments to these provisions
when allowances may differ from established allowances.

Allowance For Doubtful Accounts

Estimates are used in determining the allowance for doubtful accounts
based on the Company's historical collections experience, current trends, credit
policy and a percentage of its accounts receivable by aging category. In
determining these percentages, the Company looks at historical write-offs of its
receivables. The Company also looks at the credit quality of its customer base
as well as changes in its credit policies. The Company continuously monitors
collections and payments from its customers. While credit losses have
historically been within expectations and the provisions established, the
Company cannot guarantee that it will continue to experience the same credit
loss rates that it has in the past.

Inventories

The Company's inventories are stated at the lower of cost or market,
with cost determined on the first-in, first-out basis. In evaluating whether
inventory is stated at the lower of cost or market, management considers such
factors as the amount of inventory on hand, remaining shelf life and current and
expected market conditions, including levels of competition. As appropriate, the
Company records provisions to reduce inventories to their net realizable value.

Income Taxes

22


Deferred income taxes are recognized for temporary differences between
financial statement and income tax bases of assets and liabilities and loss
carry-forwards for which income tax benefits are expected to be realized in
future years. A valuation allowance is established, when necessary, to reduce
deferred tax assets to the amount expected to be realized. In estimating future
tax consequences, the Company generally considers all expected future events
other than an enactment of changes in the tax laws or rates. The Company has
recorded a full valuation allowance to reduce its deferred tax assets to the
amount that is more likely than not to be realized. While the Company has
considered future taxable income in assessing the need for the valuation
allowance, in the event the Company were to determine that it would be able to
realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made.

Stock Compensation

The Company accounts for stock-based employee compensation arrangements
in accordance with provisions of APB Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB No. 25") and comply with the disclosure provision of
SFAS No. 148, "Accounting for Stock-based Compensation - Transition and
Disclosure, an amendment of FASB Statement No. 123" ("SFAS No. 148"). If the
Company were to include the cost of stock-based employee compensation in the
financial statements, the Company's operating results would decline based on the
fair value of the stock-based employee compensation.

Deferred Debt Discount

Deferred debt discount results from the issuance of stock warrants and
beneficial conversion features in connection with the issuance of subordinated
debt and other notes payable. The amount of the discount is recorded as a
reduction of the related obligation and is amortized over the remaining life of
the related obligations. Management determines the amount of the discount,
based, in part, by the relative fair values ascribed to the warrants determined
by an independent valuation or through the use of the Black-Scholes valuation
model. Inherent in the Black-Scholes valuation model are assumptions made by
management regarding the estimated life of the warrant, the estimated volatility
of the Company's common stock and the expected dividend yield.

NEW ACCOUNTING PRONOUNCEMENTS

In November 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" ("FIN No. 45"). FIN No. 45
requires that upon issuance of a guarantee, a guarantor must recognize a
liability for the fair value of an obligation assumed under a guarantee. FIN No.
45 also requires additional disclosures by a guarantor in its interim and annual
financial statements about the obligations associated with guarantees issued.
The recognition provisions of FIN No. 45 are effective for any guarantees issued
or modified after December 31, 2002. The disclosure requirements are effective
for financial statements of interim or annual periods ending after December 15,
2002. The adoption of FIN No. 45 did not have a material impact on the Company's
financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure, an amendment of FASB
Statement No. 123." SFAS No. 148 amends SFAS No. 123, "Accounting for
Stock-Based Compensation," ("SFAS No. 148"), to provide alternative methods of
transition for an entity that voluntarily changes to the fair value-based method
of accounting for stock-based employee compensation. It also amends the
disclosure provisions of that Statement to require prominent disclosure about
the effects on reported net income of an entity's accounting policy decisions
with respect to stock-based employee compensation. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in APB Opinion No. 25 and related interpretations as provided
for under SFAS No. 148. Accordingly, compensation expense is only recognized
when the market value of the Company's stock at the date of the grant exceeds
the amount an employee must pay to acquire the

23


stock. The adoption of SFAS No. 148 did not have a material impact on the
Company's financial position or results of operations.

In January 2003, the FASB issued FASB Interpretation No. 46
"Consolidation of Variable Interest Entities" ("Fin No. 46"). In general, a
variable interest entity is a corporation, partnership, trust, or any other
legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. A
variable interest entity often holds financial assets, including loans or
receivables, real estate or other property. A variable interest entity may be
essentially passive or it may engage in activities on behalf of another company.
Until now, a company generally has included another entity in its consolidated
financial statements only if it controlled the entity through voting interests.
FIN No. 46 changes that by requiring a variable interest entity to be
consolidated by a company if that company is subject to a majority of the risk
of loss from the variable interest entity's activities or entitled to receive a
majority of the entity's residual returns or both. FIN No. 46's consolidation
requirements apply immediately to variable interest entities created or acquired
after January 31, 2003. The consolidation requirements apply to older entities
in the first fiscal year or interim period ending after December 15, 2003.
Certain of the disclosure requirements apply to all financial statements issued
after January 31, 2003, regardless of when the variable interest entity was
established. The Company has adopted FIN No. 46 effective January 31, 2003. The
adoption of FIN No. 46 did not have a material impact on the Company's financial
position or results of operations.

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"), which
amends and clarifies financial accounting and reporting for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities under SFAS No. 133. SFAS No. 149 is
effective for contracts entered into or modified after June 30, 2003 except for
the provisions that were cleared by the FASB in prior pronouncements. The
adoption of SFAS No. 149 did not have a material impact on the Company's
financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"). This statement establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. In accordance
with the standard, financial instruments that embody obligations for the issuer
are required to be classified as liabilities. This Statement shall be effective
for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first period beginning after June
15, 2003. . The adoption of SFAS No. 150 did not have a material impact on the
Company's financial position or results of operations.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.

As of September 30, 2003, each of Andrew Reddick, the principal
executive officer of the Company and Peter A. Clemens, the principal financial
officer of the Company has evaluated the effectiveness of the design and
operation of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended
(Exchange Act)). Based upon that evaluation, each of the principal executive
officer and the principal financial officer of the Company have concluded that
such disclosure controls and procedures are effective in timely alerting them to
any material information relating to the Company and its consolidated
subsidiaries required to be included in the Company's reports filed or submitted
with the Securities and Exchange Commission under the Exchange Act.

PART II

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

24


During the quarter ended September 30, 2003, the Company issued (i) 5%
Convertible Senior Secured Debentures in the principal amount of approximately
$860,000 in satisfaction of accrued interest on Company's outstanding 5%
Convertible Senior Secured Debentures issued in 1998, 1999 and 2002 (the
"Convertible Debentures") ,(ii) 645,000 common stock purchase warrants to the
2002 Majority Debentureholders pursuant to the May 5, 2003 Letter of Support (
the "Commitment Warrants"), (iii) 5% Convertible Senior Secured Debentures in
the principal amount of $4.500,000 .

During the quarter ended ended September 30, 2003, Debentures of
$75,000 were converted into 129,306 shares of the Company's common stock.

On September 18, 2003, the Company issued a common stock purchase
warrant to its former Chief Executive Officer as partial consideration for the
settlement of the Company's obligations under the employment agreement with such
former employee.

Each of the holders of the Convertible Debentures for which interest
payments were made in 5% Convertible Senior Secured Debentures and the 2002
Majority Debentureholders receiving the Commitment Warrants and the Company's
former CEO are accredited investors as defined in Rule 501(a) of Regulation D
promulgated under the Securities Act of 1933, as amended (the "Act"). The 5%
Convertible Senior Secured Debentures and common stock purchase warrant were
issued in satisfaction of the interest payments under the Convertible Debentures
were issued without registration under the Act in reliance upon Section 4(2) of
the Act and Regulation D promulgated thereunder.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits

The exhibits required to be filed as part of this Report on
form 10-Q are listed in the attached Exhibit Index.

(b) Reports on Form 8-K.

The Company filed a Current Report on Form 8-K dated
August 14, 2003 relating to the Company's press release for its
quarterly financial information for the quarterly period ended
June 30, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

Date: November 17, 2003 HALSEY DRUG CO., INC.

By /s/ Andrew D. Reddick
-------------------------------------
Andrew D. Reddick
Chief Executive Officer

By: /s/ Peter A. Clemens
------------------------------------
Peter A. Clemens
VP & Chief Financial Officer

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EXHIBIT INDEX

Exhibit Document

31.1 Certification of Periodic Report by Chief Executive Officer
pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange
Act of 1934.

31.2 Certification of Periodic Report by Chief Financial Officer
pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange
Act of 1934.

32.1 Certification of Periodic Report by Chief Executive Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of Periodic Report by Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

27