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EX-31 - EX-31 - PENWEST PHARMACEUTICALS COb81600exv31.htm
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EX-10.2 - EX-10.2 - PENWEST PHARMACEUTICALS COb81600exv10w2.htm
EX-10.4 - EX-10.4 - PENWEST PHARMACEUTICALS COb81600exv10w4.htm
EX-10.3 - EX-10.3 - PENWEST PHARMACEUTICALS COb81600exv10w3.htm
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2010
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from     to    
Commission File Number 001-34267
PENWEST PHARMACEUTICALS CO.
(Exact name of registrant as specified in its charter)
     
Washington
(State or other jurisdiction of
incorporation or organization)
  91-1513032
(I.R.S. Employer
Identification No.)
     
2981 Route 22
Suite 2
Patterson, New York

(Address of Principal Executive Offices)
  12563-2335
(Zip Code)
(877) 736-9378
(Registrant’s telephone number, including area code)
Not Applicable
(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 þ No o
     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
Accelerated filer þ Non-accelerated filer o Smaller reporting company o
 
  (Do not check if a smaller reporting company)  
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
        Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of August 2, 2010.
     
Class
  Outstanding
Common Stock, par value $.001   31,946,576
 
 


 

PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS
             
        Page
PART I — FINANCIAL INFORMATION
 
           
  Condensed Financial Statements (Unaudited):        
 
  Condensed Balance Sheets     3  
 
  Condensed Statements of Operations     4  
 
  Condensed Statements of Cash Flows     5  
 
  Notes to Condensed Financial Statements     6  
 
           
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     23  
 
           
  Quantitative and Qualitative Disclosures About Market Risk     36  
 
           
  Controls and Procedures     36  
 
           
PART II — OTHER INFORMATION
 
           
  Legal Proceedings     37  
 
           
Item 1A.    
  Risk Factors     41  
 
           
  Exhibits     53  
 
           
Signature     54  
 
           
Exhibit Index     55  
 EX-10.1
 EX-10.2
 EX-10.3
 EX-10.4
 EX-31
 EX-32
     TIMERx®, Geminex® and SyncroDose® are our registered trademarks. GastroDose™ is also our trademark. Other tradenames and trademarks appearing in this quarterly report, including Endo Pharmaceuticals Inc.’s Opana® trademark, are the property of their respective owners.
Forward Looking Statements
     This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,” “may,” “projects,” “will,” “could,” “should,” “targets,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we will actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. These important factors include those set forth under “Part II — Item 1A, Risk Factors”. In light of these risks, uncertainties, assumptions and factors, the forward-looking events discussed herein may not occur, and our actual performance and results may vary from those anticipated or otherwise suggested by such statements. In addition, any forward-looking statements represent our estimates only as of the date this quarterly report is filed with the Securities and Exchange Commission (“SEC”) and should not be relied upon as representing our estimates as of any other date. While we may elect to update these forward-looking statements, we specifically disclaim any obligation to do so, even if our estimates change.


Table of Contents

PART I — FINANCIAL INFORMATION
Item 1. Condensed Financial Statements (Unaudited)
PENWEST PHARMACEUTICALS CO.
CONDENSED BALANCE SHEETS
                 
       June 30,        December 31,  
    2010     2009  
    (In thousands, except share  
    amounts)  
       
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 13,098     $ 11,246  
Marketable securities
    1,309       240  
Trade accounts receivable
    13,204       6,226  
Inventories, net
    604       263  
Prepaid expenses and other current assets
    980       1,289  
 
           
Total current assets
    29,195       19,264  
Fixed assets, net
    1,233       1,576  
Patents, net
    876       996  
Deferred charges
    1,591       1,740  
Deferred income taxes
    310        
Other assets, net
    2,155       2,320  
 
           
Total assets
  $ 35,360     $ 25,896  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
  $ 587     $ 750  
Accrued expenses
    1,269       2,178  
Accrued development costs
    283       275  
Income taxes payable
    110        
Loan payable
    1,371       4,112  
Deferred compensation — current portion
    291       294  
 
           
Total current liabilities
    3,911       7,609  
Deferred revenue
    865       889  
Deferred compensation
    2,238       2,376  
 
           
Total liabilities
    7,014       10,874  
Commitments and contingencies (see Note 15)
               
Shareholders’ equity:
               
Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding
           
Common stock, par value $.001, authorized 60,000,000 shares, issued and outstanding 31,931,076 shares at June 30, 2010 and 31,778,416 shares at December 31, 2009
    32       32  
Additional paid-in capital
    251,065       249,982  
Accumulated deficit
       (222,888 )       (235,127 )
Accumulated other comprehensive income
    137       135  
 
           
Total shareholders’ equity
    28,346       15,022  
 
           
Total liabilities and shareholders’ equity
  $ 35,360     $ 25,896  
 
           
See accompanying notes to condensed financial statements

3


Table of Contents

PENWEST PHARMACEUTICALS CO.
CONDENSED STATEMENTS OF OPERATIONS
                                    
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2010   2009   2010   2009
    (Unaudited)   (Unaudited)
    (In thousands, except   (In thousands, except
    per share data)   per share data)
Revenues:
                               
Royalties
  $ 12,717     4,851     $ 20,370     $ 9,573  
Product sales
    90       158       292       338  
Collaborative licensing and development revenue
    832       250       1,735       618  
 
         
 
                   
Total revenues
    13,639       5,259       22,397       10,529  
 
                               
Operating expenses:
                               
Cost of revenues
    833       468       1,749       1,122  
Selling, general and administrative
    2,453       3,283       4,099       5,604  
Research and product development
    1,903       3,425       4,111       6,431  
 
         
 
                   
Total operating expenses
    5,189       7,176       9,959       13,157  
 
         
 
                   
Income (loss) from operations
    8,450       (1,917 )     12,438       (2,628 )
 
                               
Investment income
    2       4       3       11  
Interest expense
    (83 )     (225 )     (202 )     (483 )
 
         
 
                   
Income (loss) before income tax expense
    8,369       (2,138 )     12,239       (3,100 )
 
                               
Income tax expense
                       
 
         
 
                   
Net income (loss)
  $ 8,369     (2,138 )   $ 12,239     $ (3,100 )
 
         
 
                   
 
                               
Net income (loss) per common share:
                               
Basic
  $ 0.26     (0.07 )   $ 0.38     $ (0.10 )
 
         
 
                   
Diluted
  $ 0.26     (0.07 )   $ 0.38     $ (0.10 )
 
         
 
                   
 
                               
Weighted average shares of common stock outstanding:
                               
Basic
    31,866       31,644       31,837       31,635  
 
         
 
                   
Diluted
    32,064       31,644       31,997       31,635  
 
         
 
                   
See accompanying notes to condensed financial statements

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PENWEST PHARMACEUTICALS CO.
CONDENSED STATEMENTS OF CASH FLOWS
                 
    Six Months Ended
    June 30,
    2010   2009
    (Unaudited)
    (In thousands)
Operating activities:
               
Net income (loss)
  $ 12,239     $ (3,100 )
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities
    (6,706 )           1,607  
 
               
Net cash provided by (used in) operating activities
    5,533       (1,493 )      
 
               
Investing activities:
               
Acquisitions of fixed assets
          (16 )
Patent costs
          (34 )
Proceeds from sale of fixed assets
          6  
Reimbursements of patent costs by collaborator
          229  
Purchases of marketable securities
    (1,558 )     (499 )
Proceeds from maturities of marketable securities
    490        
 
               
Net cash used in investing activities
    (1,068 )     (314 )
 
               
Financing activities:
               
Repayment of debt
    (2,742 )     (2,741 )
Issuance of common stock
    129       30  
 
               
Net cash used in financing activities
    (2,613 )     (2,711 )
 
               
 
               
Net increase (decrease) in cash and cash equivalents
    1,852       (4,518 )
Cash and cash equivalents at beginning of period
    11,246       16,692  
 
               
Cash and cash equivalents at end of period
  $ 13,098     $ 12,174  
 
               
See accompanying notes to condensed financial statements

5


Table of Contents

PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited)
1. Business
     Penwest Pharmaceuticals Co. (“Penwest” or the “Company”) is a drug delivery company focused on applying its drug delivery technologies and drug formulation expertise to the formulation of product candidates under licensing collaborations (“drug delivery technology collaborations”). Penwest’s drug delivery technology is included in Opana® ER, a product for the treatment of moderate to severe chronic pain marketed by Endo Pharmaceuticals Inc., (“Endo”). The Company is also developing A0001, or a-tocopherolquinone, for the treatment of Friedreich’s Ataxia and MELAS syndrome.
     Opana® ER is an extended release formulation of oxymorphone hydrochloride that the Company developed with Endo using the Company’s proprietary extended release TIMERx® drug delivery technology. Opana ER was approved by the United States Food and Drug Administration (“FDA”) in June 2006 for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time, and is being marketed by Endo in the United States. In the six month period ended June 30, 2010, the Company recognized $19.5 million in royalties from Endo related to sales of Opana ER. In June 2009, Endo signed an agreement with Valeant Pharmaceuticals International (“Valeant”) to develop and commercialize Opana ER in Canada, Australia and New Zealand. Opana ER is not currently approved for sale in any country other than the United States.
     The Company is conducting two Phase IIa clinical trials of A0001. The Company is conducting one trial in patients with Friedreich’s Ataxia (“FA”), a rare degenerative neuro-muscular disorder, and the second trial in patients with the A3243G mitochondrial DNA point mutation that is commonly associated with MELAS syndrome, a rare progressive neurodegenerative disorder. The goal of these trials is to determine if A0001 has a discernible impact in the treatment of patients with these disorders using various biochemical, functional and clinical measures. The Company expects data from both of these trials by the end of 2010. In September 2009, the Company exercised its option under its agreement with Edison Pharmaceuticals, Inc. (“Edison”) to acquire the right to a second drug candidate for the treatment of mitochondrial diseases from Edison. The Company has determined not to conduct any additional development work on this compound until after it reviews the results of the Phase IIa studies of A0001. The Company is currently seeking to license A0001 to a third party to complete further development and assume responsibility for the commercialization, manufacturing and marketing of this compound.
     The Company is a party to a number of collaborations involving the use of its extended release drug delivery technologies as well as its formulation development expertise. Under these collaborations, the Company is responsible for completing the formulation work on a product specified by the collaborator using the Company’s proprietary extended release technology. If the Company successfully formulates the compound, it will transfer the formulation to its collaborator, who will then be responsible for the completion of the clinical development, manufacturing, and ultimately, the commercialization of the product. The Company has drug delivery technology collaborations with Otsuka Pharmaceuticals Co. (“Otsuka”) and with Alvogen Inc. (“Alvogen”).
2. Basis of Presentation
     The accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) 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 U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation for the interim periods presented have been included. All such adjustments are of a normal recurring nature except for: a non-cash charge recorded in the three month period ended June 30, 2010 in the amount of $467,000 for the accelerated vesting of certain outstanding stock option and restricted stock awards (see Note 8); and costs incurred by the Company approximating $821,000 and $846,000 for the three and six month periods ended June 30, 2010, respectively, in connection with the Company’s proxy contest associated with its 2010 annual meeting of shareholders; a charge recorded in the six month period ended June 30, 2009 in the amount of $550,000 for severance costs associated with staff reductions implemented in January 2009; a non-cash credit recorded in the six month period ended June 30, 2009 in the amount of $885,000 associated with the forfeiture of stock options held by these former employees (see Note 10); and costs incurred by the Company approximating $1.1 and $1.3 million for the three and six month

6


Table of Contents

PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
periods ended June 30, 2009, respectively, in connection with the Company’s proxy contest associated with the Company’s 2009 annual meeting of shareholders and the related litigation. Operating results for the three and six month periods ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. For further information, refer to the financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
     The balance sheet at December 31, 2009 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.
     During the three and six month periods ended June 30, 2010, there were no significant changes in the Company’s significant accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.
     The Company evaluates subsequent events occurring between the most recent balance sheet date and the date that the financial statements are available to be issued, in order to determine whether the subsequent events are to be recorded in and/or disclosed in the Company’s financial statements and footnotes. The financial statements are considered to be available to be issued at the time that they are filed with the SEC.
3. Recent Accounting Pronouncements
     In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2009-13, “Multiple-Deliverable Revenue Arrangements” (“ASU 2009-13”). ASU 2009-13, amends existing revenue recognition accounting pronouncements that are currently within the scope of Accounting Standards Codification (“ASC”) Subtopic 605-25. This authoritative guidance provides principles for allocation of consideration among its multiple-elements, allowing more flexibility in identifying and accounting for separate deliverables under an arrangement. ASU 2009-13 introduces an estimated selling price method for valuing the elements of a bundled arrangement if vendor-specific objective evidence or third-party evidence of selling price is not available, and significantly expands related disclosure requirements. This guidance is effective on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Alternatively, adoption may be on a retrospective basis, and early application is permitted. The Company is currently evaluating the impact that the adoption of this guidance will have on its results of operations, financial position or cash flows.
     In January 2010, the FASB issued Accounting Standards Update No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820)” (“ASU 2010-06”). This authoritative guidance provides amendments to Subtopic 820-10 and related guidance within U.S. GAAP to require disclosure of the transfers in and out of Levels 1 and 2, and a schedule for Level 3 that separately identifies purchases, sales, issuances and settlements. It also amends disclosure requirements to increase the required level of disaggregate information regarding classes of assets and liabilities that make up each level, and more detail regarding valuation techniques and inputs. This guidance is effective for fiscal years beginning on or after December 15, 2009, except for the disclosure regarding Level 3 activity, which is effective for fiscal years beginning after December 15, 2010. The Company’s adoption of ASU 2010-06 as of January 1, 2010 did not have a material effect on its results of operations, financial position or cash flows.
     In April 2010, the FASB issued Accounting Standards Update No. 2010-17, “Milestone Method of Revenue Recognition (Topic 605)” (“ASU 2010-17”). This update provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Authoritative guidance on the use of the milestone method did not previously exist. This guidance is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Alternatively, retrospective adoption is permitted for all prior periods. The Company is currently evaluating the impact that the adoption of this guidance will have on its results of operations, financial position or cash flows.
     Other pronouncements issued by the FASB or other authoritative accounting standards groups with future effective dates are either not applicable or not significant to the financial statements of the Company.

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Table of Contents

PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
4. Per Share Data
Income (Loss) Per Share
This table shows the computation of basic and diluted income (loss) per share (in thousands, except per share data):
                                 
    Three Months Ended     Six Months Ended  
   
June 30
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Numerator:
                               
Net income (loss)
  $ 8,369     $ (2,138 )   $ 12,239     $ (3,100 )
 
                               
Denominator:
                               
Denominator for basic income (loss) per common share - weighted average shares
    31,866       31,644       31,837       31,635  
Dilutive effect of employee stock options
    198             160        
 
                       
 
                               
Denominator for diluted income (loss) per common share – weighted average shares
    32,064       31,644       31,997       31,635  
 
                       
 
                               
Income (loss) per common share-basic
  $ 0.26     $ (0.07 )   $ 0.38     $ (0.10 )
 
                       
Income (loss) per common share-diluted
  $ 0.26     $ (0.07 )   $ 0.38     $ (0.10 )
 
                       
     The following are the potential shares of common stock, which were excluded from the calculation of weighted-average shares outstanding because their effect was determined to be anti-dilutive. For the three and six month periods ended June 30, 2010, all of the exercise prices of the outstanding stock options and the exercise price of the outstanding warrants included in the table below were each greater than the average market price per share for such period. For the three and six month periods ended June 30, 2009, the Company incurred a net loss and thus anti-dilutive.
                                 
    Three Months Ended     Six Months Ended  
   
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
    (In thousands of shares)  
Stock options outstanding
    1,500       2,727       1,548       2,625  
Restricted stock outstanding (unvested)
          90             92  
Warrants to purchase common stock
    4,070       4,070       4,070       4,070  
 
                       
 
    5,570       6,887       5,618       6,787  
 
                       
5. Fair Value Measurement
     Financial assets and financial liabilities are required to be measured and reported on a fair value basis using the following three categories for classification and disclosure purposes:
     Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.
     Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.
     Level 3: Unobservable inputs that are used when little or no market data is available. The fair value hierarchy gives the lowest priority to Level 3 inputs.
     In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Company also considers counterparty credit risk in its assessment of fair value.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
     Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2010 are classified in the table below in one of the three categories described above:
                                 
    Level 1     Level 2     Level 3   Total  
    (In thousands)  
Cash and cash equivalents
  $ 13,098     $     $     $ 13,098  
Marketable securities
          1,309             1,309  
Money market account
    77                   77  
 
                       
Total
  $ 13,175     $ 1,309     $     $ 14,484  
 
                       
     Marketable securities consist of debt securities issued by a U.S. government sponsored enterprise and corporate commercial paper. Each security is valued by the Company, after considering a third party pricing service that reviews various market makers. The original maturity of the securities are greater than three months but do not exceed one year.
     There were no transfers of financial assets or liabilities as described in the table above between Level 1 and Level 2 during the six month period ended June 30, 2010.
     Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2009 are classified in the table below in one of the three categories described above:
                                 
    Level 1     Level 2   Level 3   Total  
    (In thousands)  
Cash and cash equivalents
  $ 11,246     $     $     $ 11,246  
Marketable securities
          240             240  
Money market account
    296                   296  
 
                       
Total
  $ 11,542     $ 240     $     $ 11,782  
 
                       
     Marketable securities consist of a certificate of deposit issued by a banking institution. The original maturity was greater than three months but did not exceed one year. The certificate of deposit matured in January 2010. At December 31, 2009, the Company did not have any certificates of deposit in amounts which were in excess of the FDIC insurance limit.
6. Other Assets
     Other assets, net are comprised of the following:
                 
    June 30,   December 31,
    2010   2009
    (Unaudited) (In thousands)
 
               
Assets held in a trust for the Company’s Supplemental Executive Retirement Plan and Deferred Compensation Plan (see Note 12):
               
Cash surrender value of life insurance policies
  $ 2,078     $ 2,024  
Money market account
    77       296  
 
           
 
    2,155       2,320  
Loan receivable from collaborator (see Note 14)
    1,000       1,000  
 
           
 
    3,155       3,320  
Allowance for loan receivable from collaborator
    (1,000 )     (1,000 )
 
           
Other assets, net
  $ 2,155     $ 2,320  
 
           
     The cash surrender value of life insurance policies held in the trust for the Company’s Supplemental Executive Retirement Plan are recorded at contract value as determined by the issuer of the policies, which approximates fair value. Contract value is the relevant measurement attribute because contract value is the amount the Company would receive if it were to initiate permitted transactions under the terms of the policies. The money market account held in the trust is measured and reported at fair value and classified as Level 1 as reflected in Note 5.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
7. Loan Payable
Credit Facility
     On March 13, 2007, the Company entered into a $24.0 million senior secured credit facility (the “Credit Facility”) with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., which was acquired by GE Capital in February 2008 and is now known as GE Business Financial Services Inc. The Credit Facility consists of: (i) a $12.0 million term loan advanced upon the closing of the Credit Facility and (ii) a $12.0 million term loan that the Company had the right to access until September 15, 2008, subject to conditions specified in the credit agreement. The Company did not access the second $12.0 million term loan prior to September 15, 2008, at which time it expired in accordance with the terms of the agreement.
     In connection with the Credit Facility, the Company granted the lender a perfected first priority security interest in all existing and after-acquired assets of the Company, excluding: (i) its intellectual property, which is subject to a negative pledge to GE Business Financial Securities Inc.; (ii) royalty payments from Mylan on its sales of Pfizer Inc.’s (“Pfizer”) generic version of Procardia XL 30 mg, if the Company pledges such royalty payments to another lender; (iii) up to $3.0 million of equipment which the Company may, at its election, pledge to another lender in connection with an equipment financing facility separate from the Credit Facility; and (iv) the assets of the Company’s trust described in Note 12. In addition, the Company is precluded from paying cash dividends to its shareholders during the term of the Credit Facility. The outstanding term loan has a term of 42 months from the date of advance of March 13, 2007. Interest-only payments were due for the first nine months; interest plus monthly principal payments equal to 1.67% of the loan amount were due for the period from the end of the interest-only period through December 2008; and interest plus straight-line amortization payments with respect to the remaining principal balance are due for the remainder of the term, through the loan’s maturity date in September 2010.
     The interest rate of the outstanding term loan is fixed at 10.32%. At the time of the final payment of the loan under the Credit Facility, the Company will pay an exit fee of $360,000, representing 3.0% of the original principal loan amount. Should any prepayment occur, the Company would be required to pay a prepayment penalty of 1.0% of any prepaid amount.
     As of June 30, 2010, the outstanding principal of the term loan was $1,371,000.
     The Company accrued for the $360,000 exit fee upon the closing of the Credit Facility. This fee, as well as other debt issuance costs incurred by the Company in securing the Credit Facility, were deferred and are included in prepaid expenses and other current assets in the Company’s balance sheet as of June 30, 2010 and December 31, 2009. These costs are being amortized over the term of the loan with such amortization included in interest expense in the Company’s statements of operations.
8. Shareholders’ Equity
Shelf Registration Statement
     On September 26, 2008, the Company filed a registration statement on Form S-3 with the SEC, which became effective on October 30, 2008. This shelf registration statement covers the issuance and sale by the Company of any combination of common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million. As of August 6, 2010, no securities have been issued under the registration statement.
Private Placement
     On March 11, 2008, the Company sold units representing an aggregate of 8,140,600 shares of its Common Stock, together with warrants to purchase an aggregate of 4,070,301 shares of its Common Stock, in a private placement, for a total purchase price of approximately $25.1 million. The Company received net proceeds of approximately $23.1 million from this private placement, after deducting the placement agent’s fees and other expenses.
     The warrants are exercisable on or prior to March 11, 2013 at an exercise price of $3.62 per share. The warrants may also be exercised under certain circumstances pursuant to cashless exercise provisions. As of August 6, 2010, no warrants have been exercised.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
     Pursuant to the securities purchase agreement entered into in connection with the private placement, the Company filed a registration statement with the SEC on April 10, 2008, registering for resale the shares sold in the private placement and the private placement shares issuable under the warrants. The registration statement was declared effective by the SEC on April 28, 2008. The Company has agreed to use its reasonable best efforts to maintain the registration statement’s effectiveness until the earlier of (i) the twelve month anniversary of the last date on which warrant shares are issued upon exercise of warrants and (ii) the date all of the shares and warrant shares have been resold by the original purchasers.
Share-Based Compensation
     The election of three new Class I directors at the Company’s 2010 annual meeting of shareholders resulted in a change in control of the Company’s board of directors as defined under the terms of certain outstanding stock option and restricted stock awards granted to employees and directors of the Company. As a result, on June 30, 2010, the date the election results of the annual meeting were certified, unvested stock options to purchase approximately 538,000 shares of the Company’s common stock and 25,000 shares of unvested restricted stock were automatically accelerated and vested in full. These accelerations resulted in a charge of $467,000 in the second quarter of 2010, of which $226,000 is included in selling, general and administrative expense and $241,000 is included in research and product development expense.
     The Company recognized share-based compensation in its statements of operations as follows:
                                    
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2010   2009   2010   2009
    (Unaudited) (In thousands)
Selling, general and administrative
  $ 365     $ 266     $ 513     $ (302 )
Research and product development
    342       151       442       315  
 
                               
Total
  $ 707     $ 417     $ 955     $ 13  
 
                               
     The increase in total share-based compensation expense for the three month period ended June 30, 2010, compared with the three month period ended June 30, 2009 is attributable to the accelerated vesting of stock options and restricted stock recorded in the second quarter of 2010, as discussed above.
     The increase in total share-based compensation expense for the six month period ended June 30, 2010, compared with the six month period ended June 30, 2009, reflects credits recorded in the 2009 six month period totaling approximately $885,000, which were associated with the forfeiture of employee stock options in such period due to the staff reductions implemented by the Company in the first quarter of 2009 (see Note 10). The increase is also attributable to the accelerated vesting of stock options and restricted stock recorded in the second quarter of 2010, as discussed above. Partially offsetting these increases in expense in the second quarter of 2010, compared with the second quarter of 2009, was a reduction in expense due to the forfeiture of stock options that resulted from the staff reductions implemented by the Company in the fourth quarter of 2009 (see Note 10).
Rights Agreement
     On March 11, 2009, the Company adopted a rights plan pursuant to which it issued a dividend of one preferred share purchase right for each share of common stock held by Company shareholders of record on March 23, 2009. Each right entitled Company shareholders to purchase one one-thousandth of a share of the Company’s Series A Junior Participating Preferred Stock at a price of $12.50, subject to adjustment under certain circumstances. The rights expired July 1, 2010.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
9. Cost of Revenues
                                        
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2010   2009   2010   2009
         
    (Unaudited) (In thousands)    
         
Cost of royalties
  $ 104     $ 95       $ 198        $ 207    
Cost of product sales
    142       143         329       325    
Cost of collaborative licensing and development revenue
    587       230         1,222       590    
 
                                   
Total cost of revenues
  $ 833     $ 468       $ 1,749     $ 1,122    
 
                                   
     Cost of royalties consists of the amortization of deferred royalty termination costs and the amortization of certain patent costs associated with the Company’s TIMERx technology. Cost of product sales consists of the costs related to sales of formulated TIMERx material to the Company’s collaborators. Cost of collaborative licensing and development revenues consists of the Company’s expenses under its research and development collaboration agreements involving the development of product candidates using the Company’s TIMERx technology, and includes internal costs and outside contract services.
10. Restructuring Charges
     In the three month period ended March 31, 2009, the Company reduced the number of its employees from 60 to 49, as part of its efforts to aggressively manage its overhead cost structure. The terms of the severance agreements with the terminated employees included severance pay and continuation of certain benefits, including medical insurance, over the respective severance periods. In connection with these staff reductions, the Company recorded a severance charge in its statement of operations for the three month period ended March 31, 2009 of $550,000, of which $117,000 was unpaid as of June 30, 2009, but was paid over the remainder of 2009. Of such severance charge, $464,000 and $86,000 were recorded as selling, general and administrative expense, and research and product development expense, respectively. In addition, as a result of these terminations, in the first quarter of 2009, the Company recorded a non-cash credit of $885,000 associated with the forfeiture of stock options held by these former employees. Of such amount, $844,000 and $41,000 were recorded as credits to selling, general and administrative expense, and research and product development expense, respectively.
     In the fourth quarter of 2009, the Company reduced the number of its employees from 48 to 39, and consolidated its Danbury, Connecticut headquarters into its Patterson, New York facility. In connection with the terminations, the Company entered into severance arrangements with the terminated employees, which included severance pay and continuation of certain benefits, including medical insurance, over the respective severance periods. In connection with these severance arrangements and corporate office relocation, the Company recorded a restructuring charge in its statement of operations for the fourth quarter of 2009 of $326,000, all of which was paid as of June 30, 2010. Of such charge, $260,000 and $66,000 was recorded as selling, general and administrative expense, and research and product development expense, respectively. In addition, as a result of these terminations, in the fourth quarter of 2009, the Company recorded a non-cash credit of $105,000 associated with the forfeiture of stock options held by these former employees. Of such amount, $68,000 and $37,000 were recorded as credits to selling, general and administrative expense and research and product development expense, respectively, in the fourth quarter of 2009.
11. Income Taxes
     The Company maintains a full valuation allowance against substantially all of its deferred tax assets where realization of those assets remains uncertain. Accordingly, the Company has not reported any tax benefit relating to its remaining net operating loss (“NOL”) carryforwards and income tax credit carryforwards that may be utilized in future periods with the exception of the alternative minimum tax credit of $310,000 recognized in the six months ended June 30, 2010. The Company will continue to reassess the need for a valuation allowance on a quarterly basis. The Company assesses certain factors in determining the period in which it may reverse the valuation allowance, including: (i) a demonstration of sustained profitability; and (ii) the support of internal financial forecasts demonstrating the utilization of the NOLs prior to their expiration. If the Company determines that it is more likely than not that the deferred tax assets are realizable and that the reversal of the valuation reserves is appropriate, a

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
significant one-time benefit would be recognized against its income tax provision in the period that this determination is made.
     The Company’s effective tax rates for the three and six month periods ended June 30, 2010 and 2009 were zero. The effective tax rates differ from the federal statutory rate of 35% for 2010 and 34% for 2009 primarily due to valuation allowances recorded to offset deferred tax assets relating to the Company’s net operating loss carryforwards.
12. Supplemental Executive Retirement Plan and Deferred Compensation Plan
     The Company has a Supplemental Executive Retirement Plan (the “SERP”), a nonqualified plan, which covers the former Chairman and Chief Executive Officer of Penwest, Tod R. Hamachek. Under the SERP, the Company is obligated to pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his spouse. The actuarially determined liability for the SERP was approximately $2,046,000 and $2,066,000 as of June 30, 2010 and December 31, 2009, respectively, including the current portion of approximately $147,000 at June 30, 2010, and is included in deferred compensation in the Company’s condensed balance sheets. The Company has not funded this liability and no assets are held by the SERP. The Company uses a measurement date of December 31 for its SERP. The following disclosures summarize information relating to the SERP:
Components of net periodic benefit cost:
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2010   2009   2010   2009
    (Unaudited) (In thousands)
Interest cost
  $ 28       $ 30     $ 56       $ 60  
Amortization of prior service cost
          (1 )     1       (1 )
 
                               
Net periodic benefit cost
  $ 28       $ 29     $ 57       $ 59  
 
                               
     In addition, the Company has a Deferred Compensation Plan (the “DCP”), a nonqualified plan which covers Mr. Hamachek. Under the DCP, the Company recognized interest expense of $10,000 and $13,000 for the three month periods ended June 30, 2010 and 2009, respectively and $21,000 and $28,000 for the six month period ended June 30, 2010 and 2009, respectively. The liability for the DCP was approximately $483,000 and $604,000 as of June 30, 2010 and December 31, 2009, respectively, including the current portion of approximately $144,000 at June 30, 2010, and is included in deferred compensation on the Company’s condensed balance sheets. The Company has not funded this liability and no assets are held by the DCP. In connection with the resignation and retirement of Mr. Hamachek, under the DCP, effective in May 2005, the Company commenced the payment of benefits to Mr. Hamachek, which are to be paid in ten annual installments, each approximating $140,000; however, these installments are recalculated annually based on market interest rates, as provided for under the DCP.
     The Company has two whole-life insurance policies held in a rabbi trust (the “Trust”), the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. Mr. Hamachek’s SERP and DCP benefit payments are being made directly from the assets in the Trust. The cash surrender value of these life insurance policies totaled $2,078,000 as of June 30, 2010 and $2,024,000 as of December 31, 2009. Trust assets, including $77,000 and $296,000 held in a money market account at June 30, 2010 and December 31, 2009, respectively, are included in other assets in the Company’s condensed balance sheets.
13. Comprehensive Income (Loss)
     Accumulated other comprehensive income consists of the following:
                 
    June 30,   December 31,
    2010   2009
    (Unaudited) (In thousands)
Adjustment for funded status of post retirement plan
  $ 136     $ 135  
Unrealized gain on marketable securities
    1        
 
               
 
  $ 137     $ 135  
 
               

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
     The components of comprehensive income (loss) are as follows:
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2010   2009   2010   2009
    (Unaudited) (In thousands)
Net income (loss)
  $ 8,369     $ (2,138 )   $ 12,239     $ (3,100 )
Amortization of prior service cost
          (1 )     1       (1 )
 
                               
Comprehensive income (loss)
  $ 8,369     $ (2,139 )   $ 12,240     $ (3,101 )
 
                               
14. Collaborative and Licensing Agreements
     The Company enters into collaborative and licensing agreements with pharmaceutical companies to in-license, develop, manufacture and/or market products that fit within its business strategy or to perform research and development for collaborators utilizing the Company’s drug delivery technology and formulation expertise.
   Endo Pharmaceuticals Inc.
     In September 1997, the Company entered into a strategic alliance agreement with Endo with respect to the development of Opana ER, an extended release formulation of oxymorphone hydrochloride using the Company’s TIMERx technology. This agreement was amended and restated in April 2002, and the Company further amended it in January 2007, July 2008, March 2009, April 2010 and June 2010.
     Under the agreement, the Company agreed to supply bulk TIMERx material to Endo, the selling price of which is contractually determined and may be adjusted annually, and Endo agreed to manufacture and market Opana ER in the United States. The Company also agreed with Endo that any development and commercialization of Opana ER outside the United States would be accomplished through licensing to third parties approved by both Endo and the Company, and that the Company and Endo would divide equally any fees, royalties, payments or other revenue received by the parties in connection with such licensing activities. In June 2009, Endo signed a collaboration agreement with Valeant to develop and commercialize Opana ER in Canada, Australia and New Zealand.
     Under the current terms of the Company’s agreement with Endo:
    Endo has agreed to pay the Company royalties on U.S. sales of Opana ER calculated based on a royalty rate starting at 22% of annual net sales of the product up to $150 million of annual net sales, with the royalty rate then increasing, based on agreed-upon levels of annual net sales achieved, from 25% up to a maximum of 30%. In the June 2010 amendment however, the parties agreed that the royalty rate would be fixed at 22% during the period from April 1, 2010 through December 31, 2012 (“the 2010-2012 Royalty Period”), provided that with respect to the fourth quarter of 2012, the rate would be adjusted to a rate that would result in the aggregate royalties paid to the Company for the 2010-2012 Royalty Period being $7.3 million less than the aggregate royalties that would otherwise have been paid to the Company if the royalty rate had not been fixed at 22%. The parties also agreed in the June 2010 amendment that the royalty rate on net sales of Opana ER would be fixed at 20% during 2013, provided that with respect to the fourth quarter of 2013, the rate would be adjusted to a rate that would result in the aggregate royalties paid to the Company for 2013 being $700,000 less than the aggregate royalties that would have been paid to the Company if the royalties had not been fixed at 20%.
 
    No royalty payments were due to the Company for the first $41 million of royalties that would otherwise have been payable to the Company beginning from the time of the product launch in July 2006 (the “Royalty Holiday”). In the third quarter of 2008, the Royalty Holiday ended. The Company recognized royalties from Endo related to sales of Opana ER of $12.3 million and $4.4 million for the three month periods ending June 30, 2010 and 2009, respectively, and $19.5 million and $4.4 million for the six month periods ended June 30, 2010 and 2009, respectively.
 
    The Company’s share of the development costs for Opana ER that it opted out of funding in April 2003 totaled $28 million and was recouped by Endo through a temporary 50% reduction in royalties. Commencing in the third quarter of 2008, the Company began to receive reduced royalty payments from Endo, with such temporary reductions to continue until the $28 million was fully recouped. In the three month period ended March 31,

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
      2010, Endo recouped the remaining balance of unfunded development costs of $3.7 million and as a result, the temporary 50% reduction in the royalty rate has ended.
 
    Endo will pay the Company a percentage of any sublicense income it receives and milestone payments of up to $90 million based upon the achievement of agreed-upon annual net sales thresholds.
     In March 2009, the Company and Endo entered into a Third Amendment to the Amended and Restated Strategic Alliance Agreement with respect to Opana ER, effective January 1, 2009 (the “Third Amendment”). Under the terms of the Third Amendment, Endo agreed to directly reimburse the Company for costs and expenses incurred by the Company in connection with patent applications and patent maintenance related to Opana ER. If any of such costs and expenses are not reimbursed to the Company by Endo, the Company may bill Endo for these costs and expenses through adjustments to the pricing of TIMERx material that the Company supplies to Endo for use in Opana ER. In connection with the Third Amendment, Endo reimbursed the Company for such costs and expenses incurred prior to December 31, 2008, which had been capitalized as patent assets, in the amount of $206,000. Such payment, as well as reimbursement by Endo of an additional $23,000 in patent costs incurred prior to the Third Amendment, was received by the Company in the second quarter of 2009. The Company credited such reimbursements to its patent assets in 2009. Such patent related costs and expenses incurred by the Company subsequent to the Third Amendment have either been reimbursed or are expected to be reimbursed to the Company by Endo, with such reimbursements recorded by the Company as offsets to its costs.
     On June 8, 2009, Endo and Valeant signed a license agreement granting Valeant the exclusive right to develop and commercialize Opana ER in Canada, Australia and New Zealand (the “Valeant Agreement”). Under the terms of the Valeant Agreement, Valeant paid Endo an up-front fee of C$2 million, and agreed to make payments totaling up to C$1 million upon the achievement of sales milestones in Canada, and payments totaling up to AUS $1.1 million upon achievement of regulatory and sales milestones in Australia and New Zealand. In addition, Valeant agreed to pay tiered royalties ranging from 10% to 20% of annual net sales of Opana ER in each of the three countries, subject to royalty reductions upon patent expiration or generic entry. The Valeant Agreement also includes rights to Opana®, the immediate release formulation of oxymorphone developed by Endo for which the Company has no rights to. In connection with the Valeant Agreement, the Company signed a supply agreement with Valeant, agreeing to supply bulk TIMERx material to Valeant for its use in manufacturing Opana ER under the Valeant Agreement, the selling price of which will approximate Penwest’s cost, as defined in the agreement, and may be adjusted annually. The supply agreement is for a ten year term and may be terminated upon the occurrence of certain events including Valeant’s discontinuation of marketing Opana ER in the licensed territories.
     In connection with the Valeant Agreement and the Company’s supply agreement with Valeant, on June 8, 2009, the Company and Endo signed a consent agreement, consenting to these arrangements and confirming the share of the payments to be made by Valeant that would be due to the Company. In July 2009, the Company received payment from Endo in the amount of $764,000 for the Company’s share of the up-front payment received by Endo under the Valeant Agreement, which amount the Company recorded as deferred revenue. The Company began to recognize revenue from this up-front payment in the third quarter of 2009, and expects to recognize revenue on the remainder of this payment ratably over the remaining estimated marketing period. The Company and Endo will share equally in the royalties and sales milestones received from Valeant for Opana ER under the terms of the Valeant Agreement. In the first quarter of 2010, Valeant filed a New Drug Submission for marketing approval for Opana ER in Canada.
     On April 8, 2010, the Company and Endo entered into a Fourth Amendment to the Amended and Restated Strategic Alliance Agreement (the “Fourth Amendment”). Under the terms of the Fourth Amendment, the Company granted Endo an exclusive license under various patents to make, use and commercialize in the United States additional extended-release products containing oxymorphone HCl. Endo may grant sublicenses under such license with the prior written consent of the Company, which the Company may not unreasonably withhold. Sales of such additional products in the United States will be aggregated with sales of Opana ER in the United States for purposes of determining royalties payable to the Company. The Company is entitled to the same portion of payments obtained by Endo from sublicensees with respect to such additional products in the United States as with respect to Opana ER in the United States.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
     On June 8, 2010, the Company and Endo entered into a Fifth Amendment to the Amended and Restated Strategic Alliance Agreement (the “Fifth Amendment”). Under the terms of the Fifth Amendment, the Company and Endo amended the royalty rates provided for by the agreement in accordance with the description of the current financial terms described above.
  Edison Pharmaceuticals, Inc.
     On July 16, 2007, the Company entered into an agreement with Edison (the “Edison Agreement”), under which the Company and Edison agreed to collaborate on the development of Edison’s lead drug candidate, A0001, and up to one additional candidate of Edison’s. Under the terms of the Edison Agreement, the Company has exclusive worldwide rights to develop and commercialize A0001 and an additional compound of Edison’s, which the Company selected in 2009, for all indications, subject to the terms and conditions in the Edison Agreement. The Company is currently developing A0001 for patients with FA and MELAS syndrome. A0001 has been granted orphan drug designation by the FDA for treatment of inherited mitochondrial respiratory chain diseases and received fast track designation by the FDA for the treatment of FA.
     As consideration for the rights granted to the Company under the Edison Agreement, the Company paid Edison an up-front cash payment of $1.0 million upon entering into the Edison Agreement and agreed to loan Edison up to an aggregate principal amount of $1.0 million solely to fund Edison’s research and development. The Company is also required to make payments to Edison upon the achievement of specified milestones set forth in the Edison Agreement and to make royalty payments based on net sales of products containing A0001 and any other compound as to which the Company has exercised its option.
     On February 5, 2008, the Company loaned Edison $1.0 million pursuant to the loan agreement provisions of the Edison Agreement. The loan bears interest at an annual rate of 8.14%, which rate is fixed for the term of the loan. The loan matures on the earlier of July 16, 2012 and the occurrence of an event of default, as defined in the Edison Agreement. All accrued and unpaid interest is payable on the maturity date; however, interest accruing on any outstanding loan amount after July 16, 2010 is due and payable monthly in arrears. During the first quarter of 2008, the Company recorded an impairment charge of $1.0 million to selling, general and administrative expense as a result of its collectability assessment of the loan to Edison. In addition, as a result of the Company’s continuing collectability assessment, the Company is not recognizing any accrued interest income on the loan to Edison. The amount of such accrued interest income not recognized by the Company approximated $24,000 and $22,000 for the three month periods ended June 30, 2010 and 2009, respectively, and $48,000 and $44,000 for the six month periods ended June 30, 2010 and 2009, respectively. Cumulatively, as of June 30, 2010, such accrued interest not recognized by the Company approximated $215,000.
     Under the Edison Agreement, the Company also agreed to pay Edison a total of $5.5 million over an 18-month research period to fund Edison’s discovery and research activities during the period. The funding was made in the form of payments made in advance each quarter. As of June 30, 2010, the Company had paid approximately $5.4 million of such amount, and no further research and development funding is currently owed to Edison in accordance with the May 5, 2009 agreement with Edison, described below. Research and development expense associated with the Edison collaboration, which included expenses relating to the development of A0001 and contract research and milestone payments to Edison were approximately $401,000 and $1.1 million for the three and six month periods ending June 30, 2010 and $1.5 million and $2.5 million, respectively, for the three and six months periods ended June 30, 2009. The Company had the option to extend the term of the research period for up to three consecutive six-month periods, subject to the Company’s funding of Edison’s activities in amounts to be agreed upon, but the Company did not exercise this option.
     In 2009, Edison presented the Company with an additional compound of Edison’s and the Company exercised its option to select this compound for all indications, subject to the terms and conditions in the Edison Agreement. Upon the selection of this additional compound, the Company made a milestone payment in the amount of $250,000 to Edison, which it recorded in research and product development expense in the third quarter of 2009.
     The license for the compounds under the Edison Agreement ends, on a country-by-country and product-by-product basis, when neither Edison nor the Company has any remaining royalty payment obligations to the other

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
with respect to such compound. Each party’s royalty payment obligation ends upon the later of the expiration of the last-to-expire claim of all licensed patents covering such party’s product or the expiration of the FDA’s designation of such product as an orphan drug. The Edison Agreement may be terminated by the Company with 120 days prior written notice to Edison. The Edison Agreement may also be terminated by either party in the event of the other party’s uncured material breach or bankruptcy.
     On May 5, 2009, the Company and Edison entered into an agreement under which Edison agreed that the Company could offset $550,000, and following that, the loan amount of $1.0 million plus accrued interest, against 50% of any future milestone and royalty payments which may be due to Edison under the terms of the Edison Agreement. The loan amount is otherwise due and payable by Edison according to the original loan terms under the loan agreement. In addition, the agreement provides that the Company has no further contractual payment obligations in connection with the research period. Following the milestone payment that the Company made to Edison in 2009 as noted above, $300,000 remains of the $550,000 offset provided for under the May 5, 2009 agreement.
  Mylan Pharmaceuticals Inc.
     On March 2, 2000, Mylan announced that it had signed a supply and distribution agreement with Pfizer to market generic versions of all three strengths (30 mg, 60 mg, 90 mg) of Pfizer’s generic Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL, a generic version of Procardia XL that the Company had developed in collaboration with Mylan. As a result, Mylan entered into a letter agreement with the Company under which Mylan agreed to pay Penwest a royalty on all future net sales of Pfizer’s generic version of Procardia XL 30 mg. The royalty percentage was comparable to the percentage called for in Penwest’s original agreement with Mylan for Nifedipine XL 30 mg. Mylan has retained the marketing rights to Nifedipine XL 30 mg. Mylan’s sales in the United States of Pfizer’s generic version of Procardia XL 30 mg totaled approximately $3.5 million and $7.1 million for the three and six month periods ended June 30, 2010, respectively. The term of the letter agreement continues until such time as Mylan permanently ceases to market Pfizer’s generic version of Procardia XL 30 mg.
     Royalties from Mylan were approximately $418,000 and $426,000 for the three month periods ended June 30, 2010 and 2009, respectively, and $853,000 and $776,000 for the six month periods ended June 30, 2010 and 2009, respectively.
     Mylan notified the Company that Mylan did not renew its supply and distribution agreement with Pfizer, and that the agreement expired in March 2010. As a result, the Company does not expect to receive royalties from Mylan on sales of Pfizer’s generic version of Procardia XL 30 mg with respect to any period after the third quarter of 2010.
     In October 2009, Mylan resolved a dispute with the Department of Justice (the “DOJ”) regarding Medicaid rebate classifications with respect to some of the products it sold from 2000 to 2004. One of these products was Pfizer’s generic version of Procardia XL. Following its settlement with the DOJ, Mylan delivered a letter to the Company seeking approximately $1.1 million plus interest from the Company. Mylan claims that if it had used the rebate classifications asserted by the DOJ, it would have paid the Company approximately $1.1 million less in royalties during the 2000 to 2004 period than it did pay. The Company has reviewed its agreement with Mylan and notified Mylan that it does not believe it is liable to Mylan for this claim.
  Drug Delivery Technology Collaborations
     The Company enters into development and licensing agreements with third parties under which the Company develops formulations of third parties’ or generic compounds, utilizing the Company’s TIMERx drug delivery technologies and formulation expertise. In connection with these agreements, the Company may receive nonrefundable up-front payments, which are recorded as deferred revenue upon receipt and are recognized as revenue over the respective contractual performance periods. Under these agreements, the Company may also be reimbursed for development costs incurred up to amounts specified in each agreement. Additionally, under these agreements, the Company may receive milestone payments upon the achievement of specified events. Finally, these agreements may provide for the Company to receive payments from the sale of bulk TIMERx material and royalties on product sales upon commercialization of the product. As of August 6, 2010, the Company has multiple drug delivery technology collaborations, including with Otsuka and a multi-drug agreement for generic products with Alvogen discussed below.

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NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
     In April 2010, the Company signed a drug development and commercialization agreement with Alvogen under which the Company and Alvogen have agreed to identify and select up to five compounds for generic development. Under this agreement, the Company agreed to formulate the agreed-upon compounds for which it will receive up-front as well as periodic payments, and may also receive milestone and royalty payments relating to the development of each compound. Alvogen is responsible for manufacturing, clinical trials and regulatory filings for each of the formulations, as well as for commercialization of the products worldwide.
15. Contingencies
     On November 12, 2008, the Company entered into executive retention agreements with each of its executive officers. These retention agreements replaced prior retention agreements with each of its executive officers that had been scheduled to expire on December 31, 2008. On March 10, 2010, the Company entered into amendments to these agreements. The retention agreements provide that if, within 18 months following a change in control of the Company, the executive’s employment is terminated by the Company other than for cause, death, or disability, or by the executive for good reason, as such terms are defined in the agreement, the executives are entitled to payments for severance and other benefits, including medical insurance, and the automatic vesting of all unvested stock options.
     The election of three new Class I directors at the 2010 annual meeting of shareholders resulted in a change in control of the Company under the retention agreements as of June 30, 2010, the date that the election results of the annual meeting were certified. As a result, under the executive retention agreements if, within 18 months of the June 30, 2010 change in control, an executive officer is terminated by the Company other than for cause, death, or disability, or by the executive for good reason, the Company would be obligated to pay the benefits provided for under these retention agreements which, as of June 30, 2010, the Company estimates would total approximately $3.4 million under all executive retention agreements.
     Substantial patent litigation exists in the pharmaceutical industry. Patent litigation generally involves complex legal and factual questions, and the outcome frequently is difficult to predict. An unfavorable outcome in any patent litigation involving the Company could cause the Company to be liable for substantial damages, alter its products or processes, obtain additional licenses and/or cease certain activities. Even if the outcome is favorable to the Company, the Company could incur substantial costs in litigating such matters.
  Impax ANDA Litigation
     On December 14, 2007, the Company received a notice from IMPAX Laboratories, Inc. (“IMPAX”), advising the Company of the FDA’s apparent acceptance for substantive review, as of November 23, 2007, of IMPAX’s amended ANDA for a generic version of Opana® ER. IMPAX stated in its letter that the FDA requested IMPAX to provide notification to the Company and Endo of any Paragraph IV certifications submitted with its ANDA, as required under section 355(j) of the Federal Food, Drug and Cosmetics Act, or the FDC Act. Accordingly, IMPAX’s letter included notification that it had filed Paragraph IV certifications with respect to the Company’s U.S. Patent Nos. 7,276,250, 5,958,456 and 5,662,933, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2023, 2013 and 2013, respectively. Endo’s Opana® ER product had new dosage form exclusivity that prevented final approval of any ANDA by the FDA until the exclusivity expired on June 22, 2009. In addition, because IMPAX’s application referred to patents owned by the Company and contained a Paragraph IV certification under section 355(j) of the FDC Act, the Company believes that IMPAX’s notice triggered the 45-day period under the FDC Act in which the Company and Endo could file a patent infringement action and trigger the automatic 30-month stay of approval. Subsequently, on January 25, 2008, the Company and Endo filed a lawsuit against IMPAX in the United States District Court for the District of Delaware in connection with IMPAX’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, IMPAX filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable.
     On June 16, 2008, the Company and Endo received a notice from IMPAX that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg, 15 mg and 30 mg strengths of Opana® ER. The notice covers the Company’s U.S. Patent Nos. 7,276,250, 5,958,456 and 5,662,933. Subsequently, on July 25, 2008, the

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NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
Company and Endo filed a lawsuit against IMPAX in the United States District Court for the District of Delaware in connection with IMPAX’s amended ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, IMPAX filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable. All three of these suits against IMPAX were transferred to the United States District Court for the District of New Jersey.
     On June 8, 2010, the Company and Endo settled the IMPAX litigation. Both sides dismissed their respective claims and counterclaims with prejudice. Under the terms of the settlement, IMPAX agreed not to challenge the validity or enforceability of Penwest’s patents relating to Opana® ER with respect to IMPAX’s generic version of Opana ER and not to sell a generic version of Opana ER until January 1, 2013 or earlier under specified circumstances (such date being the “Commencement Date”). The Company and Endo agreed to grant IMPAX a license under the Opana Patents permitting the sale of generic Opana® ER upon the Commencement Date. The license granted to IMPAX is non-exclusive except with respect to the 180 day period following the Commencement Date for those dosage strengths for which IMPAX is entitled to first-to-file exclusivity, during which period the license is exclusive as to all but the Opana ER branded product and licenses previously granted by the Company and Endo to ANDA holders.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
  Actavis ANDA Litigation
     In February 2008, the Company received a notice from Actavis South Atlantic LLC (“Actavis”) advising the Company of the filing by Actavis of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) for a generic version of Opana® ER. The Actavis Paragraph IV certification notice refers to the Company’s U.S. Patent Nos. 5,128,143, 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire or expired in 2008, 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER has a new dosage form (referred to as NDA) exclusivity that prevents final approval of any ANDA by the FDA until the exclusivity expires on June 22, 2009. Subsequently, on March 28, 2008, the Company and Endo filed a lawsuit against Actavis in the U.S. District Court for the District of New Jersey in connection with Actavis’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. On May 5, 2008, Actavis filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable, as well as a claim of unfair competition against the Company and Endo.
     On or around June 2, 2008, the Company received a notice from Actavis that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg and 15 mg dosage strengths of Opana® ER. On or around July 2, 2008, the Company received a notice from Actavis that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 30 mg dosage strength. Both notices cover the Company’s U.S. Patent Nos. 5,128,143, 7,276,250, 5,958,456 and 5,662,933. On July 11, 2008, the Company and Endo, filed suit against Actavis in the United States District Court for the District of New Jersey. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. On August 14, 2008, Actavis filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable, as well as a claim of unfair competition against the Company and Endo.
     On February 20, 2009, the Company and Endo settled all of the Actavis litigation. Both sides dismissed their respective claims and counterclaim with prejudice. Under the terms of the settlement, Actavis agreed not to challenge the validity or enforceability of the Company’s patents relating to Opana® ER. The Company and Endo agreed to grant Actavis a license permitting the production and sale of generic Opana® ER 7.5 and 15 mg tablets by the earlier of July 15, 2011, the last day Actavis would forfeit its 180-day exclusivity, and the date on which any third party commences commercial sales of Opana® ER, but not before November 28, 2010. The Company and Endo also granted Actavis a license to produce and market other strengths of Opana® ER generic on the earlier of July 15, 2011 and the date on which any third party commences commercial sales of a generic form of the drug.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
  Sandoz ANDA Litigation
     On July 14, 2008, the Company received a notice from Sandoz, Inc. (“Sandoz”) advising the Company of the filing by Sandoz of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 5 mg, 10 mg, 20 mg and 40 mg dosage strengths. The Sandoz Paragraph IV certification notice refers to the Company’s U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER has a new dosage form (NDA) exclusivity that prevents final approval of any ANDA by the FDA until the exclusivity expires on June 22, 2009. Subsequently, on August 22, 2008, the Company and Endo filed a lawsuit against Sandoz in the United States District Court for the District of Delaware in connection with Sandoz’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. In response, Sandoz filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable.
     On November 20, 2008, the Company received a notice from Sandoz that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg, 15 mg and 30 mg dosage strengths of Opana® ER. The notice covers the Company’s U.S. Patent Nos. 5,128,143, 7,276,250, 5,958,456 and 5,662,933. On December 30, 2008, the Company and Endo, filed suit against Sandoz in the United States District Court for the District of New Jersey. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. In response, Sandoz filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable. Both of these pending suits against Sandoz were transferred to the United States District Court for the District of New Jersey.
     On June 8, 2010, the Company and Endo settled the Sandoz litigation. Both sides dismissed their respective claims and counterclaims with prejudice. Under the terms of the settlement, Sandoz agreed not to challenge the validity or enforceability of Penwest’s patents relating to Opana® ER. The Company and Endo agreed to grant Sandoz a license permitting the production and sale of all strengths of Opana® ER commencing on September 15, 2012, or earlier under certain circumstances.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
  Barr ANDA Litigation
     On September 12, 2008, the Company received a notice from Barr Laboratories, Inc. (“Barr”) advising the Company of the filing by Barr of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in a 40 mg dosage strength. On September 15, 2008, the Company received a notice from Barr that it had filed an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 5 mg, 10 mg, and 20 mg dosage strengths. Both notices refer to the Company’s U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER had a new dosage form exclusivity that prevented final approval of any ANDA by the FDA until the exclusivity expired on June 22, 2009. Subsequently, on October 20, 2008, the Company and Endo filed a lawsuit against Barr in the United States District Court for the District of Delaware in connection with Barr’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, Barr filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable. This suit was transferred to the United States District Court for the District of New Jersey. On June 2, 2009, the Company received a notice from Barr that it had filed an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 7.5 mg, 15 mg, and 30 mg dosage strengths. This notice also refers to the Company’s U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. On July 2, 2009, the Company and Endo filed a lawsuit against Barr in the United States District Court for the District of New Jersey in connection with Barr’s ANDA.
     On April 12, 2010, the Company and Endo settled the litigation with Barr. Under the terms of the settlement, Barr agreed not to challenge the validity or enforceability of the Company’s patents relating to the production and sale of

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
generic formulations of Opana® ER and the Company and Endo agreed to grant Barr a license under the Orange-Book listed patents to sell a generic of Opana® ER on or after September 15, 2012, or earlier under certain circumstances.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
  Roxane ANDA Litigation
     On December 29, 2009, the Company received a notice from Roxane Laboratories (“Roxane”) advising the Company of the filing by Roxane of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355(j) with respect to Opana® ER in a 40 mg dosage strength. The notice refers to the Company’s U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013, and 2023, respectively. Subsequently, on January 29, 2010, the Company and Endo filed a lawsuit against Roxane in the United States District Court for the District of New Jersey in connection with Roxane’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation.
     On or about March 18, 2010, the Company received a notice from Roxane that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 5, 7.5, 10, 15, 20 and 30 mg dosage strengths of Opana® ER. Subsequently, on April 16, 2010, the Company and Endo filed a lawsuit against Roxane in the United States District Court of the District of New Jersey in connection with Roxane’s amended ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation.
  Watson ANDA Litigation
     On January 20, 2010, the Company received a notice from Watson Laboratories, Inc. (“Watson”) advising the Company of the filing by Watson of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355(j) with respect to Opana® ER in a 40 mg dosage strength. The notice refers to the Company’s U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013, and 2023, respectively. Subsequently, on March 4, 2010, the Company and Endo filed a lawsuit against Watson in the United States District Court for the District of New Jersey, in connection with Watson’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. On March 19, 2010, the Company received a notice from Watson advising of the filing by Watson of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355 (j) with respect to Opana ER in 5, 7.5, 10, 15, 20 and 30 mg dosage strengths. Subsequently, on April 23, 2010, the Company and Endo filed a lawsuit against Watson in the United States District Court of the District of New Jersey in connection with Watson’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana ER formulation.
     The Company and Endo intend to pursue all available legal and regulatory avenues in defense of Opana® ER, including enforcement of each Company’s intellectual property rights and approved labeling. The Company cannot, however, predict or determine the timing or outcome of any of these litigations but will explore all options as appropriate in the best interests of the Company.
  Tang/Edelman Shareholder Claim
     In March and April 2009, Tang Capital Partners, LP (“Tang Capital”) and Perceptive Life Sciences Master Fund Ltd. (“Perceptive”), the Company’s two largest shareholders, brought a total of three lawsuits against the Company; two in Thurston County, Washington, and one in King County, Washington. Following the 2009 dismissal of the two Thurston County actions and the May 2010 dismissal of the complaint in King County, as discussed below, none of these lawsuits remains pending. The lawsuits were brought in connection with a proxy contest initiated by Tang Capital and Perceptive.
     On March 12, 2009, Tang Capital and Perceptive brought suit against the Company in the Superior Court of the State of Washington, Thurston County, (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co., No. 09-2-

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
00617-0), seeking declaratory and injunctive relief to uphold their claims that their notice of nomination of directors had satisfied the requirements set forth in the Company’s bylaws and requesting that the court issue an order preventing the Company from seeking to disallow or otherwise prevent or not recognize their nominations, or the casting of votes in favor of their designees, on the basis that they had not complied with the provisions of the Company’s bylaws or applicable state law. On March 13, 2009, Tang Capital and Perceptive moved for a preliminary injunction to enjoin the Company from mailing any ballots to shareholders that contained provisions to vote for director nominees and enjoining any shareholder vote on individuals nominated for the board of directors unless the three designees of Tang Capital and Perceptive were permitted to be nominated and votes were permitted to be cast in their favor, or a court resolved the merits of their declaratory judgment action described above. On March 20, 2009, the Company confirmed in writing that Tang Capital and Perceptive’s nomination notice had been timely received and that, assuming the accuracy and completeness of the information contained in their notice, their notice in all other respects met the requirements of the Company’s bylaws in regard to notices of intention to nominate. On March 23, 2009, Tang Capital and Perceptive withdrew their motion for injunctive relief, and on April 10, 2009, Tang Capital and Perceptive voluntarily dismissed the suit.
     On April 20, 2009, Tang Capital and Perceptive brought suit against the Company in the Superior Court of the State of Washington, King County, (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co.), No. 09-2-16472-0), seeking to enforce their alleged rights under the Washington Business Corporation Act to inspect certain Company documents (“the King County Action”). The Company’s position is that certain of the requested documents are outside the scope of documents for which the Washington Business Corporation Act permits a statutory inspection right and that certain of the conditions to qualify for statutory inspection rights have not been satisfied.
     On April 28, 2009, Tang Capital and Perceptive brought suit against the Company in the Superior Court of the State of Washington, Thurston County, (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co.), seeking either for the court to set the number of directors to be elected at the 2009 annual meeting of shareholders at three rather than two, or for the court to require the Company to waive the advance notice provisions of its bylaws to permit Tang Capital and Perceptive to include a proposal in which the required percentage for board approval of certain matters would be 81% or more, rather than 75% or more. On May 13, 2009, Tang Capital and Perceptive dismissed this Thurston County action, reasserting the same claims via an amended complaint in the King County Action. Tang Capital and Perceptive sought preliminary injunctive relief on their claims prior to the 2009 annual meeting of shareholders and the motion was denied by the court on May 22, 2009. The proposed bylaw amendment was not approved by the Company’s shareholders at the Company’s 2009 annual meeting of shareholders. By stipulation of the parties, the suit was dismissed without prejudice on May 13, 2010.
     The Company is also a party from time to time to certain other types of claims and proceedings in the ordinary course of business. The Company does not believe any of these matters will result, individually or in the aggregate, in a material adverse effect upon its financial condition or future results of operations.
16. Subsequent Events
     In July 2010, the Company determined that it would reduce its staff from 38 to 27 in the third quarter of 2010, as part of its continuing efforts to aggressively manage its overhead cost structure. In connection with these actions, the Company anticipates recording a restructuring charge in the third quarter of 2010 of approximately $250,000, which amount is net of a non-cash credit of approximately $10,000, associated with the expected forfeiture of certain stock options held by affected employees. This charge relates primarily to arrangements for severance pay and the continuation of certain benefits, including medical insurance, over the respective periods, and will be recorded primarily to research and product development expense.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
      Overview
     We are a drug delivery company focused on applying our drug delivery technologies and drug formulation expertise to the formulation of product candidates under licensing collaborations (“drug delivery technology collaborations”). Our drug delivery technology is included in Opana® ER, a product for the treatment of moderate to severe chronic pain marketed by Endo. We are also developing A0001, or a-tocopherolquinone, for the treatment of Friedreich’s Ataxia and MELAS syndrome.
     Opana® ER is an extended release formulation of oxymorphone hydrochloride that we developed with Endo using our proprietary extended release TIMERx® drug delivery technology. Opana ER was approved by the United States Food and Drug Administration, or FDA, in June 2006 for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time, and is being marketed by Endo in the United States. In the six month period ended June 30, 2010, we recognized $19.5 million in royalties from Endo related to sales of Opana ER. In June 2009, Endo signed an agreement with Valeant Pharmaceuticals International, or Valeant, to develop and commercialize Opana ER in Canada, Australia and New Zealand. In the first quarter of 2010, Valeant filed a New Drug Submission for marketing approval for Opana ER in Canada. Opana ER is not approved for sale in any country other than the United States.
     We are conducting two Phase IIa clinical trials of A0001. We are conducting one trial in patients with Friedreich’s Ataxia, or FA, a rare degenerative neuro-muscular disorder, and the second trial in patients with the A3243G mitochondrial DNA point mutation that is commonly associated with MELAS syndrome, a rare progressive neurodegenerative disorder. The goal of these trials is to determine if A0001 has a discernible impact in the treatment of patients with these disorders using various biochemical, functional and clinical measures. We expect data from both of these trials by the end of 2010. We are not conducting, and do not plan to conduct, any additional development work on A0001, other than the two Phase IIa trials until we review the results for both trials. We are currently seeking to license A0001 to a third party to complete further development and assume responsibility for the commercialization, manufacturing and marketing of this compound.
     We are a party to a number of collaborations involving the use of our proprietary extended release drug delivery technologies as well as our formulation development expertise. Under these collaborations, we are responsible for completing the formulation work on a product specified by our collaborator using our proprietary extended release drug delivery technology. If we successfully formulate the compound, we transfer the formulation to our collaborator, who is then responsible for the completion of the clinical development, manufacture and, ultimately, the commercialization of the product. Under the terms of these agreements, we may receive up-front fees, reimbursement of research and product development costs incurred, up to amounts specified in each agreement, and potential milestone payments upon the achievement of specified events. These agreements may also provide for us to receive payments from the sale of bulk TIMERx material and royalties on product sales upon commercialization of the product. We have drug delivery technology collaborations with Otsuka Pharmaceuticals Co., or Otsuka, and with Alvogen Inc., or Alvogen. In the three month period ended June 30, 2010, we achieved a development milestone under one of our collaborations with Otsuka, for which we received a milestone payment. In April 2010, we signed a drug development and commercialization agreement with Alvogen, under which we and Alvogen have agreed to identify and select up to five compounds for generic development. Under the agreement, we agreed to formulate the agreed-upon compounds for which we will receive up-front as well as periodic payments, and may receive milestone and royalty payments relating to the development of each compound. Alvogen is responsible for manufacturing, clinical trials and regulatory filings for each of the formulations, as well as for commercialization of the products worldwide.
     Endo. Under the terms of our collaboration with Endo, Endo is responsible for marketing and selling Opana ER. Endo pays us royalties based on U.S. net sales of Opana ER. No payments were due to us for the first $41 million of royalties otherwise payable to us beginning from the time of the product launch in July 2006, a period we refer to as the “royalty holiday”. In the third quarter of 2008, the royalty holiday ended and we began earning royalties from Endo on sales of Opana ER. Since that time, we have recognized $43.9 million in royalties on sales of Opana ER, including $12.4 million and $19.5 million for the three and six month periods ended June 30, 2010, respectively. Endo also had the right under our agreement to recoup $28 million in development costs that Endo funded on our behalf prior to the approval of Opana ER, through a temporary 50% reduction in royalties paid to us. During the first

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quarter of 2010, Endo recouped the remaining unfunded development costs and as a result, the temporary 50% reduction in the royalty rate ended.
     Under the terms of our agreement with Endo, any fees, royalties, payments or other revenues received by the parties in connection with any collaborator outside the United States will be divided equally between Endo and us. In June 2009, Endo and Valeant signed a license agreement, the Valeant Agreement, granting Valeant the exclusive right to develop and commercialize Opana ER in Canada, Australia and New Zealand. Under the terms of the Valeant Agreement, Valeant paid Endo an up-front fee of C$2 million, and agreed to make payments totaling up to C$1.0 million upon the achievement of sales milestones in Canada and payments totaling up to AUS$1.1 million upon the achievement of regulatory and sales milestones in Australia. In addition, Valeant agreed to pay tiered royalties ranging from 10% to 20% of annual net sales of Opana ER in each of the three countries, subject to royalty reductions upon patent expiry or generic entry. The Valeant Agreement also includes rights to Opana®, the immediate release formulation of oxymorphone developed by Endo, for which we have no rights. We signed a supply agreement with Valeant, agreeing to supply bulk TIMERx material to Valeant for its use in manufacturing Opana ER under the Valeant Agreement. Under the supply agreement, we have agreed to be the exclusive supplier of bulk TIMERx material to Valeant. The price at which we will sell bulk TIMERx to Valeant will approximate our costs, as defined in the agreement, and may be adjusted annually. The supply agreement is for a ten year term and may be terminated upon the occurrence of certain events including Valeant’s discontinuation of marketing Opana ER in the licensed territories.
     In connection with the Valeant Agreement and our supply agreement with Valeant signed in June 2009, Endo and we signed a consent agreement consenting to these arrangements and confirming the share of the payments to be made by Valeant that would be due to us. In July 2009, we received payment from Endo in the amount of $764,000 for our share of the up-front payment received by Endo under the Valeant Agreement, which amount we recorded as deferred revenue. We began to recognize revenue from this up-front payment in the third quarter of 2009 and expect to recognize revenue on the remainder of this payment ratably over the remaining estimated marketing period. Endo and we will share equally in the royalties and sales milestones received from Valeant for Opana ER under the terms of the Valeant Agreement.
     In March 2009, we entered into a Third Amendment to the Amended and Restated Strategic Alliance Agreement with Endo, effective January 1, 2009, or the Third Amendment. Under the terms of the Third Amendment, Endo agreed to directly reimburse us for costs and expenses incurred by us in connection with patent applications and patent maintenance costs related to Opana ER. If any of such costs and expenses are not reimbursed to us by Endo, we may bill Endo for these costs and expenses through adjustments to the pricing of TIMERx material that we supply to Endo for use in Opana ER. In connection with the Third Amendment, Endo reimbursed us for such costs and expenses incurred prior to December 31, 2008, which we had capitalized as patent assets, in the amount of $206,000. We received such payment, as well as reimbursement by Endo of an additional $23,000 in patent costs incurred prior to the Third Amendment, in the second quarter of 2009, at which time we credited such reimbursements to our patent assets. Patent-related costs and expenses that we incurred subsequent to the Third Amendment have either been reimbursed or are expected to be reimbursed to us by Endo, with these reimbursements recorded by us as offsets to our costs.
     On April 8, 2010, we entered into a Fourth Amendment to the Amended and Restated Strategic Alliance Agreement with Endo, or the Fourth Amendment. Under the terms of the Fourth Amendment, we granted Endo an exclusive license under various patents to make, use and commercialize in the United States additional extended-release products containing oxymorphone HCl. Endo may grant sublicenses under such license with the prior written consent by us, which we may not unreasonably withhold. Sales of such additional products in the United States will be aggregated with sales of Opana ER in the United States for purposes of determining royalties payable to us. We are entitled to the same portion of payments obtained by Endo from sublicensees with respect to such additional products in the United States as with respect to Opana ER in the United States.
     On June 8, 2010, we entered into a Fifth Amendment to the Amended and Restated Strategic Alliance Agreement with Endo. Under the terms of the Fifth Amendment, Endo and we agreed that (i) the royalty rate on net sales of Opana ER under the Strategic Alliance Agreement would be fixed at 22% during the period from April 1, 2010 through December 31, 2012 (the “2010-2012 Royalty Period”), provided that with respect to the fourth quarter of 2012, the rate would be adjusted to a rate that would result in the aggregate royalties paid to us for the 2010-2012

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Royalty Period being $7.3 million less than such aggregate royalties would have been if the royalty rates had not been fixed at 22%, and (ii) the royalty rate on net sales of Opana ER under the Strategic Alliance Agreement would be fixed at 20% during 2013, provided that with respect to the fourth quarter of 2013, the rate would be adjusted to a rate that would result in the aggregate royalties paid to us for 2013 being $700,000 less than such aggregate royalties would have been if the royalty rates had not been fixed at 20%.
     A description of our agreement with Endo is included in Note 14, “Collaborative and Licensing Agreements” in “Part I. Item 1. – Notes to Condensed Financial Statements”.
     Edison. Under the terms of our agreement with Edison Pharmaceuticals, Inc., or Edison, or the Edison Agreement, we have exclusive, worldwide rights to develop and commercialize A0001 and one additional compound of Edison’s, which we selected in September 2009, for all indications, subject to the terms and conditions in the Edison Agreement. Upon our selection of this additional compound, we made a milestone payment in the amount of $250,000 to Edison, which we recorded as R&D expense in the third quarter of 2009 and paid to Edison in October 2009.
     On May 5, 2009, we and Edison entered into an agreement under which Edison agreed that we could offset $550,000, and following that, the $1.0 million principal amount of the loan we made to Edison in 2008, plus accrued interest, against 50% of any future milestone and royalty payments which may be due to Edison under the terms of the Edison Agreement. The loan amount is otherwise due and payable by Edison according to the original loan terms under the loan agreement. In addition, the agreement provides that we have no further research and development payment obligations in connection with the research period and the Edison Agreement. Following the milestone payment that we made to Edison in the fourth quarter of 2009 as noted above, $300,000 remains of the $550,000 offset provided for under the May 5, 2009 agreement.
     A description of the Edison Agreement is included in Note 14, “Collaborative and Licensing Agreements” in “Part I. Item 1. – Notes to Condensed Financial Statements”.
     Mylan. Under a collaboration agreement with Mylan Pharmaceuticals Inc., or Mylan, we developed Nifedipine XL, a generic version of Procardia XL based on our TIMERx technology, which was approved by the FDA. In March 2000, Mylan signed a supply and distribution agreement with Pfizer Inc., or Pfizer, to market Pfizer’s generic versions of all three strengths (30 mg, 60 mg, 90 mg) of Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL, and agreed to pay us a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL. In October 2009, Mylan notified us that Mylan did not renew its supply and distribution agreement with Pfizer, and that the agreement expired in March 2010. As a result, we do not expect to receive royalties from Mylan on sales of Pfizer’s generic version of Procardia XL 30 mg with respect to any period after the third quarter of 2010.
     In October 2009, Mylan resolved a dispute with the Department of Justice regarding Medicaid rebate classifications with respect to some of the products it sold from 2000 to 2004. One of these products was Pfizer’s generic version of Procardia XL. Following the settlement, Mylan delivered a letter to us seeking approximately $1.1 million plus interest. Mylan claims that if it had used the rebate classifications asserted by the Department of Justice from 2000 to 2004, it would have paid us approximately $1.1 million less from 2000 to 2004 than it did pay us. We have reviewed our agreement with Mylan and have notified Mylan that we do not believe we are liable to Mylan for this claim.
     Restructuring Charges. In the first quarter of 2009, we reduced the number of our employees from 60 to 49, as part of our efforts to aggressively manage our overhead cost structure. We entered into severance arrangements with the terminated employees, which included severance pay and continuation of certain benefits, including medical insurance, over the respective severance periods. In connection with the severance arrangements, we recorded a severance charge in our statement of operations for the first quarter of 2009 of $550,000, all of which was paid in 2009. Of such severance charge, $464,000 and $86,000 were recorded as selling, general and administrative, or SG&A, expense and R&D expense, respectively, in the first quarter of 2009. In addition, as a result of these terminations, in the first quarter of 2009, we recorded a non-cash credit of $885,000 associated with the forfeiture of stock options held by these former employees. Of such amount, $844,000 and $41,000 were recorded as credits to SG&A expense and R&D expense, respectively, in the first quarter of 2009.

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     In the fourth quarter of 2009, we reduced the number of our employees from 48 to 39 and consolidated our Danbury, Connecticut headquarters into our Patterson, New York facility as of approximately January 1, 2010. We entered into severance arrangements with the terminated employees, which included severance pay and continuation of certain benefits, including medical insurance, over the respective severance periods. In addition, we determined to defer any new development work on A0001, other than the two Phase IIa studies, pending review and analysis of the results of those studies. We recorded a restructuring charge in the fourth quarter of 2009 in the amount of $326,000, primarily for these severance agreements, all of which was paid as of June 30, 2010. Of such charge, $260,000 and $66,000 was recorded as SG&A expense and R&D expense, respectively.
     In July 2010, we determined that we would reduce our staff from 38 to 27 in the third quarter of 2010, as part of our continuing efforts to aggressively manage our overhead cost structure. In connection with these actions, we anticipate recording a restructuring charge in the third quarter of 2010 of approximately $250,000, which amount is net of a non-cash credit of approximately $10,000, associated with the expected forfeiture of certain stock options held by affected employees. This charge relates primarily to arrangements for severance pay and the continuation of certain benefits, including medical insurance, over the respective periods, and will be recorded primarily to research and product development expense.
     Share Based Compensation Charge. The election of new Class I directors at our 2010 annual meeting of shareholders resulted in a change in control of our board of directors, as defined under the terms of certain outstanding stock option and restricted stock awards granted to our employees and directors. As a result, on June 30, 2010, the date the election results were certified, unvested stock options to purchase approximately 538,000 shares of our common stock and 25,000 shares of unvested restricted stock were automatically accelerated and vested in full. These accelerations resulted in a charge in our statement of operations of $467,000 in the second quarter of 2010, of which $226,000 is included in selling, general and administrative expense and $241,000 is included in research and product development expense.
     Net Loss and Profitability
     We have incurred annual net losses since 1994 including net losses of $1.5 million, $26.7 million and $34.5 million during 2009, 2008 and 2007, respectively. As of June 30, 2010, our accumulated deficit was approximately $223 million. We currently generate revenues primarily from royalties received from Endo on Endo’s net sales of Opana ER and from Mylan on Mylan’s net sales of Pfizer’s generic version of Procardia XL 30 mg, from our drug delivery technology collaborations and, to a lesser extent, from bulk sales of TIMERx material to Endo for use in Opana ER. Since the third quarter of 2009, we have reported net income on a quarterly basis. We anticipate that, based upon our current operating plan, which includes expected royalties from third parties, we will achieve annual profitability in 2010. If we do not receive royalties from Endo for Opana ER in such amounts as forecasted and provided to us by Endo, or if we are unable to maintain our current operating expense level, we may not be able to maintain profitability on a quarterly basis or achieve profitability on an annual basis in 2010. However, even if we are profitable in 2010, we may not be able to sustain profitability on a quarterly or annual basis thereafter. Our future profitability will depend on numerous factors, including:
    the commercial success of Opana ER, and the amount of royalties on sales of Opana ER, which may be adversely affected by any potential generic competition or the marketing of competitive products;
 
    the prosecution, defense and enforcement of our patents and other intellectual property rights, such as our Orange Book listed patents for Opana ER, and the prosecution by us and Endo of additional patent applications with respect to Opana ER;
 
    our ability to enter into drug delivery technology collaborations and generate revenues under drug delivery technology collaborations;
 
    our ability to access funding support for A0001 from third party collaborators;
 
    the level of our investment in research and development activities, including the timing and costs of conducting clinical trials of A0001;

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    the level of our general and administrative expenses; and
 
    the successful development and commercialization of product candidates in our portfolio and products being developed for collaborations.
     Our results of operations may fluctuate from quarter to quarter depending on the amount and timing of royalties on sales of Opana ER, the volume and timing of shipments of bulk TIMERx material, including to Endo, the variations in payments under our drug delivery technology collaborations, and the amount and timing of our investment in research and development activities.
Critical Accounting Policies and Estimates
     The discussion and analysis of our financial condition and results of operations are based upon our condensed financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances. We regard an accounting estimate underlying our financial statements as a “critical accounting estimate” if the nature of the estimate or assumption is material due to the level of subjectivity and judgment involved, or the susceptibility of such matter to change, and if the impact of the estimate or assumption on our financial condition or performance may be material. On an ongoing basis, we evaluate these estimates and judgments. Actual results may differ from these estimates under different assumptions or conditions. Areas where significant judgments are made include, but are not limited to: revenue recognition, research and product development expenses, deferred taxes-valuation allowance, impairment of long-lived assets and share-based compensation. For a more detailed explanation of the judgments we make in these areas, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009.
Recent Accounting Pronouncements
     A detailed description of recent accounting pronouncements is included in Note 3, “Recent Accounting Pronouncements” in “Part I. Item 1. - Notes to Condensed Financial Statements”.
Results of Operations for the Three and Six Month Periods Ended June 30, 2010 and 2009
Revenues
                                         
    Three months         Three months   Six months         Six months  
    ended     Percentage   ended   ended     Percentage   ended  
    June 30,     increase   June 30,   June 30,     increase   June 30,  
    2010     (decrease)   2009   2010     (decrease)   2009  
                         
    (In thousands, except percentages)  
Royalties
  $ 12,717         162%   $ 4,851     $ 20,370        113%   $ 9,573  
Product sales
    90       (43)     158       292       (14)     338  
Collaborative licensing and development revenue
    832     233     250       1,735     181     618  
 
 
 
                           
Total revenues
  $ 13,639       159%   $ 5,259     $ 22,397        113%   $ 10,529  
 
 
 
                           
     Our royalties increased in the three and six month periods ended June 30, 2010, as compared to the three and six month periods ended June 30, 2009, reflecting increased royalties earned under our agreement with Endo on Endo’s net sales of Opana ER. For the 2010 three and six month periods, we recognized $12.3 million and $19.5 million, respectively, in royalties from Endo as compared to $4.4 million and $8.8 million, respectively, for the 2009 three and six month periods. This increase in royalties reflects both an increase in net sales of Opana ER as well as an increase in our royalty rate. In the three month period ended March 31, 2010, Endo recouped the remainder of the $28 million in development costs that Endo funded on our behalf, which resulted in an end to the temporary 50% reduction in the royalty rate we earn under our agreement. Mylan’s supply and distribution agreement with Pfizer expired in March 2010. As a result, we do not expect to receive royalties from Mylan on sales of Pfizer’s generic version of Procardia XL 30 mg with respect to any period after the third quarter of 2010.

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     Our product sales in the three and six month periods ended June 30, 2010 and 2009 consisted primarily of sales of formulated TIMERx material to Endo for use in Opana ER. Product sales were lower for the three and six month periods ended June 30, 2010 as compared to 2009 three and six month periods, primarily due to the timing of shipments to Endo. We expect product sales in the second half of 2010 to increase as compared to the first half of 2010 based on higher forecasted sales volumes of our TIMERx material to Endo.
     Revenue from collaborative licensing and development consists of the recognition of revenue relating to reimbursements of our expenses under our drug delivery technology collaborations, milestones and upfront payments from these collaborations. In the three month period ended June 30, 2010, we recognized a milestone payment we earned under one of our development collaborations with Otsuka. The increase in revenue for the three and six month periods ended June 30, 2010, compared with the three and six month periods ended June 30, 2009 reflects the recognition of this milestone payment and overall increased development activity under our drug delivery technology collaborations in effect during the 2010 three and six month periods, as described below under “Cost of Revenues,” resulting in a related increase in revenues during the 2010 three and six month periods.
Cost of Revenues
                                         
    Three months         Three months     Six months         Six months  
    ended     Percentage   ended     ended     Percentage   ended  
    June 30,     increase   June 30,     June 30,     increase   June 30,  
    2010   (decrease)   2009   2010   (decrease)   2009
    (In thousands, except percentages)  
Cost of royalties
    $ 104         9%     $ 95        $ 198        (4)%     $ 207  
Cost of product sales
    142      (1)     143       329      1     325  
Cost of collaborative licensing and development revenue
    587     155       230       1,222     107       590  
 
 
 
       
 
   
 
       
 
 
Total cost of revenues
    $ 833        78%     $ 468       $ 1,749        56%     $ 1,122  
 
 
 
       
 
   
 
       
 
 
     Cost of royalties consists of the amortization of deferred royalty termination costs associated with royalty termination agreements, and the amortization of certain patent costs associated with our TIMERx technology. The cost of royalties were comparable in the three and six month periods ended June 30, 2010 and 2009.
Cost of product sales consists of the costs related to sales of formulated TIMERx material, primarily to Endo for use in Opana ER. Cost of product sales was comparable for the three and six month periods ended June 30, 2010 and 2009. We expect cost of product sales in the second half of 2010 to increase as compared to the first half of 2010 based on higher forecasted shipments of our TIMERx material to Endo for Opana ER.
     Cost of collaborative licensing and development revenue consists of our expenses under our drug delivery technology collaborations, which are generally reimbursed by our collaborators, and which include allocations of internal research and product development, or R&D, expenses, including compensation and overhead costs associated with formulation activities under these collaborations, as well as contract and other outside service fees. These costs increased for the three and six month periods ended June 30, 2010 as compared to the three and six month period ended June 30, 2009 reflecting the increased level of development activity under our drug delivery technology collaboration agreements.
Selling, General and Administrative Expenses
                                         
    Three months       Three months     Six months         Six months  
    ended   Percentage   ended     ended     Percentage   ended  
    June 30,   increase   June 30,     June 30,     increase   June 30,  
    2010   (decrease)   2009     2010     (decrease)   2009  
    (In thousands, except percentages)  
Selling, general and administrative expense
     $  2,453     (25)%      $  3,283        $  4,099     (27)%      $  5,604  
 
 
 
       
 
   
 
       
 
 

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     Selling, general and administrative, or SG&A, expenses for the three month period ended June 30, 2010 decreased compared with the three month period ended June 30, 2009 primarily due to lower professional fees incurred in connection with the 2010 proxy contest in which we were involved as compared to the fees incurred in connection with our 2009 proxy contest and related litigation, and lower compensation expenses as a result of staff reductions implemented in the fourth quarter of 2009. The costs of the 2010 proxy contest for the three month period ended June 30, 2010 was $821,000 as compared to $1.1 million for the cost of the 2009 proxy contest and related litigation. These lower costs were partially offset by the additional share-based compensation expense of $226,000 related to the accelerated vesting of stock options and restricted stock as a result of the change in control of our board of directors in June 2010.
     The decrease in SG&A expenses for six month period ended June 30, 2010, compared with the six month period ended June 30, 2009 was primarily due to lower compensation expenses as a result of staff reductions implemented in the first and fourth quarters of 2009, and lower professional fees incurred in connection with the Company’s 2010 proxy contest as compared to the fees we incurred in connection with the Company’s 2009 proxy contest and related litigation. The cost of the 2010 proxy contest for the six month period ended June 30, 2010 was $846,000 as compared to $1.3 million for the cost of 2009 proxy contest and related litigation. These decreases were partially offset by higher share-based compensation expense in the 2010 six month period, largely reflecting a non-cash credit of $844,000 recorded in the first quarter of 2009, which resulted from the forfeiture of stock options held by former employees in connection with our January 2009 staff reductions, and the additional share-based compensation expense related to the accelerated vesting of stock options and restricted stock from the change in control in our board of directors in June 2010.
     Given the additional expense in the first half of 2010 for our proxy contest and the additional share-based compensation expense for the accelerated vesting of stock options and restricted stock, we expect that SG&A expense in the second half of 2010 will decline as compared with the expense for the first half of 2010.
Research and Product Development Expenses
     R&D expenses were $1.9 million and $4.1 million for the three and six month periods ended June 30, 2010, respectively, compared with $3.4 million and $6.4 million for the three and six month periods ended June 30, 2009, respectively. The decreases reflect lower spending on the development of A0001 in the 2010 three and six month periods, lower compensation expenses due to staff reductions implemented in the first and fourth quarters of 2009 and increased allocations of internal R&D costs relating to our drug delivery technology collaborations to cost of revenues. These lower costs were partially offset by the additional share-based compensation expense related to the accelerated vesting of stock options due to the change in control of our board of directors in June 2010.
In the table below, R&D expenses are set forth in the following categories:
                                         
    Three months       Three months   Six months       Six months
    ended   Percentage   ended   ended   Percentage   ended
    June 30,   increase   June 30,   June 30,   increase   June 30,
    2010   (decrease)   2009   2010   (decrease)   2009
    (In thousands, except percentages)  
 
                                       
A0001 costs
  $   401        (74)%   $ 1,521     $   1,077        (57)%   $   2,519  
Other phase I products and internal costs
    1,502     (21)     1,904       3,034     (22)     3,912  
 
                               
Total research and product development expense
  $ 1,903        (44)%   $   3,425     $ 4,111        (36)%   $ 6,431  
 
                               
In the preceding table, research and development expenses are set forth in the following categories:
    A0001— These expenses reflect our direct external expenses relating to the development of A0001. These expenses approximated 21% and 26%, respectively, of our R&D expenses for the three and six month periods ended June 30, 2010. These expenses for the three and six month periods ended June 30, 2010 decreased compared to the three and six month periods ended June 30, 2009 as we have not conducted any other development work for A0001 other than the two Phase IIa trials in 2010.

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      In May 2008, we submitted an IND for A0001 for the treatment of symptoms associated with inherited mitochondrial respiratory chain diseases. In July 2008, we initiated a Phase Ia placebo-controlled, single ascending dose trial designed to evaluate the safety and tolerability of A0001 in healthy subjects, and to collect pharmacokinetic data. A0001 was well tolerated by all subjects across all dose groups and there were no drug-related serious adverse events. In June 2009, we completed a Phase Ib multiple ascending dose safety study of A0001 in healthy subjects. In the Phase Ib trial, the drug was well tolerated by subjects and no serious adverse events were reported. There was a dose-dependent increase in exposure approaching steady state following repeat dosing, and a maximum tolerated dose was established. We also completed long-term animal toxicology studies to support longer dosing in the clinical program, which we completed in the fourth quarter of 2009. In December 2009 and February 2010, we initiated two Phase IIa studies in patients with mitochondrial diseases, with one trial focused on patients with FA and another trial focused on patients with the A3243G mitochondrial DNA point mutation associated with MELAS syndrome. The goal of these trials will be to determine if A0001 has a discernible impact in the treatment of patients with these disorders using various biochemical, functional and clinical measures. We expect data from both of these trials by the fourth quarter of 2010. The Company is currently seeking to license A0001 to a third party to complete further development and assume responsibility for the commercialization, manufacturing and marketing of this compound.
 
    Other Phase I Products and Internal Costs — These expenses reflect internal and external expenses not separately reported under a product development program noted above, and include the areas of pharmaceutical development, clinical and regulatory. The types of expenses included in internal expenses primarily are salary and benefits, share-based compensation costs, depreciation on purchased equipment, and the amortization or any write-downs of patent costs, other than product patent write-offs charged directly to a separately reported product development program, or amortization of patent costs relating to commercialized products, which are included in cost of revenues. The types of expenses included in external expenses are primarily related to preclinical studies, proof-of-principle biostudies conducted on our Phase I product candidates and payments to third parties for drug active. These costs decreased in the three and six month periods ended June 30, 2010, compared with the three and six month periods ended June 30, 2009 primarily as a result of lower compensation expenses in the three and six month periods ended June 30, 2010 due to staff reductions implemented in the first and fourth quarters of 2009, and increased allocations of internal R&D costs relating to our drug delivery technology collaborations to cost of revenues. These lower costs were partially offset by the additional share-based compensation expense related to the accelerated vesting of stock options due to the change in control of our board of directors in June 2010. We did not incur any expenses relating to Phase I product candidates during the three and six month periods ended June 30, 2010.
     Our product candidates may not advance through or into the clinical development process or be successfully developed, may not receive regulatory approval, or may not be successfully commercialized. Completion of clinical trials and commercialization of these product candidates may take several years, and the length of time can vary substantially according to the type, complexity and novelty of a product candidate. Due to the variability in the length of time necessary to develop a product, the uncertainties related to the estimated cost of the development process and the uncertainties involved in obtaining governmental approval for commercialization, accurate and meaningful estimates of the ultimate cost to bring our product candidates to market are not available.
     In comparison to the first half of 2010, we expect R&D expense to increase over the second half of 2010 as we continue to conduct our Phase IIa trials of A0001. However, in comparison to the full year of 2009, we expect R&D expense for the full year of 2010 to reflect overall decreased levels, primarily due to overall lower expense on A0001. In addition, we expect that the staff reductions we implemented in the first and fourth quarters of 2009, as well as other efforts to closely manage our cost structure, including the consolidation of our Danbury, CT headquarters into our Patterson, NY laboratory and office facility, will also contribute to reduced R&D expense in 2010, compared with 2009. Our development efforts in the second half of 2010 are focused on completing the Phase IIa trials of A0001, analyzing the data and seeking to license A0001 to a third party to complete further development and assume responsibility for the commercialization, manufacturing and marketing of this compound.

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Share-Based Compensation
     The election of three new Class I directors at our 2010 annual meeting of shareholders resulted in a change in control of our board of directors under the terms of certain outstanding stock option and restricted stock awards granted to our employees and directors. As a result, on June 30, 2010, the date that the election results of the annual meeting were certified, stock options to purchase approximately 538,000 shares of our common stock and 25,000 shares of unvested restricted stock were automatically accelerated and vested in full. These accelerations resulted in a charge of $467,000 in the second quarter of 2010, of which $226,000 is included in SG&A expense and $241,000 is included in R&D expense.
     We recognized share-based compensation in our statements of operations as follows:
                                 
    Three Months Ended     Six Months Ended  
   
June 30,
   
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
    (Unaudited) (In thousands)  
Selling, general and administrative
  $ 365     $ 266     $ 513     $ (302 )
Research and product development
    342       151       442       315  
 
                       
Total
  $ 707     $ 417     $ 955     $ 13  
 
                       
     The increase in total share-based compensation expense for the three month period ended June 30, 2010, compared with the three month period ended June 30, 2009 is attributable to the accelerated vesting of stock options and restricted stock recorded in the second quarter of 2010, as discussed above.
     The increase in total share-based compensation expense for the six month period ended June 30, 2010, compared with the six month period ended June 30, 2009, reflects credits recorded in the 2009 six month period totaling approximately $885,000, which were associated with the forfeiture of employee stock options in such period due to the staff reductions we implemented in the first quarter of 2009. The increase is also attributable to the accelerated vesting of stock options and restricted stock recorded in the second quarter of 2010. These increases were partially offset by a reduction in expense due to the forfeiture of stock options that resulted from the staff reductions we implemented in the fourth quarter of 2009.
Tax Rates
     Our effective tax rates for the three and six month periods ended June 30, 2010 and 2009 were zero. Our effective tax rates differ from the federal statutory rate of 35% for 2010 and 34% for 2009 primarily due to valuation allowances recorded to offset deferred tax assets relating to our net operating loss carryforwards.
Liquidity and Capital Resources
Sources of Liquidity
     Since 1998, when we became an independent, publicly owned company, we have funded our operations and capital expenditures from the proceeds of the sale and issuance of shares of common stock, sales of excipients, the sale of our excipients business, sales of formulated bulk TIMERx material, royalties and milestone payments from Endo, Mylan and other collaborators, reimbursements of R&D costs from our drug delivery technology collaborators, and advances under credit facilities. As of June 30, 2010, we had cash, cash equivalents and short-term investments of approximately $14.4 million.
     Senior Secured Credit Facility. On March 13, 2007, we entered into a $24.0 million senior secured credit facility with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., which was acquired by GE Capital in February 2008, and is now known as GE Business Financial Services Inc. The credit facility consists of: (i) a $12.0 million term loan advanced upon the closing of the credit facility and (ii) a $12.0 million term loan that we had the right to access until September 15, 2008, subject to conditions specified in the credit agreement. We did not access the second $12.0 million term loan prior to September 15, 2008, at which time it expired in accordance with the terms of the agreement.

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     Our outstanding term loan has a term of 42 months from the date of advance, with interest-only payments for the first nine months; interest plus monthly principal payments equal to 1.67% of the loan amount for the period from the end of the interest-only period through December 2008; and interest plus straight line amortization payments with respect to the remaining principal balance for the remainder of the term, through its maturity date in September 2010.
     The interest rate on our outstanding term loan is fixed at 10.32%. At the time of final payment of the loan we will pay an exit fee of 3.0% of the original principal loan amount. Should any prepayment occur, we are also required to pay prepayment penalties of 3.0% of any prepaid amount in the first year, 2.0% of any prepaid amount in the second year and 1.0% of any prepaid amount thereafter. As of June 30, 2010, $1,371,000 of the term loan was outstanding. Beginning January 2008, we began making monthly principal payments on this loan, in addition to the monthly interest payments. Beginning January 2009, the principal portion of our payments increased from their 2008 level to reflect the straight line amortization of the remaining principal amount outstanding, as noted above. Principal payments on the term loan subsequent to June 30, 2010 are expected to total approximately $1,371,000 through September 30, 2010, at which time, the loan amount will have been paid in full and the exit fee of $360,000 will be required to be paid.
Cash Flows
     We had net cash provided by operations of $5.5 million for the six month period ended June 30, 2010 that primarily resulted from our net income of $12.2 million, which included non-cash charges of $611,000 for depreciation and amortization, and $955,000 for share based compensation. Cash flow from operations also reflected an increase in receivables of $7.0 million primarily related to increased accrued royalties from Endo for the second quarter of 2010 and a $1.1 million decrease in accounts payable and accrued expenses primarily due to the net pay down of these liabilities and decreased operating expenses.
     Net cash used in investing activities was $1.1 million for the six month period ended June 30, 2010, reflecting purchases of marketable securities of $1.6 million less maturities of marketable securities of $490,000. Net cash used by financing activities was $2.6 million, reflecting the repayments of principal on our outstanding term loan described above of $2.7 million, partially offset by the cash received from the issuance of common stock through the exercise of stock options of $129,000.
Funding Requirements
     We anticipate that, based upon our current operating plan, our existing capital resources, together with expected royalties from third parties, will be sufficient to fund our operations on an ongoing basis through at least 2011, including paying off our credit facility with GE Business Financial Services Inc. and paying a special cash dividend as discussed below. If, however, we do not receive royalties from Endo for Opana ER in such amounts as we anticipate, based on forecasts we received from Endo, we may not be able to fund our ongoing operations through 2011 without seeking additional funding from the capital markets, and may not be able to declare and pay the special cash dividend.
     We have taken measures to reduce our spending and to manage our costs more closely, including the staff reductions that we implemented in the first and fourth quarters of 2009, as described above under the caption “Restructuring Charges”, and we have operated in 2009 and 2010 based on a narrowed set of priorities. In July 2010, we determined that we would reduce our staff further as part of our continuing efforts to manage our overheard costs. We did however, incur significant unplanned costs in connection with the proxy contests associated with our 2010 and 2009 annual meetings of shareholders and the related litigation. These costs, including legal and other advisory fees, totaled $846,000 for the six month period ended June 30, 2010 and $1.3 million for the six month period ended June 30, 2009, and for the 2009 six month period, included costs of litigation relating to three lawsuits brought by the shareholders who initiated the proxy contest, two of which lawsuits were dismissed in 2009 and one of which was dismissed in May 2010.
     Our board of directors currently intends to declare a special cash dividend in the fourth quarter of 2010. The Board announced that it expects that the special dividend would be between $0.50 and $0.75 per share in cash. However, any determination to pay a dividend and the size of that dividend would be subject to Endo’s net sales for

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Opana ER during the remainder of 2010 and any other events that may arise that would limit the availability of our cash resources for distribution. Our board of directors also plans to continue to consider additional cash dividends in future years as our cash resources warrant.
     We are also seeking to enter into collaboration and licensing agreements for the development and marketing of Opana ER in territories outside the United States with our partner Endo, and for nalbuphine ER, and to enter into additional drug delivery technology collaborations. These collaborations may provide additional funding for our operations.
     We expect that our total capital expenditures in 2010 will not exceed approximately $100,000.
     In connection with the expiration of our manufacturing agreement with Draxis, our contract manufacturer of TIMERx material in November 2009, we plan to increase our inventory levels of TIMERx material during the second half of 2010, which will require additional use of our cash resources. We signed a manufacturing agreement with Patheon Inc., or Patheon, in the second quarter of 2010. We have begun to work with Endo on the qualification of Patheon in connection with our supply of TIMERx material to Endo for Opana ER, which will require additional use of cash resources. We expect the qualification of Patheon will be completed by the second quarter of 2011.
     In 2010, as a result of our forecasted profitability and limitations on the amount of our net operating loss, or NOL, carryforwards, described under “Net Operating Loss Carryforwards” below, that we may use to offset our taxable income, we anticipate that we will be subject to federal alternative minimum tax under the Internal Revenue Code. Accordingly, in the first half of 2010, we made approximately $170,000 in federal income tax payments and expect to make additional income tax payments during the remainder of 2010, for a total of approximately $550,000 in estimated federal income tax payments for 2010.
     Requirements for capital in our business are substantial. Our potential need to seek additional funding will depend on many factors, including:
    the commercial success of Opana ER, and the amount of royalties from Endo’s sales of Opana ER, which may be adversely affected by any potential generic competition;
 
    the timing and amount of payments received under our drug delivery technology collaborative agreements;
 
    the results of our Phase IIa clinical trials of A0001, and our ability to license A0001 or otherwise to access funding and support for the development of A0001;
 
    our and Endo’s ability to enter into new collaborations for Opana ER outside the United States, and the structure and terms of any such agreements;
 
    our ability to access funding support for development programs from third party collaborators;
 
    our ability to enter into drug delivery technology collaborations, and the structure and terms of such collaborations;
 
    the level of our investment in capital expenditures for facilities or equipment; and
 
    our success in reducing our spending and managing our costs.
     We plan to meet our long-term cash requirements through our existing levels of cash and marketable securities, and our revenues, including royalties, from collaborative agreements.
     On September 26, 2008, we filed a registration statement on Form S-3 with the SEC, which became effective on October 30, 2008. This shelf registration statement covers the issuance and sale by us of any combination of

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common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million. No securities have been issued under this shelf registration statement.
     If we raise additional funds by issuing equity securities, further dilution to our then-existing shareholders may result. Additional debt financing, such as the credit facility noted above, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements, or research and development arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or potential products, or grant licenses on terms that may not be favorable to us.
     We cannot be certain that additional financing will be available in amounts or on terms acceptable to us, if at all. In the current economic environment, market conditions have made it very difficult for companies such as ours to obtain equity or debt financing. We believe that any such financing that we could conduct would be on significantly unfavorable terms. If we seek but are unable to obtain additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, including our planned clinical trials, which could harm our financial condition and operating results.
Contractual Obligations
     Our outstanding contractual cash obligations include obligations under our operating leases primarily for our facility in Patterson, NY; purchase obligations primarily relating to preclinical and clinical development, and our drug delivery technology collaboration obligations; payments due under our credit facility relating to interest, principal and exit fees; and obligations under deferred compensation plans as discussed below. Following is a table summarizing our contractual obligations as of June 30, 2010, excluding our contingent obligations under the Edison agreement, and our executive and employee retention agreements discussed below (in thousands).
                                         
            Less Than   1-3   4-5   After 5
    Total   One Year   Years   Years     Years
Operating leases
  $ 113     $ 113     $     $     $  
Purchase obligations
    3,801       3,801                    
Payments due under credit facility
    1,755       1,755                    
Deferred compensation
    2,528       291       582       582       1,073  
 
                             
Total
  $ 8,197     $ 5,960     $ 582     $   582     $   1,073  
 
                             
     We lease approximately 15,500 square feet of laboratory and office space in Patterson, New York. On November 3, 2009, we signed an extension to our lease for one year through December 31, 2010, with a renewal option for an additional one-year period.
      Deferred compensation reflects the commitments described below:
    We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan which covers our former Chairman and Chief Executive Officer, Tod R. Hamachek. Under the SERP, effective in May 2005, we became obligated to pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his spouse.
 
    We also have a Deferred Compensation Plan, or DCP, a nonqualified plan which covers Mr. Hamachek. Under the DCP, effective in May 2005, we became obligated to pay Mr. Hamachek approximately $140,000 per year, including interest, in ten annual installments. However, these installments are recalculated annually based on market interest rates as provided for under the DCP.
     We do not fund these liabilities, and no assets are held by the plans. However, we have two whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. Mr. Hamachek’s SERP and DCP benefit payments are being made directly from the assets in the trust. As of June 30, 2010, the trust assets consisted of the cash surrender value of these life insurance policies totaling $2,078,000 and $77,000 held in a money market account for a total of $2,155,000.

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     Under the terms of the Edison agreement, we are obligated to make milestone payments to Edison upon the achievement of certain clinical and regulatory events. We will not be responsible for the payment of future milestone and/or royalty payments in the event that the development program is discontinued and the agreement is terminated prior to the achievement of these events. Preclinical and clinical development of drug candidates is a long, expensive and uncertain process. At any stage of the preclinical or clinical development process, we may decide to discontinue the development of A0001 or other drug candidates under the Edison agreement. The contractual obligations listed in the table above do not include any such future potential milestone or royalty payments to Edison.
     On November 12, 2008, we entered into executive retention agreements with each of our executive officers. These retention agreements replaced prior retention agreements with each of our executive officers that had been scheduled to expire on December 31, 2008. On March 10, 2010, we entered into amendments to these agreements. The retention agreements provide that, if, within 18 months following a change in control of our company, the executive’s employment is terminated by us other than for cause, death, or disability, or by the executive for good reason, as such terms are defined in the agreement, the executives are entitled to payments for severance and other benefits, including medical insurance, and the automatic vesting of all invested stock options.
     The election of three new Class I directors at the 2010 annual meeting of shareholders resulted in a change in control of our company under the retention agreements as of June 30, 2010, the date that the election results of the annual meeting were certified. As a result, under the executive retention agreements, if within 18 months of the June 30, 2010 change in control, an executive officer is terminated by us other than for cause, death, or disability, or by the executive for good reason, we would be obligated to pay the benefits provided for under these retention agreements which, as of June 30, 2010, we estimate would total approximately $3.4 million under all executive retention agreements. These contingent obligations are not included in the contractual obligations table above.
     In the second quarter of 2010, we entered into employee retention agreements with certain of our employees, providing for severance pay and continued medical insurance benefits upon termination without cause as defined in the agreements. We estimate that these contingent obligations total approximately $380,000 as of June 30, 2010, which amount is not included in the contractual obligations table above.
Net Operating Loss Carryforwards
     In 2008, we determined that an ownership change had occurred under Section 382 of the Internal Revenue Code, or Section 382. As a result, the utilization of our net operating loss, or NOL, carryforwards and other tax attributes through the date of ownership change will be limited to approximately $2.8 million per year over the subsequent 20 years into 2028. We also determined that we were in a “net unrealized built-in gain” position (for purposes of Section 382) at the time of the ownership change, which increased the annual limitation over the subsequent five years into 2013 by approximately $3.4 million per year. Accordingly, we have reduced our NOL carryforwards, and research and development tax credits to the amount that we estimate that we will be able to utilize in the future, if profitable, considering the above limitations. In accordance with ASC 740 “Income Taxes”, we provided a full valuation allowance against substantially all of our net deferred tax assets because it is not more likely than not that we will realize future benefits associated with deductible temporary differences and NOLs at June 30, 2010 and December 31, 2009.
     At December 31, 2009, we had federal NOL carryforwards of approximately $90.5 million for income tax purposes, which expire at various dates beginning in 2018 through 2029. At December 31, 2009, we had state NOL carryforwards of approximately $89.5 million, which expire at various dates beginning in 2023 through 2029. In addition, at December 31, 2009, we had federal research and development tax credit carryforwards of approximately $1.8 million, which expire beginning in 2028 through 2029. The NOLs incurred subsequent to the 2008 ownership change and through December 31, 2009 of $18.0 million are not limited on an annual basis. Pursuant to Section 382, subsequent ownership changes could further limit this amount. The use of the NOL carryforwards, and research and development tax credit carryforwards are limited to our future taxable earnings.
     For financial reporting purposes, at December 31, 2009 and 2008, respectively, valuation allowances of $43.3 million and $40.6 million have been recognized to offset net deferred tax assets, primarily attributable to our NOL carryforwards. As previously noted, in 2008, we reduced our tax attributes (NOLs and tax credits) as a result

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of our ownership change under Section 382 and the limitation placed on the utilization of our tax attributes, as a substantial portion of the NOLs and tax credits generated prior to the ownership change will likely expire unused. Accordingly, the NOLs were reduced by $123.0 million and the tax credits were reduced by $6.7 million upon the ownership change in 2008. Our valuation allowance increased (decreased) in 2009, 2008 and 2007 by $2.6 million, ($32.0) million and $9.9 million, respectively. The decrease in the valuation allowance in 2008 of $32.0 million was primarily due to the limitations placed on the utilization of our tax attributes as noted above.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk and Risk Management Policies
     Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates and other market changes. Market risk is attributed to all market sensitive financial instruments, including debt instruments. Our operations are exposed to financial market risks, primarily changes in interest rates. Our outstanding term loan under our credit facility is at a fixed rate of interest and therefore, we do not believe that there is significant exposure to changes in interest rates under the term loan. Our interest rate risk primarily relates to our investments in marketable securities.
     The primary objectives for our investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return, consistent with these two objectives. Our investment policy limits investments to specific types of instruments issued by institutions with investment grade credit ratings and places certain restrictions on maturities and concentration by issuer.
     At June 30, 2010, our marketable securities consisted primarily of debt securities issued by a U.S. government sponsored enterprise and corporate commercial paper, and approximated $1.3 million. These marketable securities had maturity dates of up to three months. Due to the relatively short-term maturities of these securities, management believes they have no significant market risk. At June 30, 2010, our marketable securities were carried at market value. Due to the nature of our cash equivalents, which are money market accounts at June 30, 2010, management believes they have no significant market risk. As of June 30, 2010, we had approximately $14.4 million in cash, cash equivalents and marketable securities, and accordingly, a sustained decrease in the rate of interest earned of 1% would have caused a decrease in the annual amount of interest earned of up to approximately $144,000. However, due to the minimal yields actually earned on our investments during 2010, the maximum impact to our investment earnings would have been approximately $3,000, which was our total investment income for the first half of 2010.
Item 4. Controls and Procedures
     (a) Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our chief executive officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2010. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (or the Exchange Act) means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2010, our chief executive officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

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       (b) Changes in Internal Control Over Financial Reporting. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
Item 1. Legal Proceedings
Impax ANDA Litigation
     On December 14, 2007, we received a notice from IMPAX Laboratories, Inc., or IMPAX, advising us of the FDA’s apparent acceptance for substantive review, as of November 23, 2007, of IMPAX’s amended ANDA for a generic version of Opana® ER. IMPAX stated in its letter that the FDA requested that IMPAX provide notification to us and Endo of any Paragraph IV certifications submitted with its ANDA, as required under section 355(j) of the Federal Food, Drug and Cosmetics Act, or the FDC Act. Accordingly, IMPAX’s letter included notification that it had filed Paragraph IV certifications with respect to our U.S. Patent Nos. 7,276,250, 5,958,456 and 5,662,933, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2023, 2013 and 2013, respectively. Endo’s Opana® ER product had new dosage form exclusivity that prevented final approval of any ANDA by the FDA until the exclusivity expired on June 22, 2009. In addition, because IMPAX’s application referred to patents owned by us and contained a Paragraph IV certification under section 355(j) of the FDC Act, we believe that IMPAX’s notice triggered the 45-day period under the FDC Act in which Endo and we could file a patent infringement action and trigger the automatic 30-month stay of approval. Subsequently, on January 25, 2008, Endo and we filed a lawsuit against IMPAX in the United States District Court for the District of Delaware in connection with IMPAX’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, IMPAX filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable.
     On June 16, 2008, Endo and we received a notice from IMPAX that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg, 15 mg and 30 mg strengths of Opana® ER. The notice covers our U.S. Patent Nos. 7,276,250, 5,958,456 and 5,662,933. Subsequently, on July 25, 2008, Endo and we filed a lawsuit against IMPAX in the United States District Court for the District of Delaware in connection with IMPAX’s amended ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, IMPAX filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable. All three of these suits against IMPAX were transferred to the United States District Court for the District of New Jersey.
     On June 8, 2010, Endo and we settled the IMPAX litigation. Both sides dismissed their respective claims and counterclaims with prejudice. Under the terms of the settlement, IMPAX agreed not to challenge the validity or enforceability of our patents relating to Opana® ER with respect to IMPAX’s generic version of Opana ER and not to sell a generic version of Opana ER until January 1, 2013 or earlier under specified circumstances (such date being the “Commencement Date”). Endo and we agreed to grant IMPAX a license under the Opana Patents permitting the sale of generic Opana® ER upon the Commencement Date. The license granted to IMPAX is non-exclusive except with respect to the 180 day period following the Commencement Date for those dosage strengths for which IMPAX is entitled to first-to-file exclusivity, during which period the license is exclusive as to all but the Opana ER branded product and licenses previously granted by Endo and us to ANDA holders.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.

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Actavis ANDA Litigation
     In February 2008, we received a notice from Actavis South Atlantic LLC, or Actavis, advising of the filing by Actavis of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) for a generic version of Opana® ER. The Actavis Paragraph IV certification notice refers to our U.S. Patent Nos. 5,128,143, 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire or expired in 2008, 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER has a new dosage form (referred to as NDA) exclusivity that prevents final approval of any ANDA by the FDA until the exclusivity expires on June 22, 2009. Subsequently, on March 28, 2008, Endo and we filed a lawsuit against Actavis in the United States District Court for the District of New Jersey, in connection with Actavis’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. On May 5, 2008, Actavis filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable, as well as a claim of unfair competition against the us and Endo.
     On or around June 2, 2008, we received a notice from Actavis that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg and 15 mg dosage strengths of Opana® ER. On or around July 2, 2008, we received a notice from Actavis that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 30 mg dosage strength. Both notices cover our U.S. Patent Nos. 5,128,143, 7,276,250, 5,958,456 and 5,662,933. On July 11, 2008, Endo and we filed suit against Actavis in the United States District Court for the District of New Jersey. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. On August 14, 2008, Actavis filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable, as well as a claim of unfair competition against Endo and us.
     On February 20, 2009, Endo and we settled all of the Actavis litigation. Both sides dismissed their respective claims and counterclaim with prejudice. Under the terms of the settlement, Actavis agreed not to challenge the validity or enforceability of our patents relating to Opana® ER. Endo and we agreed to grant Actavis a license permitting the production and sale of generic Opana® ER 7.5 and 15 mg tablets by the earlier of July 15, 2011, the last day Actavis would forfeit its 180-day exclusivity, and the date on which any third party commences commercial sales of Opana® ER, but not before November 28, 2010. Endo and we also granted Actavis a license to produce and market other strengths of Opana® ER generic on the earlier of July 15, 2011 and the date on which any third party commences commercial sales of a generic form of the drug.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
Sandoz ANDA Litigation
     On July 14, 2008, we received a notice from Sandoz, Inc., or Sandoz, advising us of the filing by Sandoz of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 5 mg, 10 mg, 20 mg and 40 mg dosage strengths. The Sandoz Paragraph IV certification notice refers to our U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER has a new dosage form (NDA) exclusivity that prevents final approval of any ANDA by the FDA until the exclusivity expires on June 22, 2009. Subsequently, on August 22, 2008, Endo and we filed a lawsuit against Sandoz in the United States District Court for the District of Delaware in connection with Sandoz’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. In response, Sandoz filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable.
     On November 20, 2008, we received a notice from Sandoz that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 7.5 mg, 15 mg and 30 mg dosage strengths of Opana® ER. The notice covers our U.S. Patent Nos. 5,128,143, 7,276,250, 5,958,456 and 5,662,933. On December 30, 2008, Endo and we filed suit against Sandoz in the United States District Court for the District of New Jersey. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation. In response, Sandoz filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange

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Book are invalid, not infringed and/or unenforceable. Both of these pending suits against Sandoz were transferred to the United States District Court for the District of New Jersey.
     On June 8, 2010, Endo and we settled the Sandoz litigation. Both sides dismissed their respective claims and counterclaims with prejudice. Under the terms of the settlement, Sandoz agreed not to challenge the validity or enforceability of our patents relating to Opana® ER. Endo and we agreed to grant Sandoz a license permitting the production and sale of all strengths of Opana® ER commencing on September 15, 2012, or earlier under certain circumstances.
The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
Barr ANDA Litigation
     On September 12, 2008, we received a notice from Barr Laboratories, Inc., or Barr, advising us of the filing by Barr of an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in a 40 mg dosage strength. On September 15, 2008, we received a notice from Barr that it had filed an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 5 mg, 10 mg, and 20 mg dosage strengths. Both notices refer to our U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013 and 2023, respectively. In addition to these patents, Opana® ER had a new dosage form exclusivity that prevented final approval of any ANDA by the FDA until the exclusivity expired on June 22, 2009. Subsequently, on October 20, 2008, Endo and we filed a lawsuit against Barr in the United States District Court for the District of Delaware in connection with Barr’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. In response, Barr filed an answer and counterclaims, asserting claims for declaratory judgment that the patents listed in the Orange Book are invalid, not infringed and/or unenforceable. This suit was transferred to the United States District Court for the District of New Jersey. On June 2, 2009, we received a notice from Barr that it had filed an ANDA containing a Paragraph IV certification under 21 U.S.C. Section 355(j) with respect to Opana® ER in 7.5 mg, 15 mg, and 30 mg dosage strengths. This notice also refers to our U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. On July 2, 2009, Endo and we filed a lawsuit against Barr in the United States District Court for the District of New Jersey in connection with Barr’s ANDA.
     On April 12, 2010, Endo and we settled the litigation with Barr. Under the terms of the settlement, Barr agreed not to challenge the validity or enforceability of our patents relating to the production and sale of generic formulations of Opana® ER (oxymorphone hydrochloride) Extended Release Tablets CII, and Endo and we agreed to grant Barr a license under the Orange-Book listed patents to sell a generic of Opana® ER on or after September 15, 2012, or earlier under certain circumstances.
     The settlement is subject to the review of the U.S. Federal Trade Commission and Department of Justice.
Roxane ANDA Litigation
     On December 29, 2009, we received a notice from Roxane Laboratories, or Roxane, advising us of the filing by Roxane of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355(j) with respect to Opana® ER in a 40 mg dosage strength. The notice refers to our U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013, and 2023, respectively. Subsequently, on January 29, 2010, Endo and we filed a lawsuit against Roxane in the United States District Court for the District of New Jersey in connection with Roxane’s ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation.
     In March 2010, we received a notice from Roxane that it had filed an amendment to its ANDA containing Paragraph IV certifications for the 5, 7.5, 10, 15, 20 and 30 mg dosage strengths of Opana® ER. Subsequently, on April 16, 2010, Endo and we filed a lawsuit against Roxane in the United States District Court of the District of New Jersey in connection with Roxane’s amended ANDA. The lawsuit alleges infringement of an Orange Book-listed U.S. patent that covers the Opana® ER formulation.

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Watson ANDA Litigation
     On January 20, 2010, we received a notice from Watson Laboratories Inc., or Watson, advising us of the filing by Watson of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355(j) with respect to Opana® ER in a 40 mg dosage strength. The notice refers to our U.S. Patent Nos. 5,662,933, 5,958,456 and 7,276,250, which cover the formulation of Opana® ER. These patents are listed in the FDA’s Orange Book and expire in 2013, 2013, and 2023, respectively. Subsequently, in March 2010, Endo and we filed a lawsuit against Watson in the United States District Court for the District of New Jersey, in connection with Watson’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana® ER formulation. On March 19, 2010, we received a notice from Watson advising of the filing by Watson of an ANDA containing a Paragraph IV certification under 21 U.S.C. section 355 (j) with respect to Opana ER in 5, 7.5, 10, 15, 20 and 30 mg dosage strengths. Subsequently, on April 23, 2010, Endo and we filed a lawsuit against Watson in the United States District Court of the District of New Jersey in connection with Watson’s ANDA. The lawsuit alleges infringement of certain Orange Book-listed U.S. patents that cover the Opana ER formulation.
     We intend to pursue all available legal and regulatory avenues in defense of Opana® ER, including enforcement of our intellectual property rights and approved labeling. We cannot, however, predict or determine the timing or outcome of any of these litigations but will explore all options as appropriate in the best interests of Endo and us.
Tang/Edelman Shareholder Claim
     In March and April 2009, Tang Capital and Perceptive, our two largest shareholders and each of which owns more than 20% of our outstanding securities, brought a total of three lawsuits against us in 2009: two in Thurston County, Washington and one in King County, Washington. Following the 2009 dismissal of the two Thurston County actions and the May 2010 dismissal of the complaint in King County, as discussed below, none of these lawsuits remains pending.
     On March 12, 2009, Tang Capital and Perceptive brought suit against us in the Superior Court of the State of Washington, Thurston County (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co., No. 09-2-00617-0), seeking declaratory and injunctive relief to uphold their claims that their nomination notice had satisfied the requirements set forth in our bylaws and requesting that the court issue an order preventing us from seeking to disallow or otherwise prevent or not recognize their nominations, or the casting of votes in favor of their designees, on the basis that they had not complied with the provisions of our bylaws or applicable state law. On March 13, 2009, Tang Capital and Perceptive moved for a preliminary injunction to enjoin us from mailing any ballots to shareholders that contain provisions to vote for director nominees and enjoining any shareholder vote on individuals nominated for the board of directors unless the three designees of Tang Capital and Perceptive are permitted to be nominated and votes are permitted to be cast in their favor, or a court resolves the merits of their declaratory judgment action described above. On March 20, 2009, we confirmed in writing that Tang Capital and Perceptive’s nomination notice had been timely received and that, assuming the accuracy and completeness of the information contained in their notice, their notice in all other respects met the requirements of our bylaws in regard to notices of intention to nominate. On March 23, 2009, Tang Capital and Perceptive withdrew their motion for injunctive relief, and on April 10, 2009, they voluntarily dismissed the suit.
     On April 20, 2009, Tang Capital and Perceptive brought suit against us in the Superior Court of the State of Washington, King County, (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co.), seeking to enforce their alleged rights under the Washington Business Corporation Act to inspect certain Company documents (the “King County Action”). Our position is that certain of the requested documents are outside the scope of documents for which the Washington Business Corporation Act permits a statutory inspection right and that certain of the conditions to qualify for statutory inspection rights have not been satisfied.
     On April 28, 2009, Tang Capital and Perceptive brought suit against us in the Superior Court of the State of Washington, Thurston County (Tang Capital Partners, et al. v. Penwest Pharmaceuticals Co.), seeking either for the court to set the number of directors to be elected at our 2009 annual meeting of shareholders at three rather than two, or for the court to require us to waive the advance notice provisions of our bylaws to permit Tang Capital and Perceptive to include a proposal in the proxy statement in which the required percentage for board approval of

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certain matters would be 81% or more, rather than 75% or more. On May 13, 2009, Tang Capital and Perceptive dismissed this Thurston County action reasserting the same claims via an amended complaint in the King County Action. Tang Capital and Perceptive sought preliminary injunctive relief on their claims prior to our 2009 annual meeting of shareholders and the motion was denied by the court on May 22, 2009. The proposed bylaw amendment and bylaw proposal were not approved by our shareholders at our 2009 annual meeting of shareholders.
     By stipulation of the parties, the suit was dismissed without prejudice on May 13, 2010.
Item 1A. Risk Factors
     Our business faces many risks. If any of the events or circumstances described in the following risks actually occurs, our business, financial condition or results of operations could suffer and the trading price of our common stock could decline. The following risks should be considered, together with all of the other information in this annual report before deciding to invest in our securities.
We have a history of net losses and may not be able to achieve or maintain profitability on an annual basis
     We have incurred annual net losses since 1994, including annual net losses of $1.5 million, $26.7 million and $34.5 million in 2009, 2008 and 2007, respectively. Net losses have had an adverse effect on our shareholders’ equity, total assets and working capital, and may continue to do so in the future. As of June 30, 2010, our accumulated deficit was approximately $223 million.
     We have been profitable on a quarterly basis since the third quarter of 2009, our first quarter of net profitability from continuing operations. If we do not receive royalties from Endo for Opana ER in such amounts as forecasted and provided to us by Endo, we may not be able to achieve profitability for the remaining individual quarters of 2010 or for the full year 2010. In addition, we may not be able to achieve profitability on a quarterly or annual basis in periods beyond 2010, and even if we are able to achieve such profitability, we may not be able to maintain it.
     Our future profitability will depend on numerous factors, including:
    the commercial success of Opana ER, and the amount of royalties on sales of Opana ER, which may be adversely affected by any potential generic competition;
 
    the prosecution, defense and enforcement of our patents and other intellectual property rights, such as our Orange Book listed patents for Opana ER, and the prosecution by us and Endo of additional patent applications with respect to Opana ER;
 
    our ability to enter into drug delivery technology collaborations and generate revenues under drug delivery collaborations;
 
    our ability to license or to access funding and support for A0001 from third party collaborators;
 
    the level of our investment in research and development activities, including the timing and costs of conducting clinical trials of A0001;
 
    the amount of our general and administrative expenses; and
 
    the successful development and commercialization of product candidates in our portfolio, and products being developed for collaborations.
We may require additional funding, which may be difficult to obtain
     As of June 30, 2010, we had cash, cash equivalents and marketable securities of approximately $14.4 million.
     Requirements for capital in our business are substantial. Our potential need to seek additional funding will depend on many factors, including:

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    the commercial success of Opana ER, and the amount of royalties we receive on sales of Opana ER, which may be adversely affected by any potential generic competition;
 
    the timing and amount of payments received under our drug delivery technology collaboration agreements;
 
    the results of our Phase IIa clinical trials of A0001, and our ability to license or enter into collaborations for A0001 or otherwise access funding and support for the development of A0001;
 
    our and Endo’s ability to enter into collaborations for Opana ER outside the United States, and the structure and terms of any such agreements;
 
    our ability to access funding support for development programs from third party collaborators;
 
    our ability to enter into drug delivery technology collaborations, and the structure and terms of such collaborations;
 
    the level of our investment in capital expenditures for facilities and equipment; and
 
    our success in continuing to reduce our spending and managing our costs.
     We anticipate that, based upon our current operating plan, our existing capital resources, together with expected royalties from third parties, will be sufficient to fund our operations on an ongoing basis through at least 2011, including paying off our credit facility with GE Business Financial Services Inc. and paying a special cash dividend in the fourth quarter of 2010 that our board of directors intends to declare. If, however, we do not receive royalties from Endo for Opana ER in such amounts as we anticipate based on forecasts we received from Endo, we may not be able to fund our ongoing operations through 2011 without seeking additional funding from the capital markets and we may not be able to pay the special cash dividend.
     Under the current economic environment, market conditions have made it very difficult for companies like ours to obtain equity or debt financing in the capital markets. We believe that any such financing that we could obtain would be on significantly unfavorable terms. If we raise additional funds by issuing equity securities, further dilution to our then-existing shareholders may result. Additional debt financing, such as the credit facility noted below, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements, or research and development arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or potential products, or grant licenses on terms that may not be favorable to us. If we seek but are unable to obtain additional financing, we may be required to delay, reduce the scope of, or eliminate our planned development activities, including our planned clinical trials, which could harm our financial condition and operating results.
Our ability to generate revenues depends heavily on the success of Opana ER
     We made a significant investment of our financial resources in the development of Opana ER. In the near term, our ability to generate significant revenues will depend primarily on the growth of Opana ER sales by Endo. Opana ER competes with a number of approved drugs manufactured and marketed by major pharmaceutical companies and generic versions of some of these drugs. Opana ER may have to compete against new drugs and generic versions of Opana ER that may enter the market in the future. If Opana ER sales do not grow steadily or substantially, it would have a material adverse effect on our business, financial condition and results of operations.
     The degree of market success of Opana ER depends on a number of factors, including:
    the safety and efficacy of Opana ER as compared to competing products;
 
    Endo’s ability to educate the medical community about the benefits, safety and efficacy of Opana ER;
 
    the effectiveness of Endo’s sales and marketing activities;

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    the potential impact of tamper resistant opioids being developed or newly available in the market;
 
    Endo’s ability to manufacture and maintain suitable inventory for sale on an ongoing basis;
 
    the reimbursement policies of government and third party payors with respect to Opana ER;
 
    the pricing of Opana ER;
 
    the level of stocking of Opana ER by wholesalers and retail pharmacies;
 
    the required risk evaluation management strategy currently being considered by the FDA; and
 
    the availability of generic versions of Opana ER and the timing of generic competition.
     IMPAX, Actavis, Sandoz, Barr, Roxane and Watson have each filed ANDA’s for generic versions of Opana ER that, together with their respective amendments, cover all seven strengths of Opana ER. Each of these ANDA filings contained paragraph IV certifications under the Hatch-Waxman Act. Endo and we have filed patent infringement lawsuits against each of Roxane and Watson in connection with their respective ANDAs. We have settled our litigation with IMPAX, Sandoz, Actavis and Barr. Descriptions of these lawsuits are included in “Part I. Item 3. — Legal Proceedings.”
     Endo and we intend to pursue all available legal and regulatory avenues defending Opana ER. Under the Hatch-Waxman Act, the FDA may not grant final approval of any of these ANDA’s for 30 months after the date we received the certifications. Following the expiration of the 30-month stay, the FDA could grant final marketing approval to any of these ANDAs whether or not the litigation is still pending. IMPAX did receive final marketing approval of its ANDA upon expiration of the 30-month stay in June 2010. However, under the terms of our settlement agreement, IMPAX has agreed not to market a generic version of Opana ER until January 2013. Because of IMPAX’s first-to-file status of the approved strengths of Opana ER, the other generic filers will not be able to launch their generic until IMPAX has had 180 days of market exclusivity. Under the terms of our agreement with Actavis, we granted Actavis a license to produce and market the 7.5 mg and 15 mg strengths as early as July 2011.
     If we are unsuccessful in our Hatch-Waxman patent lawsuits against Roxane and Watson, Opana ER could be subject to generic competition upon the conclusion of such lawsuits and the end of the thirty month stay. We expect that competition from one or more generic companies could cause significant erosion to the pricing of Opana ER, which in turn would adversely affect the royalties that we receive from Endo and our results of operations and financial condition.
     In the event that we are able to obtain regulatory approval of any of our other product candidates, the success of those products would also depend upon their acceptance by physicians, patients, third party payors or the medical community in general. There can be no assurance as to market acceptance of our drug products or our drug delivery technologies.
Our success depends on our ability, or our collaborator’s ability, to protect our patents and other intellectual property rights
     Our success depends in significant part on our ability, or our collaborator’s ability, to obtain patent protection for our products, both in the United States and in other countries, or on our collaborator’s ability to obtain patents with respect to products on which we are collaborating with them. Our success also depends on our and our collaborator’s ability to enforce these patents. Patent positions can be uncertain and may involve complex legal and factual questions. Endo and we have filed additional patent applications with respect to Opana ER which, if issued, could delay generic competition. However, patents may not be issued from these patent applications or any other patent applications that we own or license. If patents are issued, the claims allowed may not be as broad as we have anticipated and may not sufficiently cover our drug products or our technologies. In addition, issued patents that we own or license may be challenged, invalidated or circumvented and we may not be able to bring suit to enforce these patents.
     We have four issued U.S. patents listed in the Orange Book for Opana ER, the earliest of which already expired and the other three patents expire in 2013, 2013 and 2023, respectively. As the owner of the patents listed in the

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Orange Book for Opana ER, we have become a party to ongoing Hatch-Waxman patent litigation. Endo and we filed patent infringement suits against Roxane and Watson in connection with their respective ANDAs for their generic versions of Opana ER, and settled our litigation with IMPAX , Sandoz, Actavis and Barr. We believe that we are entitled to the “30-month stay” available under the Hatch-Waxman Act against each of Roxane and Watson because we initiated the suit within 45 days of our receipt of their respective notice letters. If we proceed with Hatch-Waxman litigation, we may not prevail on defending our patents. Litigation is inherently unpredictable and an unfavorable ruling may occur in this case. An unfavorable ruling or loss of the 30-month stay could subject Opana ER to earlier generic competition. We expect that generic competition would adversely affect the pricing of Opana ER, the royalties that we receive from Endo, and the results of our operations and financial condition.
     Our research, development and commercialization activities or any products in development may infringe or be claimed to infringe patents of competitors or other third parties. In such event, we may be ordered to pay such third parties’ lost profits or punitive damages. We may have to seek a license from a third party and pay license fees or royalties. Awards of patent damages can be substantial. Licenses may not be available at all or available on acceptable terms, or the licenses may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. If we or our collaborators are not able to obtain a license, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations.
     Our success also depends on our ability to maintain the confidentiality of our trade secrets. We seek to protect such information by entering into confidentiality agreements with employees, consultants, licensees and other companies. These agreements may be breached by such parties. We may not be able to obtain an adequate remedy to such a breach. In addition, our trade secrets may otherwise become publicly known or be independently developed by our competitors.
We are dependent on our collaborators to develop, manufacture and commercialize our products
     We have historically collaborated with partners to facilitate the manufacture and commercialization of our products and product candidates. We continue to depend on our collaborators to manufacture, market and sell our products. In particular, we are dependent on Endo to manufacture, market and sell Opana ER in the United States, Valeant to develop, manufacture, market and sell Opana ER in Canada, Australia and New Zealand, and Otsuka and Alvogen to develop, manufacture, market and sell the drug products under the drug delivery technology collaborations.
     We have limited experience in manufacturing, marketing and selling pharmaceutical products. Accordingly, if we cannot maintain our existing collaborations or establish new collaborations with respect to our products, we will have to establish our own capabilities or discontinue commercialization of the affected products. Developing our own capabilities may be expensive and time consuming and could delay the commercialization of the affected products. There can be no assurance that we will be successful in developing these capabilities.
     Our existing collaborations may be subject to termination on short notice under certain circumstances such as upon a bankruptcy event or if we breach the agreement. If any of our collaborations are terminated, we may be required to devote additional internal resources to the product, seek a new collaborator on short notice or abandon the product. The terms of any additional collaborations or other arrangements that we establish may not be favorable to us.
     We are also at risk that these collaborations or other arrangements may not be successful. Factors that may affect the success of our collaborations include:
    Our collaborators may be pursuing alternative technologies or developing alternative products, either on their own or in collaboration with others, that may be competitive to the product on which we are collaborating, which could affect our collaborator’s commitment to our collaboration.
 
    Our collaborators may reduce marketing or sales efforts, or discontinue marketing or sales of our products, which could reduce the revenues we receive on the products.
 
    Our collaborators may pursue higher priority programs or change the focus of their commercialization

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      programs, which could affect the collaborator’s commitment to us. Pharmaceutical and biotechnology companies re-evaluate their priorities from time to time, including following mergers and consolidations, which have been common in recent years in these industries.
 
    Disputes may arise between us and our collaborators from time to time regarding contractual or other matters. In 2006, we were engaged in a dispute with Endo with regard to the sharing of marketing expenses during the period prior to when Opana ER reaches profitability, which dispute we subsequently resolved. Any other such disputes with Endo or other collaborators could be time consuming and expensive, and could impact our anticipated rights under our agreements with those collaborators.
We have limited experience in developing, manufacturing, marketing and selling pharmaceutical products
     We have limited experience in developing, manufacturing, marketing and selling pharmaceutical products. In the past, we have relied on our collaborators to conduct clinical trials, manufacture, market and sell our products. However, we are responsible for pharmaceutical and clinical development, seeking regulatory approvals, manufacturing and marketing of the product candidates we licensed from Edison. Accordingly, if we are unable to enter into a collaboration for these compounds and desire to develop, manufacture or market such compounds, we will have to continue to develop our own capabilities in these areas. If we cannot establish our own capabilities successfully and on a timely basis, we may not be able to develop or commercialize these drug candidates. Developing our own capabilities may be expensive and time consuming, and could delay the commercialization of these drug candidates.
The Drug Enforcement Administration, or DEA, limits the availability of the active drug substances used in Opana ER. As a result, Endo’s procurement quota may not be sufficient to meet commercial demand
     Under the Controlled Substances Act of 1970, the DEA regulates “controlled substances” as Schedule I, II, III, IV or V substances, with Schedule I substances considered to present the highest risk of substance abuse and Schedule V substances considered to present the lowest risk of abuse among such substances. The active drug substance in Opana ER, oxymorphone hydrochloride, is listed by the DEA as a Schedule II substance. Consequently, the manufacture, shipment, storage, sale, prescribing, dispensing and use of Opana ER are subject to a high degree of regulation. For example, all Schedule II drug prescriptions must be written and signed by a physician, physically presented to a pharmacist and may not be refilled without a new prescription.
     Furthermore, the DEA limits the availability of the active drug substance used in Opana ER. As a result, Endo’s procurement quota of the active drug substance may not be sufficient to meet commercial demands. Endo must apply to the DEA annually for the procurement quota in order to obtain the substance. Any delay or refusal by the DEA in establishing the procurement quota could cause trade inventory disruptions, which could have a material adverse effect on our business, financial condition and results of operations.
Misuse and/or abuse of Opana ER, which contains a narcotic ingredient, could subject us to additional regulations, including compliance with risk management programs, which may prove difficult or expensive for us to comply with, and we may face lawsuits as a result
     Opana ER contains a narcotic ingredient. Misuse or abuse of drugs containing narcotic ingredients can lead to physical or other harm. In the past few years, for example, reported misuse and abuse of OxyContin, a product containing the narcotic oxycodone, resulted in the strengthening of warnings on its labeling and other restrictions on the product. The sponsor of OxyContin also faced numerous lawsuits, including class action lawsuits, related to OxyContin misuse or abuse. Misuse or abuse of Opana ER could also lead to additional regulation of Opana ER and subject us to litigation.
We face significant competition, which may result in others discovering, developing or commercializing products before us or more successfully than we do
     The pharmaceutical industry is highly competitive and is affected by new technologies, governmental regulations, healthcare legislation, availability of financing and other factors. Many of our competitors have:
    significantly greater financial, technical and human resources than we have and may be better equipped to develop, manufacture and commercialize drug products;

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    more extensive experience than we have in conducting preclinical studies and clinical trials, obtaining regulatory approvals, and manufacturing and marketing pharmaceutical products;
 
    competing products that have already received regulatory approval or are in late-stage development; or
 
    collaborative arrangements in our target markets with leading companies and research institutions.
     We face competition based on the safety and effectiveness of our products, the timing and scope of regulatory approvals, the availability and cost of supply, marketing and sales capabilities, reimbursement coverage, pricing, patent position and other factors. Our competitors may develop or commercialize more effective, safer or more affordable products, or obtain more effective patent protection. Accordingly, our competitors may commercialize products more rapidly or effectively than we do, which would adversely affect our competitive position, the likelihood that our product will achieve initial market acceptance and our ability to generate meaningful revenues from our products. Even if our products achieve initial market acceptance, competitive products may render our products obsolete or noncompetitive. If our products are rendered obsolete, we may not be able to recover the expenses of developing and commercializing those products.
     Opana ER faces competition from products with the same indications. For instance, Opana ER competes in the moderate-to-severe long acting opioid market with products such as OxyContin and MS Contin, Exalgo, Duragesic patch, Avinza and Kadian and the generic versions of some of these drugs. Opana ER may also be subject to competition from generic versions of the product, such as the generic versions being developed by IMPAX, Actavis, Sandoz, Barr, Roxane and Watson. Recently, tamper resistant formulations of morphine have been approved by the FDA and we are aware of tamper resistant formulations of other opioids that are under development or review by the FDA. We expect that these products will also compete against Opana ER.
     Products developed through our collaboration with Edison may compete against products being developed by numerous private and public companies for at least some of the indications we may pursue. Various companies and institutions are conducting studies in the area of inherited mitochondrial disease. At least two companies have announced that they are pursuing programs based upon mitochondrial respiratory chain disease pathways. Santhera Pharmaceuticals is currently conducting clinical trials of the coenzyme Q analog, idebenone for the diseases of Duchenne’s muscular dystrophy, MELAS and Leber’s Hereditary Optic Neuropathy. Santhera has received regulatory approval in Canada for idebenone to be sold as a treatment for FA under the brand name Catena®. Repligen has recently filed an IND to conduct studies in FA of an HDAC inhibitor. If these companies, or any other companies developing products for mitochondrial diseases, are able to receive regulatory approvals for their products before we do, it may negatively impact our ability to receive regulatory approvals for our products if these products have orphan drug exclusivity or to achieve market acceptance of our products. If their products are more effective, safer or more affordable, our products may not be competitive.
     Our drug delivery technologies, and our efforts to enter into drug delivery technology collaborations, face competition from numerous public and private companies and their extended release technologies, including the oral osmotic pump (OROS) technology marketed by Johnson & Johnson, multiparticulate systems marketed by Elan Corporation plc, Biovail Corporation and KV Pharmaceutical Company, and traditional matrix systems marketed by SkyePharma plc, as well as a gastroretentive system by Depomed.
If our clinical trials are not successful or take longer to complete than we expect, we may not be able to develop and commercialize our products such as A0001
     In order to obtain regulatory approvals for the commercial sale of our products, we or our collaborators will be required to complete clinical trials in humans to demonstrate the safety and efficacy of the products. However, we may not be able to commence or complete these clinical trials in any specified time period, or at all, because FDA or other regulatory agencies, or an Institutional Review Board, or IRB, may object for various reasons.
     Even if we complete a clinical trial of one of our potential products, the clinical trial may not prove that our product is safe or effective to the extent required by the FDA, the European Medicines Agency, or EMEA, or other regulatory agencies to approve the product. We or our collaborators may decide, or regulators may require us or our collaborators, to conduct additional clinical trials. For example, Endo received an approvable letter for Opana ER from the FDA in response to its NDA for Opana ER, which required Endo to conduct an additional clinical trial and

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which significantly delayed the approval of Opana ER. In addition, regulators may require post-marketing testing and surveillance to monitor the safety and efficacy of a product after commercialization.
     Some of the drug candidates we may develop will be in the early stages of development. There will be limited information and understanding of the safety and efficacy of these drug candidates. There may not be any clinical data available. We will have to conduct preclinical testing and clinical trials to demonstrate the safety and efficacy of these drug candidates. The results from preclinical testing of a product that is under development may not be predictive of results that will be obtained in human clinical trials. In addition, the results of early human clinical trials may not be predictive of results that will be obtained in larger scale advanced stage clinical trials. Furthermore, we, our collaborators, the IRB or the FDA may suspend or terminate clinical trials at any time if the subjects or patients participating in such trials are being exposed to unacceptable health risks or for other reasons.
     The rate of completion of clinical trials is dependent in part upon the rate of enrollment of patients. Patient accrual is a function of many factors, including the size of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the study and the existence of competitive clinical trials. Delays in planned patient enrollment, or difficulties retaining study participants, may result in increased costs, program delays or program termination.
     If clinical trials do not show any potential product to be safe or efficacious, if we are required to conduct additional clinical trials or other testing of our products in development beyond those that we currently contemplate or if we are unable to successfully complete our clinical trials or other testing, we may:
    be delayed in obtaining marketing approval for our products;
 
    not be able to obtain marketing approval for our products; or
 
    not be able to obtain approval for indications that are as broad as intended.
     Our product development costs may also increase if we experience delays in testing or approvals. In addition, significant delays in clinical trials could allow our competitors to bring products to market before we do and impair our ability to commercialize our products.
We may not be able to obtain orphan drug exclusivity for our products. If our competitors are able to obtain orphan drug exclusivity for their products, we may not be able to have our competitive products approved by the applicable regulatory authority for a significant period of time
     We have received orphan drug designation for A0001 from the FDA for the treatment of inherited mitochondrial respiratory chain diseases. We plan to file for orphan drug status for A0001 in the European Union. The FDA and the European Union regulatory authorities grant orphan drug designation to drugs intended to treat a rare disease or condition. In the United States, orphan drug designation is generally for drugs intended to treat a disease or condition that affects fewer than 200,000 or more than 200,000 individuals and for which there is no reasonable expectation that the cost of developing and making available in the United States a product for this type of disease or condition will be recovered from sales in the United States for the product. In the European Union, orphan drug designation is for drugs intended for the diagnosis, prevention or treatment of life-threatening or chronically debilitating conditions affecting not more than five in 10,000 individuals, or of life-threatening, seriously debilitating or serious and chronic conditions and without incentives it is unlikely that sales of the drug in the European Union would be sufficient to justify developing the drug.
     Generally, if a product with an orphan drug designation subsequently receives the first marketing approval for the indication for which it has such designation, the product is entitled to orphan drug exclusivity. Orphan drug exclusivity means that another application to market the same drug for the same indication may not be approved for a period of up to 10 years in the European Union, and for a period of seven years in the United States, except in limited circumstances, such as a showing of clinical superiority over the product with orphan drug exclusivity. Obtaining orphan drug designations and orphan drug exclusivity for our products for the treatment of inherited mitochondrial respiratory chain diseases may be critical to the success of these products. If our competitor receives marketing approval before we do for a drug that is considered the same as our drug candidate for the same indication

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we are pursuing, we will be prevented from receiving marketing approval for our drug candidate during the orphan drug exclusivity period of the competitor.
     Even if we obtain orphan drug exclusivity for any of our potential products, we may not be able to maintain it. If a competitor product, containing the same drug as our product and seeking approval for the same indication, is shown to be clinically superior to our product, any orphan drug exclusivity we have obtained will not block the approval of such competitor product. In addition, if a competitor develops a different drug for the same indication as our approved indication, our orphan drug exclusivity will not prevent the competitor drug from obtaining marketing approval.
     Orphan drug designation does not convey any advantage in, or shorten the duration of, the regulatory review and approval process. Obtaining orphan drug designation may not provide us with a material commercial advantage.
Even if we are able to obtain regulatory approvals for any of our product candidates, if they exhibit harmful side effects after approval, our regulatory approvals could be revoked or otherwise negatively impacted, and we could be subject to costly and damaging product liability claims
     Even if we receive regulatory approval for A0001 or any other product candidate that we develop, we will have tested them in only a small number of carefully selected patients during our clinical trials. If our applications for marketing are approved and more patients from the general population begin to use our products, new risks and side effects associated with our products may be discovered. As a result, regulatory authorities may revoke their approvals. In addition, we may be required to conduct additional clinical trials, make changes in labeling of our products, reformulate our products or make changes and obtain new approvals for our and our suppliers’ manufacturing facilities. We might have to withdraw or recall our products from the marketplace. We may also experience a significant drop in the potential sales of our product if and when regulatory approvals for such products are obtained, experience harm to our reputation in the marketplace or become subject to lawsuits, including class actions. Any of these results could decrease or prevent any sales of our approved products or substantially increase the costs and expenses of commercializing and marketing our products.
Our controlled release drug delivery technologies rely on the ability to control the release of the active drug substances, and our business would be harmed if it was determined that there were circumstances under which the active drug substances from one of our extended release products would be released rapidly into the blood stream
     Our controlled release products and product candidates rely on our ability to control the release of the active drug substance. Some of the active ingredients in our controlled release products, including Opana ER, contain levels of active drug substance that could be harmful, even fatal, if the full dose of active drug substance were to be released over a short period of time, which is referred to as dose-dumping.
     In 2005, Purdue Pharma voluntarily withdrew from the market its product Palladone® (hydromorphone hydrochloride extended release capsules), after acquiring new information that serious and potentially fatal adverse reactions can occur when the product is taken together with alcohol. The data, gathered from a study testing the potential effects of the drug with alcohol use, showed that when Palladone is taken with alcohol, the extended release mechanism can fail and may lead to dose-dumping. In anticipation of questions from the FDA with respect to the potential dose-dumping effect of Opana ER given the FDA’s experience with Palladone, Endo conducted both in vitro and human testing of the effect of alcohol on Opana ER. In the in vitro testing, Endo did not find any detectible effect of alcohol on the time release mechanism of the product. In the human testing in the presence of alcohol, there was evidence of an increase in blood levels. The FDA received this data before approving the NDA and required that the Opana ER labeling specifically warn against taking the drug with alcohol of any kind.
We are subject to extensive government regulation, including the requirement of approval before our products may be marketed. Even if we obtain marketing approval, our products will be subject to ongoing regulatory review
     We, our collaborators, our products, and our product candidates are subject to extensive regulation by governmental authorities in the United States and other countries. Failure to comply with applicable requirements

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could result in warning letters, fines and other civil penalties, delays in approving or refusal to approve a product candidate, product recall or seizure, withdrawal of product approvals, interruption of manufacturing or clinical trials, operating restrictions, injunctions and criminal prosecution.
     Our products cannot be marketed in the United States without FDA approval. Obtaining FDA approval requires substantial time, effort and financial resources, and there can be no assurance that any approval will be granted on a timely basis, if at all. We have had only limited experience in preparing applications and obtaining regulatory approvals. If the FDA does not approve our product candidates or does not approve them in a timely fashion, our business and financial condition may be adversely affected. Furthermore, the terms of marketing approval of any application, including the labeling content, may be more restrictive than we desire and could affect the marketability of our products.
     Certain products containing our controlled release technologies require the submission of a full NDA. A full NDA must include complete reports of preclinical, clinical and other studies to prove to the FDA’s satisfaction that the product is safe and effective. These studies may involve, among other things, full clinical testing, which requires the expenditure of substantial resources. The drug candidates we are developing in collaboration with Edison will also require submission of full NDAs. In certain other cases when we seek to develop a controlled release formulation of an FDA-approved drug with the same active drug substance, we may be able to rely, in part, on previous FDA determinations of safety and efficacy of the approved drug to support a section 505(b)(2) NDA. We can provide no assurance, however, that the FDA will accept a submission of a section 505(b)(2) NDA for any particular product. Even if the FDA did accept such a submission, the FDA may not approve the application in a timely manner or at all. The FDA may also require us to perform additional studies to support the modifications of the reference listed drug.
     In addition, both before and after regulatory approval, we, our collaborators, our products, and our product candidates are subject to numerous FDA regulations, among other things, covering testing, manufacturing, quality control, cGMP, adverse event reporting, labeling, advertising, promotion, distribution and export of drug products. We and our collaborators are subject to surveillance and periodic inspection by the FDA to ascertain compliance with these regulations. The relevant law and regulations may also change in ways that could affect us, our collaborators, our products and our product candidates. Failure to comply with regulatory requirements could have a material adverse impact on our business.
We may become involved in patent litigation or other proceedings relating to our products or processes, which could result in liability for damages or termination of our development and commercialization programs
     The pharmaceutical industry has been characterized by significant litigation, interference and other proceedings regarding patents, patent applications and other intellectual property rights. The types of situations in which we may become parties to such litigation or proceedings include:
    We or our collaborators may initiate litigation or other proceedings against third parties to enforce our intellectual property rights.
 
    If our competitors file patent applications that claim technology also claimed by us, we or our collaborators may participate in interference or opposition proceedings to determine the priority of invention.
 
    If third parties initiate litigation claiming that our processes or products infringe their patent or other intellectual property rights, we and our collaborators will need to defend our rights in such proceedings.
     An adverse outcome in any litigation or other proceeding could subject us to significant liabilities and/or require us to cease using the technology that is at issue or to license the technology from third parties. We may not be able to obtain any required licenses on commercially acceptable terms, or at all.
     The cost of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. We could incur significant costs in participating or assisting in the litigation. In the case of the generic litigation involving Opana ER, our collaborator Endo is bearing all litigation costs. However, on other products we develop, we may be required to incur these costs to defend our patents. Our competitors may have substantially greater resources to

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sustain the cost of such litigation and proceedings more effectively than we can. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.
We have only limited manufacturing capabilities and will be dependent on third party manufacturers
     We lack commercial-scale facilities to manufacture our TIMERx materials or other products we are developing. Since September 1999, we have relied on Draxis for the bulk manufacture of our TIMERx materials. Our agreement with Draxis expired in November 2009. We believe that there are a limited number of manufacturers that comply with cGMP regulations and are capable of manufacturing our TIMERx materials. We signed a manufacturing agreement with Patheon, in the second quarter of 2010 on terms that are comparable to our manufacturing agreement with Draxis. However, we may not be able to qualify Patheon on a timely basis, if at all. Since the expiration of our manufacturing and supply agreement, Draxis has continued to honor our outstanding purchase orders, which we expect will provide us with a sufficient amount of TIMERx material to satisfy the current forecasted requirements until Endo and we have completed the qualification of Patheon, which we expect by the second quarter of 2011.
     However, if Draxis ceases to honor our purchase orders or if we are unable to successfully complete the qualification of Patheon as a supplier on a timely basis, or at all, we may not be able to comply with our supply obligations to Endo and Valeant with respect to Opana ER, which could adversely affect sales of Opana ER, and our supply obligations to Otsuka and Alvogen, which could delay or otherwise adversely affect the clinical development of products being developed under our collaborations with Otsuka and Alvogen.
     We are not a party to any agreements with our third-party manufacturers for A0001, except for purchase orders or similar arrangements. If we are unable to enter into longer-term manufacturing arrangements for A0001 on acceptable terms, particularly as it advances through clinical development, our business and the development and commercialization of A0001 could be materially adversely affected.
     In addition, any third parties we rely on for supply of our TIMERx materials or other products may not perform. Any failures by third party manufacturers may delay the development of products or the submission for regulatory approval, impair our or our collaborators’ ability to commercialize products as planned and deliver products on a timely basis, require us or our collaborators to cease distribution, or recall some or all batches of products or otherwise impair our competitive position, which could have a material adverse effect on our business, financial condition and results of operations.
     If our third party manufacturers fail to perform their obligations, we may be adversely affected in a number of ways, including:
    we or our collaborators may not be able to meet commercial demands for Opana ER or our other products in development;
 
    we may not be able to initiate or continue clinical trials on our collaborations for products that are under development; and
 
    we may be delayed in submitting applications for regulatory approvals of our products.
     We may not be able to successfully develop our own manufacturing capabilities. If we decide to develop our own manufacturing capabilities, we will need to recruit qualified personnel, and build or lease the requisite facilities and equipment we currently do not have. Moreover, it may be very costly and time consuming to develop such capabilities.
     The manufacture of our products is subject to regulations by the FDA and similar agencies in foreign countries. For example, the FDA and other regulatory authorities require that our products and product candidates be manufactured in accordance with current Good Manufacturing Practices, or cGMPs, and similar foreign standards.

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Any delay in complying or failure to comply with such manufacturing regulations by us or our third-party manufacturers could materially adversely affect the marketing of our products and our business, financial condition and results of operations.
We are dependent upon a limited number of suppliers for the gums used in our TIMERx materials
     Our TIMERx drug delivery systems are based on a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan gum and locust bean gum, in the presence of dextrose. These gums are also used in our Geminex, gastroretentive and SyncroDose drug delivery systems. We purchase these gums from a primary supplier. We have qualified alternate suppliers with respect to such materials, but we can provide no assurance that interruptions in supplies will not occur in the future. Any interruption in these supplies could have a material adverse effect on our ability to manufacture bulk TIMERx materials for delivery to our collaborators.
We may lose business opportunities as a result of healthcare reform and the expansion of managed-care organizations.
     Numerous governments, including the U.S. government, have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with medical care providers and drug companies.
     In March 2010, the U.S. Congress passed and President Obama signed into law the Patient Protection and Affordable Care Act and the Healthcare and Education Reconciliation Act. These healthcare reform laws are intended over time to expand health insurance coverage, impose health industry cost containment measures, impose new taxes and fees on certain sectors of the health industry; and impose additional health policy reforms. This legislation may significantly impact the pharmaceutical industry. We are presently uncertain as to the effects of the recently enacted legislation on our business and are unable to predict what legislative proposals will be adopted in the future, if any.
     In addition, new laws or regulations may create a risk of liability, increase our costs or limit our service offerings. The U.S. Congress has also considered and may adopt legislation that could have the effect of putting downward pressure on the prices that pharmaceutical companies can charge for prescription drugs. Various state legislatures and European and Asian governments may consider various types of healthcare reform in order to control growing healthcare costs. We expect Endo to experience pricing pressure with respect to Opana ER. We may experience similar pressure for other products for which we obtain marketing approvals in the future due to the trend toward managed healthcare, the increasing influence of health maintenance organizations and additional legislative proposals.
     In addition to healthcare reform proposals, the expansion of managed-care organizations in the healthcare market and managed-care organizations’ efforts to cut costs by limiting expenditures on pharmaceuticals could result in pharmaceutical companies spending less on research and development. If this were to occur, we would have fewer business opportunities and our revenue could decrease, possibly materially.
If we or our collaborators fail to obtain an adequate level of reimbursement by governmental or third party payors for Opana ER or any other products we develop, we may not be able to successfully commercialize the affected product
     The availability of reimbursement by governmental and other third party payors affects the market for any pharmaceutical products, including Opana ER. These third party payors continually attempt to contain or reduce the costs of health care by challenging the prices charged for pharmaceutical products. Reimbursement in the United States, Europe or elsewhere may not be available for Opana ER or any products we may develop or, if already available, may be decreased in the future. We may not get reimbursement or reimbursement may be limited if authorities, private health insurers and other organizations are influenced by existing drugs and prices in determining our reimbursement.
     In certain countries, particularly the countries of the European Union, the pricing of prescription pharmaceuticals and the level of reimbursement are subject to governmental control. In some countries, it can take an extended

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period of time to establish and obtain reimbursement, and reimbursement approval may be required at the individual patient level, which can lead to further delays. In addition, in some countries, it may take an extended period of time to collect payment even after reimbursement has been established. Neither we nor our collaborators may be able to sell products profitably if access to managed care or government formularies is restricted or denied, or if reimbursement is unavailable or limited in scope or amount.
We will be exposed to product liability claims and may not be able to obtain adequate product liability insurance
     Our business exposes us to potential product liability risks that are inherent in the testing, manufacturing, marketing and sale of pharmaceutical products. Product liability claims might be made by consumers, healthcare providers, other pharmaceutical companies, or third parties that sell our products. These claims may be made even with respect to those products that are manufactured in regulated facilities or that otherwise possess regulatory approval for commercial sale.
     We are currently covered by primary product liability insurance in the amounts of $15 million per occurrence and $15 million annually in the aggregate on a claims-made basis, and by excess product liability insurance in the amounts of $5 million per occurrence and $5 million annually in the aggregate. This coverage may not be adequate to cover all product liability claims. Product liability coverage is expensive. In the future, we may not be able to maintain or obtain such product liability insurance at a reasonable cost or in sufficient amounts to protect us against potential liability claims. Claims that are not covered by product liability insurance could have a material adverse effect on our business, financial condition and results of operations.
If we are unable to retain our key personnel and continue to attract additional professional staff, we may not be able to maintain or expand our business
     Because of the scientific nature of our business, our ability to develop products and compete with our current and future competitors will remain highly dependent upon our ability to attract and retain qualified scientific, technical and managerial personnel. The loss of key scientific, technical or managerial personnel, or the failure to recruit additional key personnel, could have a material adverse effect on our business. We do not have employment agreements with our key executives and we cannot guarantee that we will succeed in retaining all of our key personnel. There is intense competition for qualified personnel in our industry, and there can be no assurance that we will be able to continue to attract and retain the qualified personnel necessary for the success of our business. Our recent reductions in the numbers of our employees could adversely affect our ability to hire and retain key personnel.
The market price of our common stock may be volatile
     The market price of our common stock, like the market prices for securities of other pharmaceutical, biopharmaceutical and biotechnology companies, has been volatile. For example, the high and low closing prices of our common stock were $3.74 per share and $1.93 per share, respectively, during the twelve months ended June 30, 2010. On August 2, 2010, the closing market price of our common stock was $3.48. The market from time to time experiences significant price and volume fluctuations that are unrelated to the operating performance of particular companies. The market price of our common stock may also fluctuate as a result of our operating results, sales of Opana ER, our patent litigation, future sales of our common stock, announcements of technological innovations, new therapeutic products or new generic products by us or our competitors, announcements regarding collaborative agreements, clinical trial results, government regulations, developments in patent or other proprietary rights of us or our collaborators, public concern as to the safety of drugs developed by us or others, changes in reimbursement policies, comments made by securities analysts and other general market conditions.
Specific provisions of our Articles of Incorporation and Bylaws and the laws of Washington State make a takeover of Penwest or a change in control or management of Penwest more difficult
     Various provisions of our Articles of Incorporation, our Bylaws and the laws of the State of Washington may also have the effect of deterring hostile takeovers, or delaying or preventing changes in control or management of our company, including transactions in which our shareholders might otherwise receive a premium for their shares over then-current market prices. In addition, these provisions may limit the ability of shareholders to approve transactions

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that they may deem to be in their best interest. We may in the future adopt measures that may have the effect of deterring hostile takeovers, or delaying or preventing changes in control or management of our company.
Item 6. Exhibits
     See the exhibit index below for a list of the exhibits filed as part of this Quarterly Report on Form 10-Q, which exhibit index is incorporated herein by reference.

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SIGNATURE
     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.
         
 
  PENWEST PHARMACEUTICALS CO.    
 
       
Date:  August 6, 2010
  /s/ Jennifer L. Good    
 
       
 
  Jennifer L. Good    
 
  President and Chief Executive Officer    

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EXHIBIT INDEX
     
Exhibit    
Number   Description
 
   
10.1†
 
Manufacturing Services Agreement dated June 7, 2010 between the Registrant and Patheon Inc.
 
   
10.2
 
Fourth Amendment, dated April 18, 2010, to the Amended and Restated Strategic Alliance Agreement, dated as of April 2, 2002, by and between the Registrant and Endo Pharmaceuticals Inc.
 
   
10.3
 
Fifth Amendment, dated June 8, 2010, to the Amended and Restated Strategic Alliance Agreement, dated as of April 2, 2002, by and between the Registrant and Endo Pharmaceuticals Inc.
 
   
10.4†
 
Settlement and License Agreement dated as of June 8, 2010 by and among the Registrant, Endo Pharmaceuticals Inc. and IMPAX Laboratories, Inc.
 
   
31
 
Certification of Principal Executive Officer and Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
 
   
32
 
Certification of Principal Executive Officer and Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
 
† Confidential treatment requested as to certain portions, which portions are omitted and filed separately with the Commission.

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