COMPANY SUMMARY

We are a specialty pharmaceutical company applying our platform technology, based on humanized lung surfactants, to develop potential novel respiratory therapies and pulmonary drug delivery products. Surfactants are substances that are produced naturally in the lungs and are essential to the lungs' ability to absorb oxygen. Our humanized surfactant technology is being developed initially for critical care patients with life-threatening respiratory disorders where there are few, if any, approved therapies. These severe respiratory disorders generally are associated with a lack of functional surfactant. Surfaxin(R), our lead product, is an engineered humanized surfactant and is currently in two Phase 3 clinical trials for Respiratory Distress Syndrome in premature infants, a Phase 3 clinical trial for Meconium Aspiration Syndrome in full-term infants, and a Phase 2 clinical trial for Acute Lung Injury/Acute Respiratory Distress Syndrome in adults.

We are currently conducting research and development of aerosolized formulations of our humanized surfactant to treat respiratory conditions such as asthma and as a novel pulmonary drug delivery vehicle to render drugs more effective when delivered to or via the respiratory tract.

We believe that our platform technology has the potential to generate products for the critical care markets as well as for use in the broad non-critical care, ambulatory markets. We are presently developing a dedicated sales and marketing capability through a collaboration with Quintiles Transnational to commercialize Surfaxin in the United States. We also have entered into a strategic alliance with Laboratorios del Dr. Esteve to commercialize Surfaxin in Europe, Central and South America, and Mexico. In the non-critical care, ambulatory markets, we plan to establish strategic alliances for the development and commercialization of our products.

PLATFORM TECHNOLOGY

Surfactants are protein and lipid (fat) compositions that are produced naturally in the lungs and are critical to all air-breathing mammals. They facilitate respiration by continually modifying the surface tension of the fluid normally present within the air sacs, or alveoli, that line the inside of the lungs. In the absence of sufficient surfactant, these air sacs tend to collapse, and, as a result, the lungs do not absorb sufficient oxygen.

A lack of surfactant adversely affects both infants and adults. Premature infants born prior to 32 weeks gestation have not fully developed a natural lung surfactant and therefore need treatment to sustain life. In other clinical conditions, surfactant that normally exists in the lungs is degraded or otherwise destroyed, resulting in a variety of respiratory diseases.

Human surfactants include four known surfactant proteins, A, B, C and D. Surfactant protein B has been found essential for respiratory function in numerous studies. Our humanized surfactant

platform technology, including Surfaxin, is engineered to mimic human surfactant protein B and is based on our proprietary peptide, which is known as sinapultide (a 21 amino acid protein-like substance that mimics an important human lung protein). This technology was invented at The Scripps Research Institute and was exclusively licensed to Johnson & Johnson which, together with its wholly owned subsidiary, Ortho Pharmaceutical, developed it further. We acquired the exclusive worldwide sublicense to the technology in October 1996.

Presently, the FDA has only approved replacement surfactants for Respiratory Distress Syndrome in premature infants. The most commonly used of these approved replacement surfactants are derived from pig and cow lungs. Though they are clinically effective, they have drawbacks and cannot readily be scaled and developed to treat broader populations for Respiratory Distress Syndrome in premature infants and other respiratory diseases. These animal-sourced products are prepared using a chemical extraction process from minced cow and pig lung. Because of the animal-sourced materials and the chemical extraction processes, there is significant variation in production lots and, consequently, product quality specifications must be broad. In addition, the protein levels of these animal-derived surfactants are inherently lower than the protein levels of native human surfactant. The production costs of these animal-derived surfactants are high, relative to other pharmaceutical products, generation of large quantities is severely limited, and these products cannot readily be reformulated for aerosol delivery to the lungs.

We believe that our potential products, based on engineered humanized surfactant, can be manufactured less expensively than the animal-derived surfactants, in exact and consistent pharmaceutical grade quality, and in volumes to meet significant medical needs. In addition, we believe that our engineered humanized surfactants might possess other pharmaceutical benefits not currently found with the animal surfactants such as longer shelf-life, reduced number of administrations to the patient's lungs, and elimination of the risk of animal-borne diseases including the brain-wasting bovine spongiform encephalopathy (commonly called "mad-cow disease") and adverse immunological responses in young and older adults. Our products also have the ability to be more precisely formulated, such as aerosolized liquids or dry powders, to address various medical indications.

PRODUCTS

Surfaxin(R)

Surfaxin, our lead product, is the first humanized, protein B-based agent that mimics the surface-active properties of human surfactant. Surfaxin has been shown to remove inflammatory and infectious infiltrates from patients' lungs when used by our proprietary lavage (or "lung wash") and replenish the vital surfactant levels in the lungs. Currently, we are developing Surfaxin for the treatment of Respiratory Distress Syndrome in premature infants, Meconium Aspiration Syndrome in full-term infants, and Acute Lung Injury/Acute Respiratory Distress Syndrome in adults. Surfaxin is delivered in a liquid form and is injected through an endotracheal tube (a tube inserted into the infant's mouth and down the trachea) in premature infants, and as a proprietary lavage through a tube, called a bronchoscope, in full-term infants and adults.

Respiratory Distress Syndrome is a condition in which premature infants are born with an insufficient amount of their own natural surfactant. Meconium Aspiration Syndrome is a condition in which full-term infants are born with meconium in their lungs that depletes the natural surfactant in their lungs. Meconium is a baby's first bowel movement in its mother's womb and Meconium Aspiration Syndrome can occur if the baby breathes it in. Both Respiratory Distress Syndrome and Meconium Aspiration Syndrome can be life-threatening as a result of the failure of the lungs to absorb sufficient oxygen. These conditions can also deplete natural surfactants in the lungs and result in the need for mechanical ventilation.

Acute Lung Injury/Acute Respiratory Distress Syndrome in adults is a life-threatening disorder for which no approved therapies exist anywhere in the world. It is characterized by an excess of fluid in the lungs and decreased oxygen levels in the patient. One prominent characteristic is the destruction of surfactants present in lung tissue. The conditions are caused by illnesses including pneumonia and septic shock (a toxic condition caused by infection) and events such as smoke inhalation, near drowning, industrial accidents and other traumas.

Respiratory Distress Syndrome in Premature Infants

In 2001, we initiated two Phase 3 clinical trials for the treatment of Respiratory Distress Syndrome in premature infants - a pivotal, multinational landmark trial in 1,500 patients and a 500 patient supportive, multinational trial. The landmark trial is designed to demonstrate the superiority of Surfaxin over certain commercially available treatments. The supportive trial is being conducted in Europe and is designed to demonstrate the safety and non-inferiority of Surfaxin over a certain animal-derived surfactant. These trials are intended, if successful, to provide the basis for New Drug Applications with the FDA and other worldwide regulatory authorities. Enrollment for these trials is expected to be completed by the end of 2002 with data expected to be announced in the first half of 2003.

Respiratory Distress Syndrome in premature infants affects approximately two million babies worldwide with approximately 270,000 cases occurring in the developed world. Due to limitations associated with the products currently approved, only approximately 100,000 infants are estimated to be receiving surfactant therapy worldwide.

The FDA has granted us Orphan Drug Designation for Surfaxin for this indication. Orphan drugs are pharmaceutical products that are intended to treat diseases affecting fewer than 200,000 patients in the United States. The Office of Orphan Product Development of the FDA grants certain advantages to the sponsors of orphan drugs including, but not limited to, seven years of market exclusivity upon approval of the drug, certain tax incentives for clinical research and grants to fund testing of the drug. We also are seeking Orphan Product designation from the European Medicines Evaluation Agency (Europe's regulatory approval agency that is similar to the FDA) for Surfaxin for the treatment of Respiratory Distress Syndrome in premature infants.

Meconium Aspiration Syndrome in Full-Term Infants

Surfaxin is being evaluated in a Phase 3 clinical trial for the treatment of Meconium Aspiration Syndrome in full-term infants and may be the only product in the world being developed to treat this syndrome. The trial is designed for the enrollment of up to 200 infants at medical centers throughout the United States to compare Surfaxin lavage to the current standard of care. Enrollment is ongoing but has been slower than expected and completion is now anticipated for late 2003. Given our belief in the importance of the pivotal Phase 3 trial for Respiratory Distress Syndrome in premature infants to our present development plan, resources have been and may continue to be reallocated from the Meconium Aspiration Syndrome program to the Respiratory Distress Syndrome program, as needed.

We are also developing a clinical program for Surfaxin lavage potentially for use as a prophylactic for infants who are at risk for Meconium Aspiration Syndrome but have not shown symptoms of compromised respiratory function. There are approximately 600,000 babies born each year that are at risk for Meconium Aspiration Syndrome, of which about 10% develop the condition. We believe an effective and affordable surfactant prophylactic therapy could significantly lower the risk to meconium-stained infants of chronic respiratory conditions and reduce the need for costly mechanical ventilation.

There are presently no drug therapies approved for the treatment of Meconium Aspiration Syndrome in full-term infants. The FDA has granted us Fast Track Approval Status and Orphan Drug Designation for Surfaxin for the treatment of Meconium Aspiration Syndrome in full-term infants. We have also received Orphan Product designation of Surfaxin for the treatment of Meconium Aspiration Syndrome from the European Medicines Evaluation Agency. In October 1998, the Office of Orphan Products Development awarded us a renewable Orphan Products Development Grant for up to approximately $580,000 over three or more years to finance our Meconium Aspiration Syndrome trial. Continued funding of the grant is subject to our meeting certain performance criteria.

Acute Lung Injury and Acute Respiratory Distress Syndrome in Adults

In 2001, we initiated a Phase 2 randomized dose-ranging, open-label, controlled, multi-center clinical trial of Surfaxin in adults with Acute Respiratory Distress Syndrome. Up to 110 patients will receive high concentrations of Surfaxin via our proprietary lavage technique that administers the drug sequentially to the different segments of the lung through a tube, called a bronchoscope. The procedure is intended to cleanse and remove inflammatory substances and debris from the lungs, while leaving amounts of Surfaxin behind to help re-establish the lungs' capacity to absorb oxygen. The objective is to restore functional surfactant levels and to get critically ill patients off mechanical ventilation. We expect data from this trial to be available in the second half of 2002.

The current standard of care for Acute Lung Injury and Acute Respiratory Distress Syndrome includes placing patients on mechanical ventilators in intensive care units at a cost of approximately $3,000 to $4,000 per day. There are estimated to be between 150,000 and 250,000 adults per year in the United States suffering from Acute Lung Injury and Acute

Respiratory Distress Syndrome with similar numbers afflicted in Europe. Because there are no approved treatments for these diseases, the mortality rate can range from 35% to 50%.

The FDA has granted us Fast Track Approval Status and Orphan Drug Designation for Surfaxin for the treatment of Acute Respiratory Distress Syndrome for adults. The European Medicines Evaluation Agency has granted us Orphan Product designation for Surfaxin for the treatment of Acute Lung Injury in adults (which in this circumstance encompasses Acute Respiratory Distress Syndrome). In October 2000, we were awarded a $1 million Fast-Track S Innovative Research Grant by the National Institutes of Health to develop Surfaxin for the treatment of Acute Respiratory Distress Syndrome and Acute Lung Injury in adults.

Aerosolized Humanized Surfactants for Respiratory Therapy

We have begun preclinical research for the use of our engineered humanized surfactant as an aerosol spray for the treatment of asthma, chronic obstructive pulmonary disease (commonly known as COPD, which is a chronic condition of the lung that prevents enough oxygen from reaching the blood), and a variety of other respiratory diseases. In all of these conditions a patient's endogenous lung surfactant is destroyed. If this surfactant is not replaced, the air-sacs in the lung collapse and the patient will require mechanical ventilation to survive. In addition, upper respiratory conditions such as ear infections and sinusitis are characterized by a loss of functioning surfactants in the upper airways.

According to data from the Centers for Disease Control in Atlanta, asthma afflicts approximately 14 million people in the United States and its incidence rate is rising. In the United States alone, there are roughly one million emergency room visits each year due to acute asthma attacks, while the worldwide population of COPD sufferers is estimated at 100 million. We believe that our engineered humanized surfactant can also be used in an aerosol form as a prophylactic treatment for Acute Lung Injury/Acute Respiratory Distress Syndrome in adults. We believe that we may have our lead aerosol product in a Phase 1 clinical trial in late 2003.

Aerosolized Humanized Surfactants for Pulmonary Drug Delivery

We are also initiating preclinical research to evaluate formulations of our engineered humanized surfactants as novel pulmonary drug delivery vehicles with the potential to deliver other pharmaceutical products to the lungs so that such products can exert their pharmacological effects locally or systemically.

Existing drug delivery technology has effectively addressed the development of delivery devices, drug storage systems and compatible drug formulations. However, a significant unmet need in pulmonary drug delivery is to provide better performance once a drug is deposited in the lungs.

Currently existing technologies for delivering insulin through the respiratory system may require up to seven times the amount of insulin administered by injection. An aerosol version of our humanized lung surfactant, with its ability to penetrate and spread in an even manner throughout the lungs, has the potential to be an excellent vehicle to more efficiently deliver drugs via or within the respiratory tract. These drugs include antibiotics, pulmonary vasodilators that lower

blood pressure in the lung arteries, elastase inhibitors (drugs that are anti-inflammatory by inhibiting a potentially destructive enzyme that comes from certain types of white blood cells), bronchodilators (drugs that mitigate constriction of small airways), steroids and proteins. Surfactant delivery of drugs through the respiratory tract may efficiently treat tens of millions of people afflicted with hepatitis, diabetes, cystic fibrosis, pneumonia and tuberculosis. We believe that we may have our first drug delivery product in a Phase 1 clinical trial in late 2003.

Supervent(R)

We have decided to discontinue the clinical development of Supervent(R) for Cystic Fibrosis in its current form. However, we believe that tyloxapol, the active compound of Supervent, is potentially a multi-dimensional therapy and has the possibility to be used in combination with other drugs for the treatment of Cystic Fibrosis or other inflammatory respiratory diseases. We intend to evaluate future development activities for tyloxapol over the next year.

STRATEGIC ALLIANCES

Laboratorios del Dr. Esteve, S.A.

On March 6, 2002, we significantly expanded our existing relationship with Laboratorios del Dr. Esteve by entering into a new collaboration arrangement with Esteve. This new collaboration supersedes the Sublicense and Supply Agreements we entered into with Esteve on October 26, 1999, and expands the territory covered by those original agreements to all of Europe, Central America and South America, and Mexico.

In connection with this new Esteve collaboration, Esteve purchased 821,862 shares of our common stock at $4.867 per share for $4.0 million in gross proceeds and paid us a non-refundable licensing fee of $500,000. Esteve agreed to provide certain commercialization services in the expanded territory for Surfaxin for the treatment of Respiratory Distress Syndrome in premature infants, Meconium Aspiration Syndrome in full-term infants and Acute Lung Injury/Acute Respiratory Distress Syndrome in adult patients.

We have agreed to an exclusive supply agreement which provides that Esteve will purchase from us all of its Surfaxin drug product requirements at an established transfer price based on sales of Surfaxin by Esteve and/or its sublicensee(s). Esteve has also agreed to sponsor certain clinical trial costs related to obtaining European Medicines Evaluation Agency approval for commercialization of Surfaxin in Europe for the Acute Lung Injury/Acute Respiratory Distress Syndrome indications. Esteve also agreed to make certain milestone payments upon the attainment of European Medicines Evaluation Agency marketing regulatory approval of Surfaxin for sale in Europe for the foregoing indications.

Quintiles Transnational Corp., and PharmaBio Development, Inc.

On December 10, 2001, we entered into a collaboration arrangement with Quintiles Transnational, and its affiliate, PharmaBio Development, to provide certain commercialization services in the United States for Surfaxin for the treatment of Respiratory Distress Syndrome in

premature infants and Meconium Aspiration Syndrome in full-term infants. We issued to PharmaBio 791,905 shares of our common stock and warrants to purchase approximately 677,143 shares of our common stock for aggregate net proceeds of approximately $2.7 million. Quintiles will hire and train a dedicated United States sales force that will be branded in the market as ours. PharmaBio has agreed to fund up to $70 million of the sales force costs and other sales and marketing costs for Surfaxin for seven years of commercialization of Surfaxin in the United States.

PharmaBio also agreed to extend a secured revolving credit facility of up to $8.5 million to $10 million to fund pre-marketing activities associated with the launch of Surfaxin in the United States as we achieve certain milestones. We are obligated to use a significant portion of the funds borrowed under the credit facility for pre-launch marketing services to be provided by Quintiles. Principal amounts owed by us under the credit facility may be repaid out of the proceeds of milestone payments to be paid to us by PharmaBio upon our achievement of certain corporate milestones. To the extent that availability under the credit facility is increased to greater than $8.5 million, for each $1 million increase, the amount of shares of common stock issuable pursuant to the warrants will be increased by approximately 38,000 shares.

Under the arrangement, we will receive 100% of the revenues from sales of Surfaxin and have agreed to pay PharmaBio a commission on net sales in the United States of Surfaxin for the treatment of Respiratory Distress Syndrome in premature infants and Meconium Aspiration Syndrome in full-term infants and all "off-label" uses for 10 years following first launch of the product in the United States. The arrangement with Quintiles allows us to retain product ownership and to have sales and marketing expertise in place for the commercialization of Surfaxin, if approved. Additionally, the arrangement allows for the specialty sales force to become ours at the end of the seven year term, with an option to acquire it sooner.

LICENSING ARRANGEMENTS; PATENTS AND PROPRIETARY RIGHTS

Johnson & Johnson License Agreement

Our humanized surfactant platform technology, including Surfaxin, is based on the proprietary peptide, sinapultide, (a 21 amino acid protein-like substance that mimics an important human lung protein). This technology was invented at The Scripps Research Institute and was exclusively licensed to and further developed by Johnson & Johnson, and its wholly owned subsidiary, Ortho Pharmaceutical. We have received an exclusive, worldwide sublicense from Johnson & Johnson for, and have rights to, a series of over 30 patents which are important, either individually or collectively, to our strategy of commercializing our humanized surfactant technology for the diagnosis, prevention and treatment of disease. Such patents, which include relevant European patents, expire on various dates beginning in 2009 and ending in 2017.

Patents covering our proprietary humanized surfactant technology that have been issued or are pending worldwide include composition of matter, formulation, manufacturing and uses, including pulmonary lavage, or "lung wash" techniques. Our most significant patent rights principally consist of four issued United States patents and two pending United States patent applications. The four issued patents are: U.S. Patent No. 5,407,914; U.S. Patent No. 5,260,273;

U.S. Patent No. 5,164,369; and U.S. Patent No. 6,013,619. These patents relate to engineered humanized pulmonary surfactants (including Surfaxin), certain related peptides (amino acid protein-like substances) and a method of treating respiratory distress syndrome with these surfactants. The two pending United States applications relate to pulmonary surfactants, including related compositions and methods of treating respiratory distress syndromes with these surfactants and compositions. We also have certain pending United States patent applications that relate to methods of manufacturing certain peptides which may be used in the manufacture of Surfaxin. In October 2000, we were issued European Patent No. 0350506 covering certain surfactant peptides.

The Scripps Research Institute

U.S. Patent No. 6,013,619 was issued to Scripps and licensed to us and covers all known engineered (including Surfaxin), animal- or human-derived surfactants for use in any form of pulmonary lavage for respiratory distress syndromes. Our proprietary pulmonary lavage techniques (using surfactant) include lavage via a bronchoscope in adults as well as direct pulmonary lung lavage via an endotracheal tube in newborn babies with Meconium Aspiration Syndrome. We believe that our proprietary lavage technique may provide a clinical benefit to the treatment of Acute Lung Injury/Acute Respiratory Distress Syndrome in adults and Meconium Aspiration Syndrome in full-term infants by decreasing the amount of infectious and inflammatory debris in the lungs, restoring the air sacs to a more normal state and possibly resulting in patients getting off mechanical ventilation sooner.

We are parties with Scripps to a research funding and option agreement which expired in February 2002. We are currently negotiating an amendment to the agreement to extend the term for an additional three years but we may not be able to agree on terms that are acceptable to us. Pursuant to this agreement, we were required to fund a portion of Scripps' research efforts and Scripps granted us an option to acquire an exclusive worldwide license to the technology developed from the research program during the term of the agreement. Scripps owns all of the technology that it developed pursuant to work performed under the agreement. To the extent we did not exercise our option, we have the right to receive 50% of the net royalty income received by Scripps for inventions that were jointly developed by us and Scripps. It is our belief that Scripps will agree to extend the agreement for an additional three year term according to the same, or substantially similar, terms and conditions.

MANUFACTURING AND DISTRIBUTION - THIRD PARTY SUPPLIERS

Our products must be manufactured in compliance with good manufacturing practice requirements (GMPs) set by the FDA and other relevant worldwide regulatory authorities. We rely on outside manufacturers, for our drug substance and other active ingredients for Surfaxin and to produce material that meets appropriate standards for use in clinical studies of our products and for their commercialization. We are also in the process of qualifying alternate third party suppliers for our manufacturing and raw material needs.

We own certain specialized equipment necessary to manufacture the Surfaxin drug product. This equipment is maintained at and manufacturing occurs at a third-party facility under the direction

and supervision of our manufacturing and quality control personnel. We are presently evaluating investing in additional manufacturing capability in anticipation of optimizing the commercial process for Surfaxin and to scale up the manufacturing process to meet clinical and commercial needs as they expand.

We are currently evaluating third party distribution capability in order to commercialize Surfaxin in the United States. Our collaboration with Esteve provides that Esteve has the responsibility for distribution throughout Europe, Central and South America, and Mexico. See Item 6: "Management's Discussion and Analysis - Risks Related to Our Business-Our lack of marketing and sales experience could limit our ability to generate revenues from future product sales."

COMPETITION

We are engaged in highly competitive fields of pharmaceutical research. Competition from numerous existing companies and others entering the fields in which we operate is intense and expected to increase. We expect to compete with, among others, conventional pharmaceutical companies. Most of these companies have substantially greater research and development, manufacturing, marketing, financial, technological, personnel and managerial resources than we do. Acquisitions of competing companies by large pharmaceutical or health care companies could further enhance such competitors' financial, marketing and other resources. Moreover, competitors that are able to complete clinical trials, obtain required regulatory approvals and commence commercial sales of their products before we do may enjoy a significant competitive advantage over us. There are also existing therapies that may compete with the products we are developing. See Item 6: "Management's Discussion and Analysis - Risks Related to Our Business."

Presently, there are no approved drugs that are specifically indicated for the treatment of Meconium Aspiration Syndrome in full-term infants or Acute Lung Injury/Acute Respiratory Distress Syndrome in adults. Current therapy consists of general supportive care and mechanical ventilation.

For Respiratory Distress Syndrome in premature infants, four products are currently approved for treatment: Curosurf(TM) is a porcine lung extract that is marketed in Europe by Chiesi Farmaceutici S.p.A., and in the United States by Dey Laboratories, Inc. Exosurf(TM) is marketed by GlaxoSmithKline, plc, outside the United States and contains only phospholipids (fats that are normally present in the lungs) and synthetic organic detergents and no stabilizing protein or peptides. Survanta(TM), marketed by the Ross division of Abbott Laboratories, Inc., is derived from a chemical extraction process from minced cow lung that contains the cow version of surfactant protein B. Forrest Laboratories, Inc., markets its calf lung surfactant, Infasurf(TM) in the United States for the treatment of Respiratory Distress Syndrome in premature infants.

There are a significant number of other potential therapies in development for the treatment of Acute Lung Injury/Acute Respiratory Distress Syndrome in adults that are not surfactant related. Any of these various drugs or devices could significantly impact the commercial opportunity for Surfaxin.

We believe that engineered humanized surfactants such as Surfaxin will be far less expensive to produce than the animal-derived products currently approved for the treatment of Respiratory Distress Syndrome in premature infants and can be produced in exact and consistent pharmaceutical grade quality and in volumes to meet significant medical needs. In addition, we believe that such products might possess other pharmaceutical benefits not currently found with the animal-derived surfactants such as potentially longer shelf-life, reduced number of administrations to the patient's lungs, and would eliminate the risk of animal-borne diseases including the brain-wasting bovine spongiform encephalopathy (commonly called "mad-cow disease") and adverse immunological responses in young and older adults. Our products also have the ability to be precisely formulated, such as aerosolized liquids or dry powders, to address various medical indications.

GOVERNMENT REGULATION

The testing, manufacture, distribution, advertising and marketing of drug products are subject to extensive regulation by governmental authorities in the United States and other countries. Prior to marketing, any pharmaceutical products developed or licensed by us must undergo an extensive regulatory approval process required by the FDA and by comparable agencies in other countries. This process, which includes preclinical studies and clinical trials of each pharmaceutical compound to establish its safety and efficacy and confirmation by the FDA that good laboratory, clinical and manufacturing practices were maintained during testing and manufacturing, can take many years, requires the expenditure of substantial resources and gives larger companies with greater financial resources a competitive advantage over us. The FDA review process can be lengthy and unpredictable, and we may encounter delays or rejections of our applications when submitted. If questions arise during the FDA review process, approval may take a significantly longer period of time. Generally, in order to gain FDA approval, we first must conduct preclinical studies in a laboratory and in animal models to obtain preliminary information on a compound's efficacy and to identify any safety problems. The results of these studies are submitted as part of an Ivestigational New Drug (IND) application that the FDA must review before human clinical trials of an investigational drug can start.

Clinical trials are normally done in three phases and generally take two to five years or longer to complete. Phase 1 consists of testing the drug product in a small number of humans, normally healthy volunteers, to determine preliminary safety and tolerable dose range. Phase 2 involves larger studies to evaluate the effectiveness of the drug product in humans having the disease or medical condition for which the product is indicated and to identify possible common adverse effects in a larger group of subjects. Phase 3 consists of additional controlled testing to establish clinical safety and effectiveness in an expanded patient population of geographically dispersed test sites to evaluate the overall benefit-risk relationship for administering the product and to provide an adequate basis for product labeling.

After completion of clinical trials of a new drug product, FDA and foreign regulatory authority marketing approval must be obtained. A New Drug Application submitted to the FDA generally takes one to three years to obtain approval. If questions arise during the FDA review process, approval may take a significantly longer period of time. The testing and approval processes require substantial time and effort and we may not receive approval on a timely basis, if at all.

Even if regulatory clearances are obtained, a marketed product is subject to continual review, and later discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or withdrawal of the product from the market as well as possible civil or criminal sanctions. For marketing outside the United States, we also will be subject to foreign regulatory requirements governing human clinical trials and marketing approval for pharmaceutical products. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary widely from country to country. None of our products under development have been approved for marketing in the United States or elsewhere. We may not be able to obtain regulatory approval for any such products under development. Failure to obtain requisite governmental approvals or failure to obtain approvals of the scope requested will delay or preclude us, or our licensees or marketing partners, from marketing our products, or limit the commercial use of our products, and thereby would have a material adverse effect on our business, financial condition and results of operations. See Item 6: "Management's Discussion and Analysis - Risks Related to Our Business."

The FDA has granted us Fast Track Approval Status for the Acute Respiratory Distress Syndrome and Meconium Aspiration Syndrome indications. Fast Track Approval Status facilitates the development and expedites the review of new drugs intended for treatment of life-threatening conditions for which there is presently no medical option by providing for the FDA's review of the New Drug Application for a drug granted such Fast Track Status within six months following filing. We have also received Orphan Drug Designation from the FDA's Office of Orphan Products Development of Surfaxin as a treatment for Respiratory Distress Syndrome in premature infants, Meconium Aspiration Syndrome in full-term infants, and Acute Respiratory Distress Syndrome in adults. We have also received designation of Surfaxin as an Orphan Product for Meconium Aspiration Syndrome and Acute Lung Injury (which, in this circumstance, encompasses Acute Respiratory Distress Syndrome) from the European Medicines Evaluation Agency.

In October 2000, we were awarded a $1 million Fast-Track S Innovative Research Grant by the National Institutes of Health to develop Surfaxin for the treatment of Acute Respiratory Distress Syndrome in adults. In October 1998, the Office of Orphan Products Development awarded us a renewable Orphan Products Development Grant, ranging from $194,390 for the first year to $583,170 over three or more years, to finance our Meconium Aspiration Syndrome trial. Continued funding under both of these grants is subject to our meeting certain performance criteria.

EMPLOYEES

We have approximately 50 full-time employees. Our future success depends in significant part upon the continued service of our key scientific personnel and executive officers and our continuing ability to attract and retain highly qualified scientific and managerial personnel. Competition for such personnel is intense and we may not be able to retain our key employees or attract, assimilate or retain other highly qualified technical and managerial personnel in the future. See Item 6: "Management's Discussion and Analysis - Risks Related to Our Business."