UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from ________________________to______________________

Commission file number: 0-19825

SCICLONE PHARMACEUTICALS, INC.

(650) 358-3456
(Registrant’s telephone number, including area code)

Not Applicable

          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.

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

          As of September 30, 2004, 44,662,744 shares of the registrant’s Common Stock, $0.001 par value, were issued and outstanding.

SCICLONE PHARMACEUTICALS, INC.

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

SCICLONE PHARMACEUTICALS, INC.

See notes to condensed consolidated financial statements

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SCICLONE PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

See notes to condensed consolidated financial statements

4

SCICLONE PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

See notes to condensed consolidated financial statements

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SCICLONE PHARMACEUTICALS, INC.

Notes to Condensed Consolidated Financial Statements
(unaudited)

1. Basis of Presentation

SciClone was reincorporated in the State of Delaware on July 18, 2003. The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles consistent with those applied in, and should be read in conjunction with, the audited financial statements for the year ended December 31, 2003 included in the Company’s Form 10-K as filed with the Securities and Exchange Commission. The interim financial information reflects all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented and are not necessarily indicative of results for subsequent interim periods or for the full year. The condensed consolidated balance sheet data at December 31, 2003 is derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

2. Significant Accounting Policies

Revenue Recognition

The Company recognizes revenue from product sales at the time of shipment. There are no significant customer acceptance requirements or post shipment obligations on the part of the Company. Sales to importing agents or distributors are recognized at time of shipment when title to the product is transferred to them, and they do not have contractual rights of return except under limited terms regarding product quality. However, the Company will replace products that have expired or are deemed to be damaged or defective when delivered. Payments by the importing agents and distributors are not contingent upon sale to the end user by the importing agents or distributors.

Contract revenue for research and development is recorded as earned based on the performance requirements of the contract. Nonrefundable contract fees for which no further performance obligations exist, and there is no continuing involvement by the Company, are recognized on the earlier of when the payments are received or when collection is assured.

Revenue associated with substantive performance milestones is recognized based on the achievement of the milestones, as defined in the respective agreements and provided that (i) the milestone event is substantive and its achievement is not reasonably assured at the inception of the agreement, and (ii) there are no future performance obligations associated with the milestone payment.

Net Loss Per Share

Net loss per share is computed using the weighted average number of shares of common stock outstanding. Potentially dilutive common shares from convertible debt, stock options and warrants are excluded, as their effect is antidilutive.

Accounting For Stock-Based Compensation

The Company accounts for its stock option and employee stock purchase plans under the provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related Interpretations. Accordingly, the Company does not recognize compensation expense in accounting for its stock option and employee stock purchase plans for awards to employees and directors granted with exercise prices at fair market value.

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Pro forma information regarding net income (loss) and net income (loss) per share is required by Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”) and has been determined as if the Company had accounted for its stock awards under the fair value method of that Statement. The fair value for the options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the three-month and nine-month periods ended September 30, 2004 and the nine-month periods ended September 30, 2003 (no options were granted in the three-month period ended September 30, 2003):

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 awards have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimate, in the Company’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee and director stock options and stock purchases.

The following table illustrates the Company’s pro forma net income (loss) and net income (loss) per share, had compensation expense for the Company’s option and employee purchase plans been determined based on the fair value at the grant date consistent with the provisions of SFAS 123, as amended by SFAS 148:

The effects of applying SFAS 123 for pro forma disclosures are not likely to be representative of the effects on reported net income (loss) for future years due to the different number of options granted each year.

3. Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes net unrealized gains and losses on our available-for-sale securities. For the three-month periods ended September 30, 2004 and 2003, the Company’s total comprehensive loss amounted to $(4,873,000) and $(2,879,000), respectively. For the nine-month periods ended September 30, 2004 and 2003, the Company’s total comprehensive loss amounted to $(10,860,000) and $(529,000), respectively.

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4. Available-For-Sale Securities

The following is a summary of available-for-sale securities at September 30, 2004 and December 31, 2003:

As of September 30, 2004, the available-for-sale securities are included as follows: $27,293,000 in cash and cash equivalents; $695,000 in restricted short-term investments and $9,500,000 in other short-term investments. As of December 31, 2003, the available-for-sale securities are included as follows: $38,259,000 in cash and cash equivalents; $695,000 in restricted short-term investments and $9,381,000 in other short-term investments. As of September 30, 2004 and December 31, 2003 all available-for sale securities excluding the short-term municipal securities had maturities of 12 months or less. The short-term municipals are auction rate securities which have long final maturities; however, because they are highly rated, highly liquid and their interest rate is reset at auction every 30 days, they are included as available-for sale securities. Our interest rate risk associated with the auction rate securities is limited due to this interest rate reset mechanism.

5. Inventories

     The following is a summary of inventories at September 30, 2004 and December 31, 2003:

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6. Prepaid Expenses and Other Current Assets

The following is a summary of prepaid expenses and other current assets at September 30, 2004 and December 31, 2003:

7. Intangible Assets

The following is a summary of intangible assets at September 30, 2004 and December 31, 2003:

Acquired ZADAXIN product rights are being amortized on a straight-line basis beginning in September 1998. Amortization expenses for the three-month and nine-month periods ended September 30, 2004 and 2003 were both $17,500 and $52,000, respectively. For the years ending December 31, 2004 through 2012, annual amortization expense is expected to be $70,000. Based upon the progress in the ZADAXIN clinical trials and the Company’s actual experience of product sales, the Company assessed that the acquired product rights will be useful to the Company through 2012 when the European patent for the use of ZADAXIN in the treatment of hepatitis C expires. The Company’s policy is to identify and record impairment losses on intangible product rights when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. There have been no impairment losses recorded to date.

8. Contract Revenue

In January 2002, the Company received $2,685,000 from its European partner, Sigma-Tau, under the terms of its collaborative agreement announced in late December 2001. This receipt has been recorded as deferred revenue and is being recognized as contract revenue over the course of the ZADAXIN hepatitis C U.S. clinical program and the period of sharing the clinical data from this program with Sigma-Tau, the substantive performance requirements under the contract. In June 2004, the Company received a $1,000,000 milestone payment from Sigma-Tau for the enrollment of 1,000 patients into the U.S. hepatitis C clinical trials. This milestone payment was recognized as contract revenue in the three-month period ended June 30, 2004 as the substantive milestone event has been completed and there were no future performance obligations associated with the milestone payment.

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9. Compensation Expense

A non-recurring expense of $1,108,000 is included in general and administrative expense for the three-month and nine-month periods ended September 30, 2004 in connection with the separation of our former Chief Executive Officer from the Company in July 2004. The expense is recorded in the current quarter because the Company does not expect to receive future benefit from the payment obligations. Future payment obligations related to this expense include $554,000 included in accrued compensation and employee benefits and $544,000 included in other long-term liabilities.

10. Other Accrued Expenses

The following is a summary of other accrued expenses at September 30, 2004 and December 31, 2003:

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

Special Note Regarding Forward-Looking Statements

     This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on our current expectations, estimates and projections about our business, industry, management’s beliefs and certain assumptions made by us. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe” or similar expressions are intended to identify forward-looking statements including those statements we make regarding our future financial results; anticipated product sales; the sufficiency of our resources to complete clinical trials and other new product development initiatives; the timing and outcome of clinical trials; the timing of completion of therapy and observation for our clinical trials; ZADAXIN’s ability to complement existing therapies; prospects for ZADAXIN and our plans for its enhancement and commercialization; future size of the worldwide hepatitis C virus market; research and development and other expense levels; cash and other asset levels; and the allocation of financial resources to certain trials and programs. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors including, but not limited to, those described under the caption “Risk Factors” in this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Overview

     SciClone Pharmaceuticals, Inc. is a biopharmaceutical company engaged in the development and commercialization of therapeutics to treat life-threatening diseases. We are currently evaluating our lead product, ZADAXIN, in several late stage clinical trials for the treatment of patients with the hepatitis C virus, or HCV, the hepatitis B virus, or HBV, and certain types of cancer. Our primary focus is the successful completion of our two ongoing ZADAXIN phase 3 HCV clinical trials in the United States. We believe the worldwide market for HCV therapies was approximately $3 billion in 2003 and could exceed $8 billion in 2012. If approved by the U.S. Food and Drug Administration (FDA), we expect ZADAXIN to complement other HCV therapies and to expand the HCV market. In addition to the HCV trials in the United States, ZADAXIN is also being evaluated in a completed phase 3 HBV clinical trial in Japan, an ongoing, licensee-sponsored phase 2 malignant melanoma clinical trial in Europe with our exclusive marketing partner for Western Europe, Sigma-Tau, two ongoing phase 2 pilot studies in the United States for the treatment of liver cancer, an ongoing HCV pilot clinical trial in Mexico and an ongoing HBV clinical trial in Taiwan. We recently announced plans for a ZADAXIN phase 3 hepatitis C triple therapy clinical trial in Europe, sponsored and primarily funded by Sigma-Tau. Our other principal drug development candidate is SCV-07, a potential therapeutic to treat viral and other infectious diseases.

Results of Operations

     Total Revenue

     Product sales were $5,753,000 and $16,780,000 for the three-month and nine-month periods ended September 30, 2004, as compared to $5,421,000 and $26,628,000 for the corresponding periods in 2003. All product sales in each period were derived from sales of ZADAXIN. The higher level of sales in the 2003 nine-month period was related to an unanticipated increase in volume of ZADAXIN product sold in response to the SARS epidemic in China. Product prices have remained stable throughout the 2003 and 2004 periods. Sales to customers in China accounted for approximately 92% and 91% of this revenue for the three-month and nine-month periods ended September 30, 2004 and 88% and 89% in the corresponding periods in 2003.

     For the three-month period ended September 30, 2004, sales to one importing agent in China accounted for approximately 92% of our product sales. However, for the nine-month period ended September 30, 2004, the same importing agent in China accounted for 32% of our product sales and two other importing agents in China

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accounted for 59% of our product sales. We expect that the share of our product sales to China will vary among a small number of importing agents from quarter to quarter.

     Contract revenue was $134,000 and $1,497,000 for the three-month and nine-month periods ended September 30, 2004 as compared to $224,000 and $672,000 for each of the corresponding periods in 2003. We recognized $134,000 and $403,000 of contract revenue for the three-month and nine-month periods ended September 30, 2004, respectively, and all of the revenue in the corresponding 2003 periods, in connection with the $2,685,000 payment we received from Sigma-Tau in January 2002. This revenue is recognized as contract revenue over the course of the ZADAXIN hepatitis C U.S. clinical program and the period of sharing the clinical data from this program with Sigma-Tau in accordance with the requirements under our contract with Sigma-Tau. During the three-month period ended June 30, 2004, we also recognized a $1,000,000 milestone payment from Sigma-Tau for the enrollment of 1,000 patients in our phase 3 HCV clinical trials. Additionally, we recognized $94,000 of contract revenue in the three-month period ended March 31, 2004 in connection with a National Institutes of Health grant.

     Cost of Product Sales and Gross Margin on Product Sales

     Gross margin on product sales was 81% and 80% for the three-month and nine-month periods ended September 30, 2004, as compared to 83% and 82% for each of the corresponding periods in 2003. The decrease in gross margin percentage for the 2004 periods was primarily the result of higher product costs in connection with the transfer to a new toll manufacturer for ZADAXIN and lower product costs in the 2003 periods due to higher volume productions in response to the SARS epidemic in China. We expect cost of product sales, and hence gross margin on product sales, to vary from period to period, depending upon the level of ZADAXIN sales, the absorption of product-related fixed costs, and any charges associated with excess or expiring finished product inventory.

     Research and Development

     Research and development expenses were $4,858,000 and $13,552,000 for the three-month and nine-month periods ended September 30, 2004, as compared to $4,585,000 and $12,676,000 for the corresponding periods in 2003. The increase was primarily to support our ZADAXIN phase 3 clinical trials in the United States. The initiation and continuation of our current clinical development programs has had and will continue to have a significant effect on our research and development expenses. Due to the uncertain nature of the clinical trial process, it is not possible to determine the total cost expected to be incurred for each trial. In general, we expect research and development expenses to vary substantially from quarter to quarter as we pursue our strategy of initiating additional preclinical and clinical trials and testing, acquiring product rights, and expanding regulatory activities.

     Sales and Marketing

     Sales and marketing expenses were $2,317,000 and $7,290,000 for the three-month and nine-month periods ended September 30, 2004, as compared to $1,892,000 and $7,146,000 for the corresponding periods in 2003. The increase in sales and marketing expenses were associated with expenses for advertising and conferences associated with the expansion of our markets for ZADAXIN. We expect sales and marketing expenses to vary in the next several quarters and to increase in the next several years if we are successful in our efforts to expand our commercialization and marketing efforts.

     General and Administrative

     General and administrative expenses were $2,573,000 and $5,022,000 for the three-month and nine-month periods ended September 30, 2004, as compared to $998,000 and $3,045,000 for the corresponding periods in 2003. Approximately $1,098,000 of the increase in the 2004 periods is attributable to a non-recurring expense incurred in connection with the separation of our former Chief Executive Officer from the Company in July 2004. The balance of the increase in general and administrative expenses was attributable to greater general and administrative activities associated with increased securities regulation requirements. In the near term, we expect

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general and administrative expenses to vary from quarter to quarter and to increase particularly due to increased audit costs and other activities related to compliance with additional securities regulation requirements.

     Interest and Investment Income and Expense

     Interest and investment income was approximately $156,000 and $384,000 for the three-month and nine-month periods ended September 30, 2004, as compared to $47,000 and $143,000 for the corresponding periods in 2003. The increase was primarily due to higher cash balances earning interest in the 2004 period. Interest and investment expense is related to the $5,600,000 of convertible notes payable outstanding throughout the nine-month periods ended September 30, 2004 and 2003.

     Liquidity and Capital Resources

     On September 30, 2004 and December 31, 2003, we had $52,986,000 and $62,975,000, respectively, in cash, cash equivalents and short-term investments including $695,000 of restricted short-term investments. We currently estimate cash, cash equivalents and short-term investments at December 31, 2004 will be lower than the balance at September 30, 2004. The expected decrease in this balance is attributable to an expected net loss and no planned financing activities during the remainder of 2004. The short-term investments consist primarily of highly liquid marketable securities. Our restricted short-term investments relate to two letters of credit each secured by a certificate of deposit. On both September 30, 2004 and December 31, 2003, the letters of credit totaled $695,000 and were comprised of $633,000 under our lease agreement and $62,000 to facilitate our value added tax filings in Europe.

     Net cash used in operating activities amounted to $10,122,000 for the nine-month period ended September 30, 2004 as compared to net cash used in operating activities in the amount of $4,767,000 in the corresponding period in 2003. The change was primarily due to the higher net loss incurred in the 2004 period compared to the 2003 period.

     Net cash used by us in investing activities amounted to $222,000 for the nine-month period ended September 30, 2004 and related primarily to the purchase of $166,000 in property and equipment.

     Net cash provided by financing activities amounted to $236,000 for the nine-month period ended September 30, 2004 and was derived from the issuance of common stock under our employee stock purchase plan.

     We intend to give priority use of our financial resources to ZADAXIN clinical programs in the United States. We believe our existing capital resources and funds from product sales are sufficient to complete our current U.S. phase 3 clinical trials and, if the trials are successful and we receive FDA approval, to begin commercialization of ZADAXIN in the United States. We also believe that our current resources are sufficient to permit us to undertake certain additional product development initiatives over the next two years. However, we cannot assure you that such funds will be sufficient, or that sales of ZADAXIN, if approved in the United States, will result in profitable operations. In the event we need to raise additional funds, the unavailability or the inopportune timing of any financing could prevent or delay our long-term product development and commercialization programs, either of which would severely hurt our business. The need, timing and amount of any such financing would depend upon numerous factors, including the level of ZADAXIN sales, the timing and amount of manufacturing costs related to ZADAXIN, the availability of complementary products, technologies and businesses, the initiation and continuation of preclinical and clinical trials and testing, the timing of regulatory approvals, developments in relationships with existing or future collaborative parties and the status of competitive products.

Contractual Obligations

     There were no material changes in the three-month ended September 30, 2004 to our contractual obligations as disclosed in our Form 10-Q for the quarter ended June 30, 2004.

Off-Balance Sheet Arrangements

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     There were no off-balance sheet arrangements in the three-month and nine-month periods ended September 30, 2004.

Risk Factors

     You should carefully consider the risks described below, in addition to the other information in this report on Form 10-Q and our report on Form 10-K for the year ended December 31, 2003, before making an investment decision. Each of these risk factors could adversely affect our business, financial condition, and operating results as well as adversely affect the value of an investment in our common stock.

If we are unable to commercialize ZADAXIN in various markets for multiple indications, particularly in the United States for the treatment of HCV, our business will be harmed.

     Our ability to achieve and sustain operating profitability depends in large part on our ability to commence, execute and complete clinical programs and obtain additional regulatory approvals for ZADAXIN and other drug candidates, particularly in the United States, Europe and Japan. We are also dependent on our ability to increase ZADAXIN sales in existing markets and launch ZADAXIN in new markets. In particular, our ability to achieve and sustain profitability will depend in large part on our ability to commercialize ZADAXIN for the treatment of HCV in the United States. We cannot assure you that we will achieve significant levels of sales or that we will receive approval for ZADAXIN for the treatment of HCV in the United States or for the treatment of HCV or other indications in other countries. If we are unable to do so, our business will be harmed.

If we do not obtain regulatory approval for ZADAXIN for the intended indications that we are evaluating, our revenues will be limited and we will not become profitable.

     Our ability to execute on our business strategy requires that we obtain regulatory approval for the use of ZADAXIN, particularly for the treatment of HCV in the United States, both HBV and HCV in Japan and both HCV and malignant melanoma in Europe. If our current phase 3 trials in the United States and current and future trials in Europe yield favorable results, we intend to submit applications for marketing approval of ZADAXIN for the treatment of HCV in the United States and through our partner, Sigma-Tau, for the treatment of HCV and malignant melanoma in Europe. Based on the results of our recently completed phase 3 trial in Japan, we intend to submit a regulatory filing for the treatment of HBV in Japan. The regulatory approval processes in the United States, Europe and Japan are demanding and typically require 12 months or more in the United States and 18 months or more in Europe and Japan from the date of submission of a New Drug Application. We have committed significant resources, including capital and time, to develop ZADAXIN, particularly for HCV in the United States, with the goal of obtaining such approvals. If we do not obtain these approvals, we will be unable to achieve any substantial increase in our revenue.

     All new drugs, including our products, which have been developed or are under development, are subject to extensive and rigorous regulation by the FDA and comparable agencies in state and local jurisdictions and in foreign countries. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, importation, advertising, promotion, sale and distribution of our products. These regulations may change from time to time and new regulations may be adopted.

     Obtaining regulatory approval in developing countries is time-consuming and expensive. In some countries where we are contemplating marketing and selling ZADAXIN, the regulatory approval process often relies on prior approvals obtained in the United States, Europe or Japan. Without such prior approvals, our ability to obtain regulatory approvals for ZADAXIN in these countries may be delayed or prevented. In addition, to secure these regulatory approvals, we will need, among other things, to demonstrate favorable results from additional clinical trials of ZADAXIN. Even if we are able to complete the clinical trials we have sponsored or are planning in a timely or cost-effective manner, these trials may not fulfill the applicable regulatory approval criteria, in which case we will not be able to obtain regulatory approval in these countries. We cannot assure you that we will ultimately obtain regulatory approvals in our targeted countries in a timely and cost-effective manner

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or at all. If we fail to obtain the required regulatory approvals to develop, market and sell our products in countries where we currently do not have such rights, our revenues will be limited.

     Satisfaction of government regulations may take several years and the time needed to satisfy them varies substantially based on the type, complexity and novelty of the pharmaceutical product. As a result, government regulation may cause us to delay the introduction of, or prevent us from marketing, our existing or potential products for a considerable period of time and impose costly procedures upon our activities. Even if we obtain regulatory approval for our products, such approval may impose limitations on the indicated uses for which our products may be marketed. Unsatisfactory data resulting from clinical trials may also adversely affect our ability to market and sell ZADAXIN in markets where it is approved for sale.

If the results of our clinical trials are not favorable, we will be unable to obtain regulatory approval for the intended indications we are evaluating.

     To obtain regulatory approvals, we must, among other requirements, complete carefully controlled and well-designed clinical trials demonstrating that a particular drug is safe and effective for the applicable disease. We cannot depend on data from prior trial results to predict or demonstrate that our drug products are safe and efficacious under regulatory guidelines to qualify for commercial sale. We cannot assure you, nor can you rely on our previous clinical trial results to predict, that our ongoing or future clinical trials will yield favorable results. Adverse or inconclusive clinical results would prevent us from filing for regulatory approval of ZADAXIN (thymosin alpha 1) for the indications that we are evaluating, and our current programs in those areas would fail. In the past, Alpha 1 Biomedical, from which we acquired certain rights to thymosin alpha 1, conducted a phase 3 clinical trial of thymosin alpha 1 as a therapy for HBV that did not produce statistically significant results and Alpha 1 Biomedical did not submit a new drug application to the FDA.

     We are currently conducting phase 3 clinical trials based on the use of ZADAXIN in combination with pegylated interferon alpha for the treatment of HCV patients who did not previously respond to treatment. We cannot assure you that these phase 3 clinical trials will yield sufficient or adequate data to demonstrate appropriate safety and efficacy under FDA guidelines. Any failure to obtain sufficient or adequate data could delay or prevent us from securing FDA approval.

     Our two phase 3 HCV clinical trials in the United States have been designed to show that the combination of ZADAXIN and pegylated interferon alpha adds a significant clinical benefit when compared to the use of pegylated interferon alpha alone in non-responders. We cannot assure you that the results of this combination therapy will yield the favorable results we expect, or that the independent use of pegylated interferon alpha will not perform better than anticipated, which could reduce the chances that a new drug application, or NDA, will be approved. If the combination therapy of ZADAXIN and pegylated interferon alpha causes significant adverse side effects beyond those caused by pegylated interferon alpha alone, our clinical trials could be delayed, patients may drop out at a greater than anticipated rate, we may be forced to halt the trials or the FDA may reject an NDA due to safety issues. If any of the foregoing occurs, our efforts to market and sell ZADAXIN in the United States will be significantly impaired, our business will suffer and the price of our stock may decline.

The results and documentation of the hepatitis B clinical trials for ZADAXIN in Japan may not be sufficient to obtain Japanese regulatory approval.

     Our phase 3 HBV clinical trial in Japan was designed to demonstrate a clinical benefit measured by an analysis of a combination of safety and efficacy data points. We cannot assure that the results of this study will warrant favorable consideration by the Japanese Ministry of Health and Welfare or result in a marketing registration of ZADAXIN. In addition, the phase 1 and phase 2 clinical trial work for this study was sponsored and conducted by a third party and we do not have all the data and documentation relating to these trials that we believe will be necessary for us to fulfill the Japanese New Drug Application filing requirements. This information has been requested, but if we do not receive the necessary data and documentation, we may not be able to pursue filing the JNDA. If additional studies or other data are required for regulatory consideration, our

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efforts to market and sell ZADAXIN in Japan will be significantly impaired, the potential for our business in Japan will suffer and the price of our stock may decline.

If we experience higher than anticipated patient drop out rates in our clinical trials, we may not be able to obtain regulatory approval.

     Each of our two current phase 3 HCV clinical trials in the United States have enrolled the planned number of 500 patients, one trial treating patients with no liver damage and the other trial treating patients with mild cirrhosis of the liver. The trials require patient treatment for twelve months and a follow-up observation period for an additional six months. The full enrollment of the second trial has recently been achieved and all patients are scheduled to have completed therapy and observation by the end of 2005. If patient drop out rates during the course of either trial are higher than anticipated, our ability to proceed with our clinical trials and prepare an NDA would be adversely affected.

We cannot predict the safety profile of the use of ZADAXIN when used in combination with other drugs.

     Many of our trials involve the use of ZADAXIN in combination with other drugs. Some of these drugs are known to cause adverse patient reactions. Even if ZADAXIN does not produce adverse side effects when used alone, we cannot predict how it will work with other drugs, including causing possible adverse side effects not directly attributable to the other drugs that could compromise the safety profile of ZADAXIN when used in certain combination therapies.

If we lose key personnel or are unable to attract and retain additional, highly skilled personnel required for the expansion of our activities, our business will suffer. Our Board of Directors is conducting a search for a new Chief Executive Officer.

     We are highly dependent upon our ability to attract and retain qualified personnel because of the specialized, scientific and worldwide nature of our business. Following the departure of our Chief Executive Officer on July 14, 2004, we established an Office of the President, and believe that the Company will function effectively while we work to identify a new Chief Executive Officer. However, we may still be affected adversely, particularly if we cannot retain a new Chief Executive Officer in a reasonable time frame. There is intense competition for qualified management, scientific and technical personnel in the pharmaceutical industry, and we may not be able to attract and retain the qualified personnel we need to grow and develop our business globally. In addition, we assign numerous key responsibilities to a limited number of individuals, and we would experience difficulty in finding immediate replacements for any of them. If we were unable to attract and retain qualified personnel as needed or promptly replace those employees who are critical to our product development and commercialization, the development and commercialization of our products would be adversely affected. At this time, we do not maintain “key person” life insurance on any of our key personnel.

Our revenue is dependent on the sale of ZADAXIN in foreign countries, particularly China, and if we experience difficulties in our foreign sales efforts, our financial condition will be harmed.

     Our product revenue in the near term is highly dependent on the sale of ZADAXIN in foreign countries. If we experience difficulties in our foreign sales efforts, our business will suffer and our financial condition will be harmed. Substantially all of our ZADAXIN sales are to customers in China. Sales of ZADAXIN in China may be limited due to the low average personal income, lack of patient cost reimbursement, poorly developed infrastructure and existing and potential competition from other products, including generics. Several local companies have introduced lower priced locally manufactured generic competitive products. If these sales continue, there could be a negative impact on the price and the volume of ZADAXIN sold in China and this would harm our business.

     In addition, our ZADAXIN sales and operations in other parts of Asia, as well as in Latin America and the Middle East, are subject to a number of risks, including difficulties and delays in obtaining registrations, permits, pricing approvals and reimbursement and unexpected changes in regulatory requirements. In addition, we experience other issues with managing foreign sales operations including long payment cycles, difficulties in

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accounts receivable collection and, especially from significant customers, fluctuations in the timing and amount of orders. Operations in foreign countries also expose us to risks relating to difficulties in enforcing our proprietary rights, currency fluctuations and adverse or deteriorating economic conditions.

     We do not have product sales in the United States with which to offset any decrease in our revenue from ZADAXIN sales in Asia, Latin America and the Middle East. In addition, some countries in these regions, including China, regulate pharmaceutical prices and pharmaceutical importation. These regulations may reduce prices for ZADAXIN to levels significantly below those that would prevail in an unregulated market, limit the volume of product which may be imported and sold or place high import duties on the product, any of which may limit the growth of our revenues or cause them to decline.

Because of China’s tiered method of importing and distributing finished pharmaceutical products, our quarterly results may vary substantially from one period to the next.

     China uses a tiered method to import and distribute finished pharmaceutical products. At each port of entry, and prior to moving the product forward to the distributors, government-licensed importing agents must process and evaluate each shipment to determine whether such shipment satisfies China’s quality assurance requirements. In order to efficiently manage this process, the importing agents typically place large, and therefore relatively few, orders within any six month period. Therefore, our sales to an importing agent can vary substantially from quarter to quarter depending on the size and timing of the orders, which has in the past and may in the future cause our quarterly results to fluctuate. We rely on six importers to supply substantially all of our product in China. Because we use a small number of importing agents in China, our receivables from any one importing agent are material, and if we were unable to collect receivables from any importer, our business and cash-flow would be adversely affected.

Our sales of ZADAXIN may fluctuate due to seasonality of product orders and sales in any quarter may not be indicative of future sales.

     Our sales for the quarter ended June 30, 2003 were greatly affected by the demand in China for ZADAXIN in connection with the treatment of SARS. It is not possible to predict at this time if SARS will re-emerge, like influenza, as a seasonal public health problem and what effect, if any, this would have on future sales of ZADAXIN. To the extent that ZADAXIN is purchased in connection with future outbreaks of SARS or other seasonal viral contagions, product sales could become more concentrated in certain quarters of the calendar year. Quarterly sales levels could fluctuate and sales in any quarter may not be indicative of sales in future periods.

Due to the outbreak of SARS in China, sales of ZADAXIN in the second quarter of 2003 were significantly higher than expected and are not indicative of future sales.

     Our sales for the quarter ended June 30, 2003 were significantly greater than sales for any quarter in our history as a result of a previously unanticipated increase in sales of ZADAXIN to hospitals in China. This increase was related to the use of immune system enhancers, including ZADAXIN, in connection with the treatment of severe acute respiratory syndrome, or SARS. In future quarters, sales of ZADAXIN for the treatment of SARS could be affected by changes in treatment in China, changes in the rate of infection and the emergence of evidence as to the effectiveness or ineffectiveness of ZADAXIN or of other potential treatments for SARS.

     As a result of the containment of the SARS epidemic, we expect sales in future quarters to be more consistent with sales patterns of the quarters subsequent to the second quarter of 2003. We could experience fluctuations in sales in future quarters as a result of similar factors.

If we fail to protect our products, technologies and trade secrets, we may not be able to successfully use, manufacture, market or sell our products, or we may fail to advance or maintain our competitive position.

     Our success depends significantly on our ability to obtain and maintain meaningful patent protection for our products and technologies and to preserve our trade secrets. Our pending patent applications may not result in the issuance of patents in the future. Our patents or patent applications may not have priority over others’

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applications. Our existing patents and additional patents that may be issued, if any, may not provide a competitive advantage to us or may be invalidated or circumvented by our competitors. Others may independently develop similar products or design around patents issued or licensed to us. Patents issued to, or patent applications filed by, other companies could harm our ability to use, manufacture, market or sell our products or maintain our competitive position with respect to our products. Although many of our patents relating to ZADAXIN have expired, including composition of matter patents, we have rights to other patents and patent applications relating to ZADAXIN and ZADAXIN analogues, including method of use patents with respect to the use of ZADAXIN for certain indications. If other parties develop generic forms of ZADAXIN for other indications, including conducting clinical trials for such indications, our patents and other rights might not be sufficient to prohibit them from marketing and selling such generic forms of ZADAXIN. If other parties develop analogues or derivatives of ZADAXIN, our patents and other rights might not be sufficient to prohibit them from marketing these analogues or derivatives.

     Pharmaceutical products are either not patentable or have only recently become patentable in some of the countries in which we market or may market ZADAXIN. Past enforcement of intellectual property rights in many of these countries, including China in particular, has been limited or non-existent. Future enforcement of patents and proprietary rights in many other countries will likely be problematic or unpredictable. We are aware that other companies are marketing generic thymosin alpha 1 in China, possibly in violation of our trademark or other rights, and we expect such violations of our rights to continue. Moreover, the issuance of a patent in one country does not assure the issuance of a similar patent in another country. Claim interpretation and infringement laws vary by nation, so the extent of any patent protection is uncertain and may vary in different jurisdictions.

If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.

     Our commercial success depends in part on us not infringing valid, enforceable patents or proprietary rights of third parties, and not breaching any licenses that may relate to our technologies and products. We are aware of a third-party patent that may relate to our products and may cover a method of action used by ZADAXIN. We cannot assure you that our mechanism of action does not infringe on their claim. In addition, we may not be aware of all patents or patent applications that may impact our ability to make, use or sell any of our potential products. For example, U.S. patent applications may be kept confidential for 12 or more months while pending in the Patent and Trademark Office, and patent applications filed in foreign countries are often first published six months or more after filing. It is possible that we may unintentionally infringe these patents or other patents or proprietary rights of third parties. We may in the future receive notices claiming infringement from third parties as well as invitations to take licenses under third-party patents. Any legal action against us or our collaborative partners claiming damages and seeking to enjoin commercial activities relating to our products and processes affected by third-party rights may require us or our collaborative partners to obtain licenses in order to continue to manufacture or market the affected products and processes. Our efforts to defend against any of these claims, regardless of merit, would require us to devote resources and attention that could have been directed to our operations and growth plans. In addition, these actions may subject us to potential liability for damages. We or our collaborative partners may not prevail in a patent action and any license required under a patent may not be made available on commercially acceptable terms, or at all. Any conflicts resulting from the patent rights of others could significantly reduce the coverage of our patents and limit our ability to obtain meaningful patent protection.

     If other companies obtain patents with conflicting claims, we may be required to obtain licenses to those patents or develop or obtain alternative technology to manufacture or market the affected products and processes. We may not be able to obtain any such licenses on acceptable terms or at all. Any failure to obtain such licenses could delay or prevent us from pursuing the development or commercialization of our potential products. Our efforts to defend against any of these claims would require us to devote resources and attention that could have been directed to our operations and growth plans.

     We may need to initiate litigation, which could be time-consuming and expensive, to enforce our proprietary rights or to determine the scope and validity of others’ rights. If litigation results, a court may find our patents or those of our licensors invalid or may find that we have infringed on a competitor’s rights. If any of our

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competitors have filed patent applications in the United States which claim technology we also have invented, the Patent and Trademark Office may require us to participate in expensive interference proceedings to determine who has the right to a patent for the technology. These actions may subject us to potential liability for damages. We or our collaborative partners may not prevail in a patent action and any license required under a patent may not be made available on commercially acceptable terms, or at all.

We rely on third parties to supply our clinical trial and commercial products. Deficiencies in their work could delay or harm one or more important areas of our business including our sales, clinical trials or the regulatory approval process.

     We rely on third parties, who are subject to regulatory oversight, to supply our clinical and commercial products. Typically we have at any time only one supplier for each phase of manufacturing of our product. If unanticipated deficiencies in these suppliers occur, we could experience delays in our ability to assemble a timely and acceptable NDA. If sales of ZADAXIN were to increase dramatically, our third-party suppliers may not be able to supply ZADAXIN quickly enough, which could limit our ability to satisfy increased demand or could adversely affect the ability of these suppliers to provide products for our clinical trials. Not all of the ZADAXIN planned to be used in our HCV clinical trials has been manufactured and received. Roche is our exclusive supplier of pegylated interferon alpha for our current U.S. clinical trials, and we have not received all the pegylated interferon to be used in the clinical trials. Roche’s agreement with us to provide our supply of pegylated interferon alpha can be terminated by them without cause on 30-days’ notice, in which case we would need to purchase their product for use in the clinical trials. Any delay in receiving, or a recall of, pegylated interferon alpha or ZADAXIN, including by reason of Roche’s termination of its supply arrangement with us, could delay the clinical trials or detract from the integrity of the trial data. If any of the foregoing occurs, our ability to complete our clinical trials in the United States and to market and sell ZADAXIN worldwide will be delayed or impaired, our business will suffer and the price of our stock may decline. We have been in the process of qualifying a new manufacturer of ZADAXIN and if we encounter problems with this process of validation, our sales or our clinical trials could be adversely affected.

If we are not able to establish and maintain adequate manufacturing relationships, the development and sale of our products could be impaired.

     To be successful, our products must be manufactured in commercial quantities, in compliance with stringent regulatory requirements and at an acceptable cost. Typically we have at any time only one supplier for each phase of manufacturing of our product. Manufacturing interruptions or failure to comply with regulatory requirements could significantly delay clinical development of potential products and reduce third-party or clinical researcher interest and support of proposed trials. These interruptions or failures could also impede commercialization of our products, including sales of ZADAXIN in approved markets, and impair our competitive position. Any of these developments would harm our business.

     We are in the process of qualifying a new supplier for ZADAXIN with regulatory agencies. This process, quality assurance and other steps could cause delays or interruptions of supply. If we do not obtain the required regulatory approvals for a manufacturing change in a timely fashion, especially in China, our sales may be interrupted until the manufacturing change is approved. Although we are increasing inventories to prepare to manage any such occurrences, we may still experience interruptions in supply which could adversely affect our results.

     In some countries, a manufacturing change may require additional regulatory approvals which may delay ZADAXIN marketing approvals in new markets.

     In addition, manufacturing, supply and quality control problems may arise as we, either alone or with subcontractors, attempt to scale-up our manufacturing procedures. We may not be able to scale-up in a timely manner or at a commercially reasonable cost, either of which could cause delays or pose a threat to the ultimate commercialization of our products and harm our business.

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We may not be able to successfully develop or commercialize our products. We may consider strategic alliances with other companies in efforts to broaden our product development pipeline.

     While we have limited sales of ZADAXIN in certain markets, we do not yet have regulatory approval for ZADAXIN for our principal target markets, and, in this respect, ZADAXIN is still being developed. Our other potential products are in earlier stages of development than ZADAXIN. We may consider and undertake various strategies to expand our portfolio of potential products, including acquiring product candidate rights through licenses or other relationships, or through other strategic relationships including acquisitions of other companies that may have proprietary rights to other development candidates or the capability to discover new drug candidates. Such transactions could require a substantial amount of our financial resources, or, if equity is involved, may result in substantial dilution to current stockholders. Strategic transactions also require substantial management time and effort and are subject to various risks that could adversely affect us or our financial results.

     To fully develop our products, we will need to commit substantial resources to extensive research, development, pre-clinical testing, clinical trials, manufacturing scale-up and regulatory approval prior to being ready for sale. We cannot assure that our efforts will produce commercially viable products. We face significant technological risks inherent in developing these products. We may also abandon some or all of our proposed products before they become commercially viable. If any of our products, even if developed and approved, cannot be successfully commercialized in a timely manner, our business will be harmed and the price of our stock may decline.

     We have not yet sold any product other than ZADAXIN and our sales have been primarily in a single country, China. Our future revenue growth depends on increased market acceptance and commercialization of ZADAXIN in additional countries, particularly in the United States, Europe and Japan. If we fail to successfully market ZADAXIN, or if we cannot commercialize this drug in the United States and other additional markets, our revenue and operating results will suffer. If unexpected and serious adverse events are reported, or if expected efficacy results are not achieved, it would have a material adverse effect on our business. Our future revenue will also depend in part on our ability to develop other commercially viable and accepted products. Market acceptance of our products will depend on many factors, including our ability to convince prospective customers to use our products as an alternative to other treatments and therapies and to convince prospective strategic partners to market our products effectively and to manufacture our products in sufficient quantities with acceptable quality and at an acceptable cost. In addition, doctors must opt to use treatments involving our products. If doctors elect to use a different course of treatment, demand for our drug products would be reduced. Failure to do any of the above will lead to unfavorable outcome on the results of our operations.

We rely on third-party clinical investigators to conduct our clinical trials and, as a result, we may encounter delays outside our control.

     We have limited experience in conducting and managing clinical trials and we rely, in part, on third parties, particularly clinical research organizations and our development partners, to assist us in managing and monitoring clinical trials. Our reliance on these third parties may result in delays in completing, or failure to complete, these clinical trials if third parties fail to fulfill their obligations to us.

We may need to obtain additional capital to support our long-term product development and commercialization programs.

     We believe our existing resources will be sufficient to complete our current U.S. phase 3 clinical trials and, if the trials are successful and we receive FDA approval, to begin commercialization of ZADAXIN in the United States. However, we cannot assure that such funds will be sufficient, or that sales of ZADAXIN, if approved in the United States, will result in profitable operations. In addition, we may need additional funds in the future to support future growth and achieve profitability. If we need to raise additional funds in the future and such funds are not available on reasonable terms, if at all, our commercialization efforts may be impeded, our revenues may be limited and our operating results may suffer.

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We have a history of operating losses and an accumulated deficit. We expect to continue to incur losses in the near term and may never achieve profitability.

     We have experienced significant operating losses since our inception, and as of September 30, 2004, we had an accumulated deficit of approximately $149 million. We expect our operating expenses to increase over the next several years as we plan to dedicate substantially all of our resources to expanding our development, testing and marketing capabilities, particularly in the United States, and these losses may increase if we cannot increase or sustain revenue. As a result, we may never achieve profitability.

We have limited sales, marketing and distribution capabilities, which may adversely affect our ability to successfully commercialize our products.

     We currently have limited sales, marketing and distribution capabilities, and we anticipate that we may be relying on third-party collaborators to sell, market and distribute our products for the foreseeable future. If our arrangements with these third parties are not successful, or if we are unable to enter into additional third-party arrangements, we may need to substantially expand our sales, marketing and distribution force. Our efforts to expand may not succeed, or we may lack sufficient resources to expand in a timely manner, either of which will harm our operating results. Moreover, if we are able to further expand our sales, marketing and distribution capabilities, we will begin competing with other companies that have experienced and well-funded operations. If we cannot successfully compete with these larger companies, our revenues may not grow and our business may suffer.

Commercialization of some of our products depends on collaborations with others. If our collaborators are not successful, or if we are unable to find future collaborators, we may not be able to properly develop and commercialize our products.

     We depend in part on our distributors and business partners to develop and/or promote our drugs, and if they are not successful in their efforts or fail to do so, our business will suffer. For example, Sigma-Tau is responsible for the development and marketing of ZADAXIN in Europe. We generally do not have control over the amount and timing of resources that our business partners devote to ZADAXIN, and they have not always performed as or when expected. If they do not perform their obligations as we expect, particularly obligations regarding clinical trials, our development expenses would increase and the development and/or sale of our products could be limited or delayed, which could hurt our business and cause our stock price to decline. In addition, our relationships with these companies may not be successful. Disputes may arise with our collaborators, including disputes over ownership rights to intellectual property, know-how or technologies developed with our collaborators. We may not be able to negotiate similar additional arrangements in the future to develop and commercialize ZADAXIN or other products.

We may lose market share or otherwise fail to compete effectively in the intensely competitive biopharmaceutical industry.

     Competition in the biopharmaceutical industry is intense, and we expect that competition will increase. Our success depends on our ability to compete in this industry, but we cannot assure you that we will be able to successfully compete with our competitors. Increased competitive pressure could lead to intensified price-based competition resulting in lower prices and margins, which would hurt our operating results.

     We are focused on developing ZADAXIN as a treatment for HCV and HBV and certain cancers. Several large biopharmaceutical companies have substantial commitments to interferon alpha, an approved drug for treating HBV and HCV, and to lamivudine and adefovir, approved drugs to treat HBV. We cannot assure you that we will compete successfully against our competitors or that our competitors, or potential competitors, will not develop drugs or other treatments for HCV, HBV, cancer and other diseases that will be superior to ours.

If third-party reimbursement is not available or patients cannot otherwise pay for ZADAXIN, we may not be able to successfully market ZADAXIN.

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     Significant uncertainty exists as to the reimbursement status of new therapeutic products, such as ZADAXIN. We cannot assure you that third-party insurance coverage and reimbursement will be available for therapeutic products we might develop. The failure to obtain third-party reimbursement for our products, particularly in the United States, Europe and Japan, would harm our business. Further, we cannot assure you that additional limitations will not be imposed in the future in the United States on drug coverage and reimbursement due to proposed health care reforms. In many emerging markets where we have marketing rights to ZADAXIN, but where government resources and per capita income may be so low that our products will be prohibitively expensive, we may not be able to market our products on economically favorable terms, if at all.

     Efforts by governmental and third-party payers to contain or reduce health care costs or the announcement of legislative proposals or reforms to implement government controls could cause us to reduce the prices at which we market our drugs, which will reduce our gross margins and may harm our business.

We may be subject to product liability lawsuits, and our insurance may be inadequate to cover damages.

     Clinical trials or marketing of any of our current and potential products may expose us to liability claims from the use of these products. We currently carry product liability insurance. However, we cannot be certain that we will be able to maintain insurance on acceptable terms, if at all, for clinical and commercial activities or that the insurance would be sufficient to cover any potential product liability claim or recall. If we fail to have sufficient coverage, our business, results of operations and cash flows could be adversely affected.

We depend on international sales, and global conditions could negatively affect our operating results.

     A large majority of our sales are in China. Heightened tensions resulting from the current geopolitical conditions in the Middle East, North Korea and elsewhere could worsen, causing disruptions in foreign trade, which would harm our sales. In particular, our commercial product is manufactured in Europe and distributed by us from our operations in Hong Kong. Any disruption of our supply and distribution activities due to geopolitical conditions could decrease our sales and harm our operating results.

If we are unable to comply with environmental and other laws and regulations, our business may be harmed.

     We are subject to various federal, state and local laws, regulations and recommendations relating to the use, manufacture, storage, handling and disposal of hazardous materials and waste products (including radioactive compounds and infectious disease agents), as well as safe working conditions, laboratory and manufacturing practices and the experimental use of animals. The extent of government regulation that might result from future legislation or administrative action in these areas cannot be accurately predicted.

     We do not currently maintain hazardous materials at our facilities. While we outsource our research and development programs involving the controlled use of biohazardous materials, if in the future we conduct these programs ourselves, we might be required to incur significant cost to comply with environmental laws and regulations. Further, in the event of an accident, we would be liable for any damages that result, and the liability could exceed our resources.

Our stock price may be volatile, and an investment in our stock could suffer a decline in value.

     The market price of our common stock has experienced, and may continue to experience, substantial volatility due to many factors, some of which we have no control over, including:

•

progress and results of clinical trials involving ZADAXIN;

•

progress of ZADAXIN through the regulatory process, especially regulatory actions in the United States, Europe and Japan;

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timing and achievement of milestones;

•

announcements of technological innovations or new products by us or our competitors;

•

government regulatory action affecting our drug products or our competitors’ drug products in both the United States and foreign countries;

•

developments or disputes concerning patent or proprietary rights;

•

changes in company assessments or financial estimates by securities analysts;

•

actual or anticipated fluctuations in our quarterly operating results;

•

general stock market conditions and fluctuations for the emerging growth and biopharmaceutical market sectors;

•

economic conditions in the United States or abroad; and

•

broad financial market fluctuations in the United States, Europe or Asia.

     In the past, following periods of large price declines in the public market price of a company’s securities, securities class action litigation has often been initiated against that company. Litigation of this type could result in substantial costs and diversion of our attention and resources, which would hurt our business. Any adverse determination in litigation could also subject us to significant liabilities.

Substantial sales of our stock or the exercise or conversion of options or convertible securities may impact the market price of our common stock.

     As of September 30, 2004, stock options to purchase 6,653,084 shares of common stock were outstanding, of which options to purchase 4,809,188 shares were exercisable. Also outstanding as of the same date were warrants exercisable for 904,760 shares of common stock at $7.00 per share and two notes convertible into a total of 684,140 shares of common stock. The note holder has the right to purchase up to $8.3 million of additional convertible notes due on or before March 2006, which, if fully issued, will be convertible into 684,140 shares of our common stock. Upon exercise of options or warrants, or conversion of the notes, these issued shares of common stock will be freely tradable.

     Future sales of substantial amounts of our common stock could adversely affect the market price of our common stock. Similarly, if we raise additional funds through the issuance of common stock or securities convertible into or exercisable for common stock, the percentage ownership of our stockholders will be reduced and the price of our common stock may fall.

Sales of our common stock by officers and directors and a former officer could affect our stock price.

     Our Board of Directors has approved an amendment to our trading policy that permits officers and directors to enter into trading plans that comply with the requirements of Rule 10b5-1 of the Securities and Exchange Act of 1934. Rule 10b5-1 allows corporate officers and directors to adopt written, pre-arranged stock trading plans when they do not have material, non-public information. Using these plans, officers and directors can gradually diversify their investment portfolios, can spread stock trades out over an extended period of time to reduce any market impact and can avoid concerns about initiating stock transactions at a time when they might be in possession of material, non-public information. As of November 1, 2004, only one director has adopted such a plan, and other directors or officers may do so in the future. In general our officers and directors have rarely sold stock in the Company, though they have held options or stock for many years. However, the separation of our former Chief Executive Officer from the Company in July 2004 may affect his personal financial plans and result in both his exercising of stock options and selling of stock which may affect the trading price of our stock. We expect future sales by officers and directors either under 10b5-1 plans or otherwise as a result of their personal

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financial planning. We do not believe the volume of such sales would affect our trading price, however, the market could react negatively to sales by our officers and directors, which could affect the trading price of our stock.

Anti-takeover provisions in our charter documents and under Delaware law may make an acquisition of us, which may be beneficial to our stockholders, more difficult.

     Certain anti-takeover provisions of Delaware law and our charter documents as currently in effect may make a change in control of our company more difficult, even if a change in control would be beneficial to the stockholders. Prior to our reincorporation in Delaware, we had a stockholder rights plan, also commonly known as a “poison pill,” which we terminated in connection with the reincorporation. We currently do not intend to adopt a stockholder rights plan. However, our charter documents do contain certain anti-takeover provisions, including provisions in our certificate of incorporation providing that stockholders may not cumulate votes, stockholders’ meetings may be called by stockholders only if they hold 25% or more of our common stock and provisions in our bylaws providing that the stockholders may not take action by written consent. Additionally, our board of directors has the authority to issue 10 million shares of preferred stock and to determine the terms of those shares of stock without any further action by the stockholders. The rights of holders of our common stock are subject to the rights of the holders of any preferred stock that may be issued. The issuance of preferred stock could make it more difficult for a third-party to acquire a majority of our outstanding voting stock. Delaware law also prohibits corporations from engaging in a business combination with any holders of 15% or more of their capital stock until the holder has held the stock for three years unless, among other possibilities, the board of directors approves the transaction. Our board of directors may use these provisions to prevent changes in the management and control of our company. Also, under applicable Delaware law, our board of directors may adopt additional anti-takeover measures in the future.

If we are unable to favorably assess the effectiveness of our internal control over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, our stock price could be adversely affected.

     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and beginning with our Annual Report on Form 10-K for the fiscal year ending December 31, 2004, our management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal control over financial reporting as of the end of 2004. The rules governing the standards that must be met for management to assess our internal control over financial reporting are new and complex, and require significant documentation, testing and possible remediation. We are currently in the process of reviewing, documenting and testing our internal control over financial reporting, which has and may continue to result in increased expenses and the devotion of significant management resources. We may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal control over financial reporting. In addition, in connection with the attestation process by our independent auditors, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal control over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, investor confidence and our stock price could be adversely affected.

New accounting pronouncements are likely to impact our future financial position or results of operations.

     Changes in financial accounting standards, including proposed changes in accounting for stock options, may cause adverse and potentially unexpected, fluctuations in the timing of the recognition of revenues or expenses and may affect our financial position or results of operations. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in the future and we may make changes in our accounting policies in the future to comply with them.

New legislation may impact our operations and financial position or results of operations.

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     Compliance with changing regulations concerning corporate governance and public disclosure has resulted in and may continue to result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules, are creating uncertainty for companies such as ours and costs are increasing as a result of this uncertainty and other factors. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

We may be subject to currency exchange rate fluctuations, which could adversely affect our financial performance.

     Substantially all of our product sales are denominated in U.S. dollars. Fluctuation in the U.S. dollar exchange rate with local currency directly affects the customer’s cost for our product. In particular, a stronger U.S. dollar vis-à-vis the local currency would tend to have an adverse effect on sales and potentially on collection of accounts receivable. To date, this exposure to currency exchange rate fluctuations has been minimal because the Chinese currency has been pegged to the U.S. dollar. However, the fixed nature of the Chinese currency in relation to the U.S. dollar may not continue in the future and, consequently, our foreign operations may expose us to greater risk of currency exchange rate fluctuations in the future. In addition, we are subject to currency exchange rate fluctuations as a result of expenses incurred by our foreign operations. In particular, one of our supply arrangements under which we purchase finished products is denominated in euros. Consequently, changes in exchange rates could unpredictably and adversely affect our operating results and could result in exchange losses. To date, we have not hedged against the risks associated with fluctuations in exchange rates and, therefore, exchange rate fluctuations could have a material adverse impact on our operating results and stock price.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

     The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest primarily in U.S. Treasury or U.S. government agency notes. Our investments in these notes are subject to interest rate risk. To minimize the exposure due to an adverse shift in interest rates, we invest in short-term notes and maintain an average maturity of less than one year. A hypothetical 60 basis point increase in interest rates would result in an approximate $256,916 decrease (0.6%) in fair value of our available-for-sale securities. This potential change is based on sensitivity analyses performed on our financial position at September 30, 2004. Actual results may differ materially.

     Substantially all our sales and most of our manufacturing costs to date have been in U.S. dollars. Our purchases from one of our contract manufacturers, however, are denominated in euros and this exposes us to foreign currency rate fluctuations. Consequently, changes in exchange rates could unpredictably and adversely affect our operating results and could result in exchange losses. To date, we have not hedged against the risks associated with fluctuations in exchange rates and, therefore, exchange rate fluctuations could have a material adverse impact on our operating results and stock price.

Item 4. Controls and Procedures

     Under the supervision and with the participation of our management, including our Chief Financial Officer and both members of our Office of the President, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our Chief Financial Officer and the members of our Office of the President concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

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PART II. OTHER INFORMATION

Item 6. Exhibits

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*Certain information in this exhibit has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.

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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.

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INDEX TO EXHIBITS

* Certain information in this exhibit has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.

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