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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Commission file number 001-33782

ARYx THERAPEUTICS, INC.

(Exact name of registrant as specified in its charter)

6300 Dumbarton Circle, Fremont, California 94555

(Address of Principal Executive Offices including zip code)

(510) 585-2200

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No 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 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.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x

As of October 31, 2010, the registrant had 33,461,975 shares of common stock outstanding.

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ARYx THERAPEUTICS, INC.

FORM 10-Q FOR THE QUARTER ENDED September 30, 2010

INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1.  CONDENSED FINANCIAL STATEMENTS

ARYx THERAPEUTICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

The accompanying notes are an integral part of these financial statements.

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ARYx THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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ARYx THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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ARYx THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In this report, “ARYx,” “we,” “us” and “our” refer to ARYx Therapeutics, Inc. “Common Stock” refers to ARYx’s common stock, par value $0.001 per share.

1.  Organization and Summary of Significant Accounting Policies

The Company

We are a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates designed to eliminate known safety issues associated with well-established, commercially successful drugs. We use our RetroMetabolic Drug Design technology to design structurally unique molecules that retain the efficacy of these original drugs but are metabolized through a potentially safer pathway to avoid specific adverse side effects associated with these compounds. Our product candidate portfolio includes an oral prokinetic agent, naronapride (ATI-7505), designed to have the same therapeutic benefits as cisapride approved for Phase 3 clinical development for the treatment of chronic constipation, gastroparesis, functional dyspepsia, irritable bowel syndrome with constipation, and gastroesophageal reflux disease; an oral anticoagulant, tecarfarin (ATI-5923), designed to have the same therapeutic benefits as warfarin, currently in Phase 2/3 clinical development for the treatment of patients who are at risk for the formation of dangerous blood clots; an oral antiarrhythmic agent, budiodarone (ATI-2042), designed to have the efficacy of amiodarone in Phase 2 clinical development for the treatment of atrial fibrillation, a form of irregular heartbeat; and a novel, next-generation atypical antipsychotic agent, ATI-9242, currently in Phase 1 clinical development for the treatment of schizophrenia and other psychiatric disorders. Additionally, we have several product candidates in preclinical development. Each of our product candidates is an orally available, patentable new chemical entity designed to address similar indications as those of the original drug upon which each is based. Our product candidates target what we believe to be multi-billion dollar market opportunities.

We were incorporated in the State of California on February 28, 1997 and reincorporated in the State of Delaware on August 29, 2007. We maintain a wholly owned subsidiary, ARYx Therapeutics Limited, with registered offices in the United Kingdom, which has had no operations since its inception in September 2004 and was established only to serve as a legal entity as required in support of our clinical trial activities conducted in Europe. We currently are focused on the human drug development business and operate in a single business segment with regard to the development of human pharmaceutical products.

In February 2010 we shifted our primary focus to exploring strategic alternatives available to us to complete a transaction that could create significant value for stockholders. Those alternatives could include partnerships on one or more of the three lead product candidates, the sale of company assets, in whole or in part, or some other arrangement through which the value of our assets to stockholders could be optimized (“Strategic Process”). Concurrent with beginning the Strategic Process, we restructured our operations in order to conserve resources and support the process of reviewing strategic alternatives. This followed an initial reduction in our workforce headcount in October 2009. Through these two restructuring steps and following the departure in June 2010 of Peter G. Milner, M.D., our former President of Research and Development, our headcount has been reduced from 73 to 16 employees. The restructuring was necessary as we have three compounds at proof-of-concept stage but insufficient cash resources to develop these product candidates further or to complete licensing agreements in a timely manner with a high level of certainty. Our operations have consumed a substantial amount of cash since inception and we expect to continue to incur net losses for the foreseeable future. Our ability to continue operations will be dependent on our ability to obtain substantial additional funding. We may seek to raise necessary additional funds through public or private equity, debt financings, collaborative arrangements with corporate partners or other sources available to us. This may include proceeds, if any, from sales of common stock under our at market issuance sales agreement with McNicoll, Lewis & Vlak LLC and Wm Smith & Co., pursuant to which we may issue and sell up to $6.0 million of our common stock subject to limitations with respect to the market liquidity of our common stock.

The restructuring of operations we announced on February 18, 2010 included a substantial reduction in force from 56 employees to 17 employees, and further reduced to 16 employees following the departure of Peter G. Milner, M.D., our former President of Research and Development, effective June 15, 2010. The positions impacted were across all business functions, including the research and development, clinical, operations and general and administrative departments. The restructuring plan was primarily designed to reduce operating expenses and conserve cash resources as we explore various strategic options. The restructuring was substantially completed during the first quarter of 2010. Additionally, we announced the shift of our primary focus to the exploration of strategic alternatives available to us to realize optimal value for our late-stage assets.

Employees affected by the reductions in force were provided with severance payments, continuation of current benefits and outplacement assistance. Severance payments to employees terminated as part of the February 2010 restructuring consisted of 50%

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cash and 50% common stock in order to minimize the associated cash expense, with an aggregate 460,940 shares of common stock issued under our equity incentive plan as a severance payout.

As a result of the February 2010 restructuring of operations, we incurred an aggregate restructuring charge of approximately $1.6 million less a credit of approximately $0.3 million due to stock option cancellations in the first six months of 2010. These amounts were included within our general and administrative expense. Of this amount, approximately $0.1 million was recognized as expense during the second quarter of 2010. The restructuring charge includes costs for severance pay, employee benefits and outplacement services. The aggregate restructuring charge included approximately $1.0 million of cash expenditures and approximately $0.3 million of non-cash charges, net of adjustments related to stock compensation expense. As part of the restructuring effort and during the course of our continuing operations, we will be assessing on a quarterly basis any possible impairment of assets related to idle facilities and equipment resulting from the February 2010 restructuring and may incur additional expense related to any such impairment. During the first three quarters of 2010 we made an assessment in accordance with ASC 360 to determine if there had been any material impairment of assets resulting from the February 2010 restructuring and concluded that given the range of possible outcomes related to our exploration of strategic alternatives, no material impairment had occurred.

On August 13, 2010, we secured bridge financing in two related loan transactions — a bridge loan financing with entities affiliated with MPM Capital and Ayer Capital Management, L.L.P. (collectively the “Bridge Investors”) and the concurrent restructuring of our outstanding loans with Lighthouse Capital Partners V, L.P. (“Lighthouse”).  Under the terms of a secured note and warrant purchase agreement dated August 13, 2010, we issued and sold secured promissory notes (the “Notes”) in the principal amount of up to $4.0 million and warrants to purchase an aggregate of 2,000,000 shares of our common stock to the Bridge Investors in two tranches (the “Bridge Financing”). We completed the first tranche for $2.0 million of Notes and warrants to purchase 1,000,000 shares of our common stock on August 13, 2010.  We completed the second tranche for $2.0 million of Notes and warrants to purchase 1,000,000 shares of common stock on September 30, 2010. Concurrently with the initial tranche of the Bridge Financing, we amended our existing loan arrangement with Lighthouse to provide for the conversion of approximately $2.3 million of loan payments scheduled for the third quarter of 2010 into a new loan to us by Lighthouse (the “New Commitment”).  Upon the initial closing of the Bridge Financing, we made an approximately $2.0 million payment to Lighthouse out of the proceeds of the initial closing, and Lighthouse immediately loaned approximately the same amount back to us as part of the New Commitment.  On September 1, 2010, we made a subsequent payment of approximately $300,000 to Lighthouse, which Lighthouse immediately loaned back to us as the balance of the New Commitment.  We believe that our cash and cash equivalents on hand as of September 30, 2010 are sufficient to fund our operations to December 31, 2010.  We will need to seek additional sources of funding to allow us to continue our operations as we continue to explore strategic options available to us.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of our wholly-owned subsidiary, ARYx Therapeutics, Ltd. All intercompany accounts and transactions have been eliminated. These unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP, for interim financial information on the same basis as the annual financial statements and with 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 GAAP for complete financial statements. These interim financial statements include all adjustments (consisting only of normal recurring adjustments) that management believes are necessary for the fair presentation of the balances and results for the periods presented. Interim financial results are not necessarily indicative of results to be expected for the full fiscal year or any future interim period.

The balance sheet data at December 31, 2009 has been derived from our audited consolidated financial statements for the year ended December 31, 2009, contained in our Annual Report on Form 10-K. The unaudited condensed consolidated financial statements and related disclosures contained in this report have been prepared with the presumption that users of the interim financial statements have read or have access to our audited financial statements for the preceding year. Accordingly, these interim financial statements should be read in conjunction with our audited financial statements and notes thereto for the year ended December 31, 2009, contained in our Annual Report on Form 10-K. In order to ensure the comparability of our financial statements to prior periods our policy is to reclassify certain items within our financial statements so that amounts are comparable across reporting periods. For the period ended December 31, 2009, certain balances related to the classification of warrants issued to Lighthouse have been reclassified as a contra-liability to make our financial statements comparable.

Risks and Uncertainties

As of September 30, 2010, we had cash, cash equivalents and marketable securities on hand of approximately $3.0 million, current payables and accrued liabilities of approximately $0.9 million and approximately $6.9 million in current notes and interest payable. As of September 30, 2010, we had outstanding non-current liabilities of $5.9 million. Since our inception, we have incurred significant net operating losses and, as of September 30, 2010, we had an accumulated deficit of $199.6 million. We have generated no revenue from product sales to date and we have funded operations principally from the sale of our convertible preferred and common stock and payments received under our collaboration agreements. We have not achieved sustainable profitability and

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anticipate that we will continue to incur significant net losses for the foreseeable future. There can be no assurances that we will achieve positive cash flow in the foreseeable future or at all. Additionally, we do not anticipate that our cash on hand as of September 30, 2010 will be sufficient to fund our operations for the following twelve months. However, we believe that our cash on hand will provide us with sufficient funds to operate through the end of 2010. These factors raise substantial doubt about our ability to continue as a going concern. Management’s plans as to these matters are described above. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have no products that have received regulatory approval. Any products we develop will require approval from the U.S. Food and Drug Administration or foreign regulatory agencies prior to commercial sales. There can be no assurance that our products will receive the necessary approvals. If we are denied such approvals or such approvals are delayed, it could have a material adverse effect to our operations. To achieve profitable operations, we must successfully develop, test, manufacture and market products. There can be no assurance that any such products can be developed successfully or manufactured at an acceptable cost and with appropriate performance characteristics, or that such products will be successfully marketed. These factors could have a material adverse effect on our future financial results.

Financial instruments that potentially subject us to a concentration of credit risk consist of cash, cash equivalents and marketable securities. We deposit excess cash and cash equivalents with multiple financial institutions in the United States. Deposits in these financial institutions may exceed the amount of insurance provided on such deposits. We have not experienced any losses on our deposits of cash and cash equivalents.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make judgments, assumptions and estimates that affect the reported amounts in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate our critical accounting policies and estimates, including those related to clinical trial accruals and stock-based compensation. Management bases its estimates on historical experience and on assumptions believed to be reasonable under the circumstances. Actual results could differ from those estimates.

Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive income/loss. The only component of our other comprehensive income/loss is the unrealized gains and losses, if any, on our marketable securities holdings. Comprehensive loss for the three months ended September 30, 2010 and 2009 was $2.5 million and $8.1 million, respectively, and for the nine months ended September 30, 2010 and 2009 was $12.5 million and $27.4 million, respectively.

Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of fully vested common shares outstanding during the period. Diluted net loss per share is computed by giving effect to all potential dilutive common shares, including stock options and warrants. For all periods presented in this report, stock options and warrants were not included in the computation of diluted net loss per share because the inclusion would provide an anti-dilutive effect. The following table presents the calculation of basic and diluted net loss per share:

Income Taxes

We use the asset and liability method of accounting for income taxes in accordance with ASC 740, Income Taxes. Deferred tax assets and liabilities are determined based on differences between financial reporting and the tax basis of assets and liabilities and are

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measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized.

As permitted under the provisions of ASC 740, we will classify interest and penalties related to unrecognized tax benefits as part of our income tax provision, although there have been no such interest or penalties recognized to-date.

Recent Accounting Pronouncements

In January 2010, the FASB issued ASU No. 2010-06, which revised guidance intended to improve disclosures related to fair value measurements. This guidance requires new disclosures as well as clarifies certain existing disclosure requirements. New disclosures under this guidance require separate information about significant transfers in and out of Level 1 and Level 2 and the reason for such transfers, and also require purchases, sales, issuances, and settlements information for Level 3 measurement to be included in the rollforward of activity on a gross basis. ASU No. 2010-06 also clarifies the requirement to determine the level of disaggregation for fair value measurement disclosures and the requirement to disclose valuation techniques and inputs used for both recurring and nonrecurring fair value measurements in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning December 15, 2010, and for the interim periods within those fiscal years.  We do not expect adoption of this pronouncement to have a material impact to our financial statements.

2. Fair Value Measurement

The following tables summarize the fair value of our financial assets as of September 30, 2010 and December 31, 2009 that were recorded at fair value on a recurring basis consistent with the fair value hierarchy provisions of ASC 820.

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Our financial assets valued using Level 1 inputs consist primarily of certificates of deposit at a financial institution.  Our financial assets valued using Level 2 inputs consist of cash held in money market funds with fair values that are determined by our institutional portfolio managers whose valuations are based upon market-corroborated inputs such as broker/dealer quotes, reported trades, bids and offers that we believe are reasonable. Previously, the fair value of our auction rate security was measured using Level 3 inputs as determined by a discounted cash flow model that considered expected cash flows from the auction rate instrument including expected interest payments, market yields for similarly rated instruments, our estimates of time to liquidity for the security, and a marketability discount. Transfers between levels are determined and recognized at the end of each reporting period.

3.  Debt Financing

As of September 30, 2010, we had loan commitments outstanding with Lighthouse, the Bridge Investors and Oxford Finance Corporation, or Oxford. Prior to September 30, 2010 we also had loan commitments outstanding with General Electric Commercial Finance, or GE.

On August 13, 2010, we entered into an agreement with the Bridge Investors pursuant to which we agreed to issue and sell in a private placement Notes in the aggregate principal amount of up to $4.0 million, and Warrants to purchase up to an aggregate of 2,000,000 shares of our common stock, subject to the terms and conditions set forth in the agreement.  The Notes are secured by a security interest in all of our assets, including our intellectual property.

On August 13, 2010, we closed on the first tranche of $2.0 million of Notes pursuant under the terms and conditions of the Bridge Financing and, as a result, issued Warrants to the Bridge Investors to purchase 1,000,000 shares of our common stock.  On September 30, 2010, we closed on the second tranche of $2.0 million of Notes and issued Warrants to purchase an additional 1,000,000 shares of our common stock.

The Notes accrue interest at a continuously compounding rate of 12.0% per annum.  Unless earlier paid pursuant to the terms of the agreement or accelerated in connection with an event of default, we will make interest only payments through December 31, 2010, followed by 24 equal monthly payments of principal and interest through January 1, 2013. In the event we sell any or all of our assets or enter into certain strategic transactions, we may be required to repay the Notes at an earlier date under the terms of the Bridge Financing.

The Warrants had a purchase price of $0.0125 per underlying share of common stock and are exercisable for a term of five years from the date of issuance at an exercise price of $0.50 per share. On October 12, 2010, we filed a registration statement registering for resale the shares of common stock issuable upon the exercise of the Warrants pursuant to the Registration Rights Agreement we entered into with the Bridge Investors.

We received net proceeds of approximately $1.8 million in connection with the initial tranche of the Bridge Financing, after deducting certain expenses payable by us. The net proceeds from the initial tranche of the Bridge Financing were used by us to make an approximately $2.0 million repayment on our existing loan obligation with Lighthouse pursuant to the terms of our loan arrangement with Lighthouse, as more fully described below. We received net proceeds of approximately $2.0 million in connection with the second tranche of the Bridge Financing after deducting certain expenses payable by us. We currently anticipate the remaining proceeds from the Bridge Financing will be used for working capital and other corporate and operational purposes, including permitted payments to our lenders.

Concurrently with the Bridge Financing, we and Lighthouse entered into Amendment No. 8 to that certain Loan and Security Agreement No. 4521 dated March 28, 2005, as amended. The amendment to the Lighthouse agreement provides for the conversion of up to approximately $2.3 million of loan payments scheduled for the third quarter of 2010 into the New Commitment. Upon the closing of the initial tranche of the Bridge Financing, we used the net proceeds from such closing to make an approximately $2.0 million repayment of our loan obligation to Lighthouse and, pursuant to the terms of the amendment, Lighthouse promptly loaned approximately the same amount to us as part of the New Commitment. On September 1, 2010, we made a subsequent payment of approximately $300,000 to Lighthouse which was promptly loaned back to us from Lighthouse as the balance of the New Commitment.

The New Commitment is due and payable on December 31, 2010 in one lump sum payment equal to the aggregate principal amount plus accrued interest through the due date at a stated interest rate of 13.0% per annum. In the event we enter into certain strategic transactions with proceeds of at least $40.0 million prior to the applicable due date, the New Commitment will be amortized and payable in equal monthly installments of principal and interest over the 18 months following the closing of such strategic

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transaction. Upon the occurrence of an event of default or liquidation event, all outstanding amounts under the New Commitment shall be immediately due and payable.

The terms of the Lighthouse loan further provide that any assignment of the Notes without Lighthouse’s consent would now constitute an event of default under the Lighthouse loan agreement. We also granted Lighthouse a security interest in all of our assets including our intellectual property in connection with the amendment to the Lighthouse loan agreement and the New Commitment.

As of September 30, 2010, following our receipt of the New Commitment, the total principal amount borrowed under the Lighthouse loans was $21.3 million and the total unpaid principal balance outstanding was $7.9 million. The total accrued and unpaid balloon interest outstanding was $0.4 million as of September 30, 2010. We recorded interest expense related to the Lighthouse loan, including amortization of expense related to the terminal payments and the warrants issued under the agreement, of $302,000 and $488,000 for the three months ended September 30, 2010 and 2009, respectively, and $1.1 million and $1.4 million for the nine months ended September 30, 2010 and 2009, respectively.

The total principal amount borrowed under the Bridge Financing arrangement was $4.0 million and the total unpaid principal balance outstanding as of September 30, 2010, was $4.0 million. We recorded interest expense related to the Bridge Financing, including amortization of expense related to capitalized loan expenses and the warrant issued under the agreement, of $57,900 and none for the three months ended September 30, 2010 and 2009, respectively, and $57,900 and none for the nine months ended September 30, 2010 and 2009, respectively.

The total principal amount borrowed under the Oxford loan was $1.0 million and the total unpaid principal balance outstanding as of September 30, 2010, was $459,000. The total accrued and unpaid balloon interest outstanding was $12,000 as of September 30, 2010. We recorded interest expense related to the Oxford loan, including amortization of expense related to the terminal payment and the warrant issued under the agreement, of $17,800 and $27,000 for the three months ended September 30, 2010 and 2009, respectively, and $60,500 and $87,000 for the nine months ended September 30, 2010 and 2009, respectively. Pursuant to the terms of the Oxford loan, Oxford maintains a security interest in certain of our fixed assets.

The total principal amount borrowed under the GE loans was $1.9 million and as of September 30, 2010 the loans had been fully repaid. We recorded no interest expense related to the GE loans for the three months ended September 30, 2010 and $5,000 for the three months ended September 30, 2009. For the nine months ended September 30, 2010 and 2009, respectively, we recorded $650 and $20,000 in interest expense related to the GE loans.

4.  Equity Financing

On October 6, 2009, we entered into a common stock purchase agreement, or the Purchase Agreement, with Commerce Court Small Cap Value Fund, Ltd., or Commerce Court, providing for a financing arrangement that is sometimes referred to as a committed equity line financing facility. The Purchase Agreement provides that, upon the terms and subject to the conditions set forth in the Purchase Agreement, Commerce Court is committed to purchase up to $35.0 million of shares of our common stock over the 24-month term of the Purchase Agreement under certain specified conditions and limitations, provided that in no event may we sell under the Purchase Agreement more than 5,380,090 shares of common stock, which is equal to one share less than 20% of our outstanding shares of common stock on October 6, 2009, the closing date of the Purchase Agreement, less the number of shares of common stock we issued to Commerce Court on the closing date as Commitment Shares described below. Furthermore, in no event will Commerce Court be obligated to purchase any shares of our common stock which, when aggregated with all other shares of our common stock then beneficially owned by Commerce Court, would result in the beneficial ownership by Commerce Court of more than 9.9% of the then outstanding shares of our common stock.

On January 4, 2010, we delivered notice to Commerce Court, as subsequently amended, to effect a draw down of up to $1.4 million. The first trading day of the 10-day pricing period for this draw down was January 5, 2010. In connection with this draw down, we issued an aggregate of 490,864 shares of our common stock to Commerce Court, at a purchase price of approximately $2.85 per share and an aggregate purchase price of $1.4 million. The settlement date for this draw down was January 20, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average prices of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 6.1% per share. We received net proceeds from the sale of these shares of approximately $1.38 million after deducting our offering expenses of approximately $25,000, including a placement agent fee of $14,000 paid to Reedland Capital Partners connection with this draw down.

On February 19, 2010, we delivered notice to Commerce Court, to effect a draw down under the Purchase Agreement. The first trading day of the 10-day pricing period for this draw down was February 22, 2010. In connection with this draw down, we issued an aggregate of 2,764,546 shares of our common stock to Commerce Court, at a purchase price of approximately $1.19 per share and

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an aggregate purchase price of approximately $3.29 million. The settlement date for this draw down was March 8, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average price of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 7.0% per share. We received net proceeds from the sale of these shares of approximately $3.24 million after deducting our offering expenses of approximately $45,000, including a placement agent fee of $33,000 paid to Reedland Capital Partners in connection with this draw down.

On March 11, 2010, we delivered notice to Commerce Court to effect a draw down under the Purchase Agreement. The first trading day of the 10-day pricing period for this draw down was March 12, 2010. In connection with this draw down, we issued an aggregate of 1,710,784 shares of our common stock to Commerce Court, at a purchase price of approximately $1.07 per share and an aggregate purchase price of approximately $1.83 million. The settlement date for this draw down was March 26, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average price of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 7.0% per share. We received net proceeds from the sale of these shares of approximately $1.8 million after deducting offering expenses of approximately $30,000, including a placement agent fee of $18,311 payable to Reedland Capital Partners in connection with this draw down.

As of March 26, 2010, we had issued the maximum amount of common stock available for sale under the Commerce Court Purchase Agreement and therefore we will no longer be able to utilize the facility for additional funding.

On May 20, 2010, we entered into an at market issuance sales agreement, or Sales Agreement, with McNicoll, Lewis & Vlak LLC, or MLV, and Wm Smith & Co., or Wm Smith, pursuant to which we may issue and sell shares of our common stock having an aggregate offering price of up to $6.0 million from time to time through MLV and Wm Smith as our sales agents. Sales of our common stock through MLV and Wm Smith, if any, will be made on The NASDAQ Global Market by means of ordinary brokers’ transactions at market prices, in block transactions or as otherwise agreed by us and these sales agents. Subject to the terms and conditions of the Sales Agreement, MLV and Wm Smith will use commercially reasonable efforts to sell our common stock from time to time, based upon our instructions (including any price, time or size limits or other customary parameters or conditions we may impose). We will pay these sales agents an aggregate commission rate of 3.0% of the gross proceeds of the sales price per share of any common stock sold through the sales agents under the Sales Agreement. The number of shares we are able to sell under this arrangement will be limited in practice based on the trading volume of our common stock. As of September 30, 2010 we had not issued or sold any shares of our common stock pursuant to the Sales Agreement. In connection with this financing arrangement, we incurred costs of approximately $150,000 that were expensed during the second quarter of 2010 and are included within our selling, general and administrative expense.

5.  Warrants

We issue freestanding warrants from time to time pursuant to various contractual arrangements. As of September 30, 2010, the following warrants to purchase our common stock were issued and outstanding:

(1)                                 Exercisable, in whole or in part, at anytime at the option of the holder or deemed to have been automatically exercised in full immediately prior to the expiration of the warrant; expires at the earlier of (i) the close of business on October 19, 2014, or (ii) the effective date of a merger, as defined in the agreement.

(2)                                 Exercisable, in whole or in part, at anytime at the option of the holder or deemed to have been automatically exercised in full immediately prior to the expiration of the warrant; expires at the earlier of (i) the close of business on October 17, 2013, or (ii) the effective date of a merger, as defined in the agreement.

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(3)                                 Warrants to purchase 2,446,928 shares of our common stock were issued on November 14, 2008 and warrants to purchase 447,936 shares of our common stock were issued on November 24, 2008, of which warrants to purchase 322,936 shares of our common stock are currently outstanding; the warrants are exercisable, in whole or in part, at anytime at the option of the holder for a term of five years from November 14, 2008.

(4)                                 Exercisable, in whole or in part, at anytime at the option of the holder or deemed to have been automatically exercised in full immediately prior to the expiration of the warrant if the fair market value of one share of our common stock is greater than the exercise price of the warrant on such date.

(5)                                 Warrants to purchase an aggregate of 2,000,000 shares of our common stock were issued on August 13, 2010 and September 30, 2010. The warrants are exercisable, in whole or in part, at anytime at the option of the holder for a term of five years from the issue date.

We follow guidance under ASC 480 to measure the fair value of these warrants on date of issuance. The fair value of the warrant issued to ATEL for $42,000 was capitalized as a prepayment on a lease and was amortized to interest expense over the 36 month lease term. The fair value of the first warrant issued to Lighthouse for $738,000 was capitalized in three separate tranches as debt issuance cost, subsequently reclassified to contra-liability, with the first tranche amortized to interest expense over the funding commitment period ended December 31, 2005. The remainder was amortized to interest expense over the duration of the interest-only period plus the term of the loan over 42 months. The fair value of the second warrant issued to Lighthouse for $523,000 was capitalized in two separate tranches as debt issuance cost, subsequently reclassified to contra-liability, with the first tranche amortized to interest expense over the funding commitment period ended March 1, 2008, and the remainder amortized to interest expense over the duration of the interest-only period plus the term of the loan over 36 months. The fair value of the third warrant issued to Lighthouse for $396,000 was capitalized as debt issuance cost, subsequently reclassified to contra-liability, and amortized to interest expense over the duration of the interest-only period plus the term of the restructured loan over 36 months. The fair value of the warrants issued in connection with the Oxford equipment loan for $17,000 was capitalized as debt issuance cost, subsequently reclassified to contra-liability, and will be amortized to interest expense over the duration of the loan over 36 months. The fair value of the warrants issued to the Bridge Investors was $550,000 in aggregate and was recorded in two separate tranches as a contra-liability with each tranche amortized to interest expense over the contractual interest-only and loan amortization period of approximately 28 months.

We follow guidance under ASC 718, Compensation-Stock Compensations, and considered the fair value of the warrants issued to investors participating in the November 2008 private placement of equity as cost of equity financing and accordingly, we recorded the fair value of the warrants to contra-equity. The aggregate fair value of the warrants issued to the investors was approximately $4.0 million determined using the Black-Scholes option valuation model with the following assumptions: risk-free interest rate of 2.44%, contractual life of five years according to the terms of the warrants, no dividend yield and volatility of 79%.

The fair value of our warrants issued in connection with the placement of our long-term debt was amortized to interest expense as follows:

6.  Stock-Based Compensation

The components of our stock-based compensation expense recognized for the three and nine months ended September 30, 2010 and 2009 were as follows:

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We issued an aggregate 596 shares of our common stock upon the exercise of stock options during the nine months ended September 30, 2010.

7.  Subsequent Events

On October 29, 2010 we received notice from the United States Internal Revenue Service that we had received certification of our qualification for a research and development grant pursuant to the Federal Qualifying Therapeutic Discovery Project (“QTDP”) to which we had applied in July 2010. The grant totaling $943,900 was awarded based on certain research and development costs incurred to date. We expect to receive payment for the grant in November 2010 and we expect to record it as other income in the fourth quarter of 2010.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and the results of operations should be read in conjunction with the condensed consolidated financial statements and notes to condensed consolidated financial statements included elsewhere in this quarterly report on Form 10-Q. This discussion contains forward looking statements that involve risks and uncertainties. When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that characterize our business. In particular, we encourage you to review the risks and uncertainties described in Part II - Item 1A. “RISK FACTORS” elsewhere in this report. These risks and uncertainties could cause actual results to differ materially from those projected in forward-looking statements contained in this report or implied by past results and trends. Forward-looking statements are statements that attempt to forecast or anticipate future developments in our business; we encourage you to review the examples of our forward-looking statements under the heading “Cautionary Note Regarding Forward-Looking Statements” that appears at the end of this discussion. These statements, like all statements in this report, speak only as of their date (unless another date is indicated), and we undertake no obligation to update or revise these statements in light of future developments.

Overview

We are a biopharmaceutical company focused on developing a portfolio of internally discovered product candidates designed to eliminate known safety issues associated with well-established, commercially successful drugs. We use our RetroMetabolic Drug Design technology to design structurally unique molecules that retain the efficacy of these original drugs but are metabolized through a potentially safer pathway to avoid specific adverse side effects associated with these compounds. Our product candidate portfolio includes an oral prokinetic agent, naronapride (ATI-7505), designed to have the same therapeutic benefits as cisapride approved for Phase 3 clinical development for the treatment of chronic constipation, gastroparesis, functional dyspepsia, irritable bowel syndrome with constipation, and gastroesophageal reflux disease; an oral anticoagulant, tecarfarin (ATI-5923), designed to have the same therapeutic benefits as warfarin, currently in Phase 2/3 clinical development for the treatment of patients who are at risk for the formation of dangerous blood clots; an oral antiarrhythmic agent, budiodarone (ATI-2042), designed to have the efficacy of amiodarone in Phase 2 clinical development for the treatment of atrial fibrillation, a form of irregular heartbeat; and a novel, next-generation atypical antipsychotic agent, ATI-9242, currently in Phase 1 clinical development for the treatment of schizophrenia and other psychiatric disorders. Additionally, we have several product candidates in preclinical development. Each of our product candidates is an orally available, patentable new chemical entity designed to address similar indications as those of the original drug upon which each is based. Our product candidates target what we believe to be multi-billion dollar market opportunities.

We were incorporated in the State of California on February 28, 1997 and reincorporated in the State of Delaware on August 29, 2007. We maintain a wholly-owned subsidiary, ARYx Therapeutics Limited, with registered offices in the United Kingdom, which has had no operations since its inception in September 2004 and was established to serve only as a legal entity as required in support of our clinical trial activities conducted in Europe.

In February 2010 we shifted our primary focus to exploring strategic alternatives available to us to complete a transaction that could create significant value for stockholders. Those alternatives could include partnerships on one or more of the three lead product candidates, the sale of company assets, in whole or in part, or some other arrangement through which the value of our assets to stockholders could be optimized (“Strategic Process”). Concurrent with beginning the Strategic Process, we restructured our operations in order to conserve resources and support the process of reviewing strategic alternatives. This followed an initial reduction

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in our workforce headcount in October 2009. Through these two restructuring steps and following the departure in June 2010 of Peter G. Milner, M.D., our former President of Research and Development, our headcount has been reduced from 73 to 16 employees. The restructuring was necessary as we have three compounds at proof-of-concept stage but insufficient cash resources to develop these product candidates further or to complete licensing agreements in a timely manner with a high level of certainty. Our operations have consumed a substantial amount of cash since inception and we expect to continue to incur net losses for the foreseeable future. Our ability to continue operations will be dependent on our ability to obtain substantial additional funding. We may seek to raise necessary additional funds through public or private equity, debt financings, collaborative arrangements with corporate partners or other sources available to us. This may include proceeds, if any, from sales of common stock under our at market issuance sales agreement with McNicoll, Lewis & Vlak LLC and Wm Smith & Co., pursuant to which we may issue and sell up to $6.0 million of our common stock.

On August 13, 2010, we secured bridge financing in two related loan transactions — a bridge loan financing with entities affiliated with MPM Capital and Ayer Capital Management, L.L.P. (collectively the “Bridge Investors”) and the concurrent restructuring of our outstanding loans with Lighthouse Capital Partners V, L.P. (“Lighthouse”).  Under the terms of a secured note and warrant purchase agreement dated August 13, 2010, we issued and sold secured promissory notes (the “Notes”) in the principal amount of up to $4.0 million and warrants to purchase an aggregate of 2,000,000 shares of our common stock to the Bridge Investors in two tranches (the “Bridge Financing”). We completed the first tranche for $2.0 million of Notes and warrants to purchase 1,000,000 shares of our common stock on August 13, 2010.  We completed the second tranche for $2.0 million of Notes and warrants to purchase 1,000,000 shares of common stock on September 30, 2010. Concurrently with the initial tranche of the Bridge Financing, we amended our existing loan arrangement with Lighthouse to provide for the conversion of approximately $2.3 million of loan payments scheduled for the third quarter of 2010 into a new loan to us by Lighthouse (the “New Commitment”).  Upon the initial closing of the Bridge Financing, we made an approximately $2.0 million payment to Lighthouse out of the proceeds of the initial closing, and Lighthouse immediately loaned approximately the same amount back to us as part of the New Commitment.  On September 1, 2010, we made a subsequent payment of approximately $300,000 to Lighthouse, which Lighthouse immediately loaned back to us as the balance of the New Commitment.  We believe that our cash and cash equivalents on hand as of September 30, 2010 are sufficient to fund our operations to December 31, 2010.  We will need to seek additional sources of funding to allow us to continue our operations as we continue to explore strategic options available to us.

Since our inception, we have incurred significant net losses, and we expect to continue to incur net losses for the foreseeable future as we explore strategic options for the company. We are unable to predict the extent of any future losses or the degree of success we may have in the exploration and execution of our strategic options.

We have established proof of concept with our three leading product candidates, tecarfarin, budiodarone and naronapride (ATI-7505), which retain the efficacy of certain commercially successful drugs for well established chronic markets while being metabolized through a potentially safer pathway than such drugs.  The following is a summary of our product candidates:

Naronapride (ATI-7505)

Naronapride (ATI-7505) is an oral prokinetic agent that has been shown to speed up the passage of contents through the gut. We have successfully completed four Phase 2 clinical trials for the treatment of multiple gastrointestinal disorders including gastroesophageal reflux disease, or GERD, functional dyspepsia and chronic idiopathic constipation. Naronapride was designed to have the same therapeutic benefits as cisapride, a drug marketed by Johnson & Johnson under the brand name Propulsid in the United States and other countries. Launched in 1993, cisapride was withdrawn from the market in 2000 due to serious cardiovascular side effects. These side effects occurred as blood levels of cisapride rose significantly when CYP450 clearance was inhibited due to the co administration of other drugs that were cleared by the same metabolic pathway. We designed naronapride to be metabolized through the esterase pathway, eliminating metabolism through CYP450 as well as eliminating the off-target cardiovascular effects. Nearly 1,000 patients and subjects have been treated with naronapride as part of our clinical trial program. In June 2006, we entered into a collaboration agreement with Procter & Gamble Pharmaceuticals, Inc., or P&G, to develop and commercialize naronapride. On July 2, 2008, we received notice from P&G that it elected to exercise its option to terminate the collaboration agreement effective July 2, 2008. P&G subsequently announced that it is exiting pharmaceutical drug development. Upon termination of the collaboration agreement by P&G, all rights to naronapride reverted to us. Also on July 2, 2008, we announced the overall successful results of a Thorough QT trial, or TQT, on naronapride, which we believe supports the agent’s favorable cardiac safety profile. On August 22, 2008, we announced the results of a Phase 2b clinical trial testing the safety and efficacy of naronapride in patients with chronic idiopathic constipation. The clinical trial, conducted by P&G, was designed to enroll 400 patients evaluating four doses of the agent compared to placebo. As a result of the termination of the collaboration between the company and P&G, the trial was terminated early after only 214 patients had been enrolled. In spite of the early termination of the trial, naronapride achieved statistical significance at the trial’s primary endpoint in the 80 mg twice-daily dose. In addition, all doses tested demonstrated a clinically meaningful and desired increase in spontaneous bowel movements over baseline compared to placebo after one week of treatment. We have had an end of Phase 2 meeting with the FDA to seek their guidance on the size and design of the Phase 3 program required for registration. Based upon that meeting, we believe we have a clear path forward in chronic idiopathic constipation that includes safety data in line with ICH guidelines.

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Through the Strategic Process, we are seeking to identify the best path to maximize the value of naronapride and lead to its full development and eventual commercialization, in the event requisite regulatory approval is obtained.

Tecarfarin

Tecarfarin is an oral anticoagulant agent in Phase 2/3 clinical development for the treatment of patients who are at risk for the formation of dangerous blood clots, such as those with atrial fibrillation or those at risk of venous thromboembolism. Tecarfarin was designed to have the same therapeutic benefits as the drug warfarin which for over 50 years has been the oral anticoagulant of choice. Despite its widespread use, warfarin has several significant limitations. It is metabolized by CYP450 and has many drug-drug interactions that often lead to serious side effects. We designed tecarfarin to be metabolized through the esterase pathway, eliminating metabolism through CYP450 and avoiding drug-drug interactions. Warfarin also has a very steep dose response curve which means that a small change in dose may lead to a substantial change in the anticoagulation status of the patient. These two factors can create significant challenges in maintaining therapeutic levels of warfarin and this can put patients at risk for either life-threatening clotting or bleeding, especially in patients with compromised CYP450 clearance. In preclinical testing and in clinical testing to date, it appears that tecarfarin may be inherently more stable than warfarin due to its predictable metabolism through the esterase pathway that has a much larger capacity than CYP450. The level of anticoagulation produced by both warfarin and tecarfarin is measured by the standard assay known as International Normalized Ratio, or INR.

We have treated over 400 patients with tecarfarin in trials in which we measured its ability to maintain those patients within a target therapeutic range of INR of 2.0 to 3.0 (2.5 to 3.5 for heart valve patients). Two of the clinical trials performed were Phase 2 trials (CLN-504 and CLN-509) and the third was a Phase 2/3 trial, EmbraceAC (CLN-505). In each of these three trials, the results were nearly identical. Patients on tecarfarin had a time in target therapeutic range of INR of 71.5% (CLN-504), 73.9% (CLN-509), and 74% (CLN-505). Statistical significance was achieved in CLN-504 when comparing the tecarfarin response to the same patients’ historical experience with warfarin: 71.5% time within therapeutic range versus 59.3% time within therapeutic range, respectively (p=0.0009). However, statistical significance was not achieved at the primary endpoint in the 607-patient CLN-505 clinical trial, directly measuring the ability of tecarfarin to maintain patients within the target therapeutic range of INR as compared to warfarin patients. The endpoint was missed due to the unprecedented time within therapeutic range for the warfarin-treated patients of 73.2% (p=0.506). We believe the warfarin outcome resulted from the intense monitoring and dose control provided by the trial’s central dosing methodology, executed in accord with our agreement on the trial design with the U.S. Food and Drug Administration, or FDA. In a subgroup responder analysis of those CLN-505 patients taking medications which inhibit CYP450 metabolism and which can cause drug-drug interactions, the tecarfarin group showed a significantly larger proportion of responders compared to the warfarin group (67.9% versus 53.8% respectively p=0.0676). A responder is defined as a patient who is in range for more than 65% of the time during the treatment period. In addition, about one-third of the CLN-505 patients who were in the tecarfarin treatment arm and were stable on the drug at the end of the trial period continued to be treated with tecarfarin in a safety follow-up extension, allowing treatment on the agent for at least one year. During this extension phase, tecarfarin patients were monitored an average of once every four weeks. This group’s average time in therapeutic range of INR was 78.4% of the time treated during the extension phase.

Based upon feedback from the FDA subsequent to the completion of the CLN-505 clinical trial, we believe one additional Phase 3 trial needs to be conducted to potentially seek regulatory approval of tecarfarin. This trial would also directly compare tecarfarin’s ability to maintain patients in a targeted therapeutic range of INR compared to warfarin but in a “real-world” setting in which monitoring and dosing decisions would be made at the trial sites, which would be similar to how warfarin is typically dosed and titrated in clinical practice. We believe tecarfarin should compare favorably against warfarin in a real-world setting due to its inherent properties and based upon the clinical results we have collected to date. We believe this favorable result will be in contrast to the well-established published data reporting the typical time in therapeutic range of INR expected in patients treated with warfarin in similar historical trials. In our most recent discussions, the FDA confirmed that the ability to maintain patients within the targeted INR will likely be an acceptable surrogate and primary endpoint for tecarfarin’s clinical development, and that the data collected in the CLN-505 clinical trial could be used to support the registration of tecarfarin. Using INR as a surrogate measure for the primary endpoint should reduce the size of our planned second Phase 3 clinical trial compared to clinical trials measuring survival rates or other outcomes. We have submitted, in writing under a Special Protocol Assessment, or SPA, our proposed design of the second Phase 3 clinical trial. The process to negotiate a final study design with the FDA is ongoing. Through the Strategic Process, we are seeking to identify the best path to maximize the value of tecarfarin and lead to its full development and eventual commercialization, in the event requisite regulatory approval is obtained.

Budiodarone

Budiodarone is an oral antiarrhythmic agent in Phase 2 clinical development for the treatment of patients with atrial fibrillation. Budiodarone was designed to have the efficacy of amiodarone, a drug that has been used for many years, despite its adverse side effects, because physicians believe based on their own experience, as well as extensive clinical trial results, that amiodarone is the

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most effective drug for treating patients with atrial fibrillation. Amiodarone accumulates in many different organs and can only be metabolized and subsequently cleared from the body by CYP450. This accumulation can lead to serious side effects that are not immediately reversible upon withdrawal of the drug. Since budiodarone is predominantly metabolized through the esterases found extensively in the organs, it should avoid safety issues associated with accumulation and have fewer drug-drug interactions. We have completed a Phase 2 pilot trial (CLN-208) with budiodarone involving six atrial fibrillation patients with implanted recordable pacemakers who did not respond to previous drug therapy. This pilot trial suggested that the effect of budiodarone improved as the dose increased. Based upon the results of this pilot trial, we conducted an additional Phase 2b clinical trial to further demonstrate the efficacy of budiodarone in patients with atrial fibrillation. The clinical trial, which enrolled 72 patients, was a multi-centered, randomized, double blind, placebo-controlled trial of the efficacy and safety of budiodarone in patients with paroxysmal atrial fibrillation, or PAF. All patients entering this trial had previously implanted dual chamber pacemakers with diagnostic and recording capability. In December 2008, we announced successful top-line efficacy results from this Phase 2b clinical trial. By achieving statistical significance at the two highest doses of the three tested, the results essentially mirrored the findings of the earlier Phase 2 pilot trial also conducted in paroxysmal atrial fibrillation patients. The Phase 2b trial also demonstrated that patients in the trial quickly returned to their pre-treatment level of atrial fibrillation once the treatment ended. We have also announced the complete safety results from this Phase 2b clinical trial that indicate that budiodarone is generally safe and well-tolerated, and appears to avoid the tissue accumulation evident with amiodarone. Through the Strategic Process, we are seeking to identify the best path to maximize the value of budiodarone and lead to its full development and eventual commercialization, in the event requisite regulatory approval is obtained.

ATI-9242

ATI-9242 is a novel antipsychotic agent in Phase 1 clinical development for the treatment of schizophrenia and other psychiatric disorders. ATI-9242’s receptor profile is targeted at the treatment of both the positive and the negative symptoms of schizophrenia as well as the improvement of cognitive function. To date, preclinical work has supported this profile. ATI-9242 is also designed to avoid certain drug-drug interactions by avoiding CYP450 enzymes for metabolism, as well as reduce certain metabolic problems associated with this class of therapy, including weight gain and type 2 diabetes.

Restructuring of Operations

On October 29, 2009, we announced a restructuring of operations which included a reduction in personnel from 73 employees to 56 employees. The staff reduction affected all functions within the company and was accompanied by changes within the organizational structure to improve the efficiency of our operations. We recognized a charge of approximately $375,000 related to the restructuring during the fourth quarter of 2009 which included costs for severance pay, extended healthcare benefits and outplacement services for the exiting employees. Additionally, we made an assessment to determine if there had been any material impairment of assets resulting from the restructuring and concluded that no material impairment had occurred.

On February 18, 2010 we announced an additional restructuring of operations which included a substantial reduction in force from 56 employees to 17 employees, and further reduced to 16 employees following the departure of Peter G. Milner, M.D., our former President of Research and Development, effective June 15, 2010. The positions impacted were across all business functions, including the research and development, clinical, operations and general and administrative departments. The restructuring plan was primarily designed to reduce operating expenses and conserve cash resources as we explore various strategic options. The restructuring was substantially completed during the first quarter of 2010. Additionally, we announced the shift of our primary focus to the exploration of strategic alternatives available to us to realize optimal value for our late-stage assets.

Employees affected by the reductions in force were provided with severance payments, continuation of current benefits and outplacement assistance. Severance payments to employees terminated as part of the February 2010 restructuring consisted of 50% cash and 50% common stock in order to minimize the associated cash expense, with an aggregate 460,940 shares of common stock issued under our equity incentive plan as a severance payout.

As a result of the February 2010 restructuring of operations, we incurred an aggregate restructuring charge of approximately $1.6 million less a credit of approximately $0.3 million due to stock option cancellations in the first six months of 2010. Of this amount, approximately $0.1 million was recognized as expense during the second quarter of 2010. The restructuring charge includes costs for severance pay, employee benefits and outplacement services. The aggregate restructuring charge included approximately $1.0 million of cash expenditures and approximately $0.3 million of non-cash charges, net of adjustments related to stock compensation expense. As part of the restructuring effort and during the course of our continuing operations, we will be assessing on a quarterly basis any possible impairment of assets related to idle facilities and equipment resulting from the February 2010 restructuring and may incur additional expense related to any such impairment. During the first three quarters of 2010 we made an assessment in accordance with ASC 360 to determine if there had been any material impairment of assets resulting from the February 2010 restructuring and concluded that given the range of possible outcomes related to our exploration of strategic

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alternatives, no material impairment had occurred. As a result of our restructuring activities, we anticipate a substantial reduction in our operating expenses in 2010 as compared to our spending levels in 2009.

As of September 30, 2010, we had cash, cash equivalents and marketable securities on hand of approximately $3.0 million, current payables and accrued liabilities of approximately $0.9 million and approximately $6.9 million in current notes and interest payable. As of September 30, 2010, we had outstanding non-current liabilities of $5.9 million. Since our inception, we have incurred significant net operating losses and, as of September 30, 2010, we had an accumulated deficit of $199.6 million. We have not achieved sustained profitability and anticipate that we will continue to incur significant net losses for the foreseeable future. There can be no assurances that we will achieve positive cash flow in the foreseeable future or at all. Additionally, we do not anticipate that our cash on hand as of September 30, 2010 will be sufficient to fund our operations for the following twelve months. However, we believe that our cash on hand will provide us with sufficient funds to operate to December 31, 2010. For the year ended December 31, 2009 our auditor, Ernst & Young LLP, issued an audit opinion which included an explanatory paragraph raising substantial doubt about our ability to continue as a going concern.

Research and Development Expense

Our research and development expense consists of expenses incurred in identifying, testing and developing our product candidates. These expenses consist primarily of fees paid to contract research organizations and other third parties to assist us in managing, monitoring and analyzing our clinical trials, clinical trial costs paid to sites and investigators’ fees, costs of non-clinical studies including toxicity studies in animals, costs of contract manufacturing services, costs of materials used in clinical trials and non-clinical studies, laboratory related expenses, research and development support costs including certain regulatory, quality assurance, project management and administration, allocated expenses such as facilities and information technology that are used to support our research and development activities and related personnel expenses, including stock-based compensation. Research and development costs are expensed as incurred.

Clinical trial costs have been a significant component of our research and development expense. We have conducted our clinical trials primarily through coordination with contract research organizations and other third-party service providers. We recognize research and development expense for these activities based upon a variety of factors, including actual and estimated patient enrollment, clinical site initiation activities, direct pass-through costs and other activity-based factors.

The following table summarizes our research and development, or R&D, expense for the three and nine months ended September 30, 2010 and 2009:

From our inception through September 30, 2010, we estimate that approximately $40.5 million of expense was incurred for our tecarfarin product candidate, approximately $25.2 million was incurred for our budiodarone product candidate, approximately $22.7 million was incurred for our naronapride (ATI-7505) product candidate, approximately $5.2 million was incurred for our ATI-9242 product candidate, and approximately $73.7 million was incurred for costs related to our research and development personnel, administrative and other research programs.

The expenditures summarized in the above table reflect costs directly attributable to each product candidate and to our other research programs. We do not allocate salaries, employee benefits, or other indirect costs to our product candidates or other research programs and have included those expenses in “personnel, administrative and other expense” in the above table.

At this time, due to the risks inherent in our business and given the various stages of development of our product candidates, we are unable to estimate with any certainty the costs we will incur in support of our product candidates. Clinical development

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timelines, the probability of success and development costs can differ materially from expectations. In addition, we cannot forecast with any degree of certainty which product candidates may be subject to future collaborations, when such arrangements may be secured, if at all, and to what degree such arrangements would affect our current operating plans and capital requirements.

The process of developing and obtaining FDA approval of products is costly and time consuming. Development activities and clinical trials can take years to complete, and failure can occur at any time during the development and clinical trial process. In addition, the results from early clinical trials may not be predictive of results obtained in subsequent and larger clinical trials, and product candidates in later stages of clinical trials may fail to show the desired safety and efficacy despite having progressed successfully through initial clinical testing. Although our approach to identifying and developing new product candidates is designed to mitigate risk, the successful development of our product candidates is highly uncertain. Further, even if our product candidates are approved for sale, they may not be successfully commercialized and therefore the future revenue we anticipate may not materialize.

If we fail to complete the development of any of our product candidates in a timely manner, it could have a material effect on our operations, financial position and liquidity. In addition, any failure by us or our partners to obtain, or any delay in obtaining, regulatory approvals for our product candidates could have a material adverse effect on our results of operations. However, as we explore strategic alternatives, we expect to expend minimal efforts or resources towards further development of our product candidates. A further discussion of the risks and uncertainties associated with completing our programs on schedule, or at all, and certain consequences of failing to do so are discussed in Part II—Item 1A. “Risk Factors” section of this report.

Critical Accounting Policies and Significant Estimates

We have prepared our consolidated financial statements in accordance with U.S. generally accepted accounting principles. Accordingly, we have had to make estimates, assumptions and judgments that affect the amounts reported in our consolidated financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time.

Our critical accounting policies are more fully described in Note 1 of the audited consolidated financial statements for the year ended December 31, 2009, which are included in our annual report on Form 10-K filed with the Securities and Exchange Commission. There have been no material changes in our critical accounting policies and significant estimates during the three and nine months ended September 30, 2010.

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2010 and 2009

Research and Development Expense

For the three months ended September 30, 2010, as compared to the same period in 2009, our research and development expense decreased by $4.2 million, or 83%. The decrease was due to:

·                  a $1.6 million reduction in expenses related to our tecarfarin product candidate due to the substantial completion of our Phase 2/3 EmbraceAC clinical study in the second quarter of 2009;

·                  a $2.4 million reduction in personnel and administrative costs resulting primarily from our restructuring of operations in October 2009 and February 2010;

·                  a $0.1 million reduction in expenditures related to the completion of a Phase 2b clinical study for our budiodarone product candidate in the first half of 2009; and

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·                  a $0.1 million reduction in R&D costs related to our other R&D activities.

For the nine months ended September 30, 2010, as compared to the same period in 2009, our research and development expense decreased by $14.0 million, or 77%. The decrease was due to:

·                  a $6.8 million reduction in expenses related to our tecarfarin product candidate primarily due to the substantial completion of our Phase 2/3 EmbraceAC clinical study in the second quarter of 2009;

·                  a $6.4 million reduction in personnel and administrative costs resulting primarily from our restructuring of operations in October 2009 and February 2010; and

·                  a $0.8 million reduction in expenditures related to the completion of a Phase 2b clinical study for our budiodarone product candidate in the first half of 2009.

Selling, General and Administrative Expense

The decrease in selling, general and administrative expense for the three months ended September 30, 2010 as compared to the same period in 2009 was primarily due to reduced operating expenses resulting from our October 2009 and February 2010 restructuring of operations. The decrease in selling, general and administrative expense for the nine months ended September 30, 2010 as compared to the same period in 2009 was primarily due to reduced operating expenses resulting from our October 2009 and February 2010 restructuring of operations, partially offset by our recognition of a $1.6 million restructuring charge resulting from our February 2010 restructuring of operations, costs related to the departure of Peter Milner incurred in the second quarter of 2010 and costs related to the at market financing arrangement incurred during the second quarter of 2010.

Interest and Other Income (Expense)

Interest and other income, net of other expenses, consist primarily of interest income from our investments in money market funds and marketable securities, realized gains or losses from the sale of marketable securities and certain expenses such as state franchise tax. The increase in interest and other income, net of other expenses, for the three months ended September 30, 2010 as compared to the same period in 2009 was primarily due to lower expenses resulting from a federal tax grant for certain investments in fixed assets made in 2009 and lower state franchise tax expense, partially offset by lower interest income. The decrease in interest and other income, net of other expenses, for the nine months ended September 30, 2010 as compared to the same period in 2009 was primarily due to lower interest income resulting from lower cash balances, partially offset by a state franchise tax rebate recognized in the first quarter of 2010 and a realized gain of approximately $18,000 related to the sale of our auction rate security instrument during the first quarter of 2010.

Interest Expense

The decrease in interest expense for the three and nine month periods ended September 30, 2010 as compared to the same periods in 2009 was primarily due to a reduction of our debt balances outstanding with Lighthouse and Oxford resulting from the contractual pay down of our long-term debt obligations, partially offset by higher interest expense resulting from the Bridge Financing and Lighthouse debt restructure in the third quarter of 2010.

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Liquidity and Capital Resources

As of September 30, 2010, we had cash, cash equivalents and marketable securities on hand of approximately $3.0 million, current payables and accrued liabilities of approximately $0.9 million and approximately $6.9 million in current notes and interest payable. As of September 30, 2010, we had outstanding non-current liabilities of $5.9 million. Since our inception, we have incurred significant net operating losses and, as of September 30, 2010, we had an accumulated deficit of $199.6 million. We have not achieved sustained profitability and anticipate that we will continue to incur significant net losses for the foreseeable future. There can be no assurances that we will achieve positive cash flow in the foreseeable future or at all. Additionally, we do not anticipate that our cash on hand as of September 30, 2010 will be sufficient to fund our operations for the following twelve months. However, we believe that our cash on hand as of September 30, 2010 will provide us with sufficient funds to operate to December 31, 2010.

Net cash used in operating activities was $14.0 million and $28.9 million for the nine months ended September 30, 2010 and 2009, respectively. Net cash consumed in each of these periods was primarily used towards the funding of our operating costs and expenses in connection with the conduct of our research, development and administrative activities. Additionally, the nine month period ended September 30, 2010 included approximately $1.0 million of cash expenditures related to our February 2010 restructuring of operations.

Cash used in, or provided by, investing activities primarily related to purchases, sales and maturities of marketable securities, as well as changes in our restricted cash balances and levels of capital expenditure. For the nine months ended September 30, 2010, net sales of marketable securities was $0.4  million as compared to purchases of marketable securities, net of maturities, of $1.1 million for the same period in 2009. During the nine months ended September 30, 2010, we received funds from the contractual release of approximately $0.5 million of restricted cash related to our facility lease agreement and our third party payroll service provider. Purchases of property and equipment were $8,400 and $97,000 for the nine months ended September 30, 2010 and 2009, respectively.

Net cash provided by financing activities for the nine months ended September 30, 2010 was $8.7 million and was related to proceeds from the sale of common stock pursuant to the Commerce Court equity line agreement along with proceeds from our recent Bridge Financing, partially offset by principal payments on our long-term debt. For the nine months ended September 30, 2009, net cash used in financing activities was $1.4 million and consisted of principal payments on our long-term debt and equity financing costs, partially offset by proceeds from employee purchases of our common stock pursuant to our employee stock purchase plan.

Debt Arrangements

As of September 30, 2010, we had loan commitments outstanding with Lighthouse, the Bridge Investors and Oxford Finance Corporation, or Oxford. Prior to September 30, 2010 we also had loan commitments outstanding with General Electric Commercial Finance, or GE.

On August 13, 2010, we entered into an agreement with the Bridge Investors pursuant to which we agreed to issue and sell in a private placement Notes in the aggregate principal amount of up to $4.0 million, and Warrants to purchase up to an aggregate of 2,000,000 shares of our common stock, subject to the terms and conditions set forth in the agreement.  The Notes are secured by a security interest in all of our assets, including our intellectual property.

On August 13, 2010, we closed on the first tranche of $2.0 million of Notes pursuant to the terms and conditions of the Bridge Financing and, as a result, issued Warrants to the Bridge Investors to purchase 1,000,000 shares of our common stock.  On September 30, 2010, we closed on the second tranche of $2.0 million of Notes and issued Warrants to purchase an additional 1,000,000 shares of our common stock.

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The Notes accrue interest at a continuously compounding rate of 12.0% per annum.  Unless earlier paid pursuant to the terms of the agreement or accelerated in connection with an event of default, we will make interest only payments through December 31, 2010, followed by 24 equal monthly payments of principal and interest through January 1, 2013. In the event we sell any or all of our assets or enter into certain strategic transactions, we may be required to repay the Notes at an earlier date under the terms of the Bridge Financing.

The Warrants had a purchase price of $0.0125 per underlying share of common stock and are exercisable for a term of five years from the date of issuance at an exercise price of $0.50 per share. On October 12, 2010, we filed a registration statement registering for resale the shares of common stock issuable upon the exercise of the Warrants pursuant to the Registration Rights Agreement we entered into with the Bridge Investors.

We received net proceeds of approximately $1.8 million in connection with the initial tranche of the Bridge Financing, after deducting certain expenses payable by us. The net proceeds from the initial tranche of the Bridge Financing were used by us to make an approximately $2.0 million repayment on our existing loan obligation with Lighthouse pursuant to the terms of our loan arrangement with Lighthouse, as more fully described below. We received net proceeds of approximately $2.0 million in connection with the second tranche of the Bridge Financing after deducting certain expenses payable by us. The remaining proceeds from the Bridge Financing are being used for working capital and other corporate and operational purposes, including permitted payments to our lenders.

Concurrently with the Bridge Financing, we and Lighthouse entered into Amendment No. 8 to that certain Loan and Security Agreement No. 4521 dated March 28, 2005, as amended. The amendment to the Lighthouse agreement provides for the conversion of up to approximately $2.3 million of loan payments scheduled for the third quarter of 2010 into the New Commitment. Upon the closing of the initial tranche of the Bridge Financing, we used the net proceeds from such closing to make an approximately $2.0 million repayment of our loan obligation to Lighthouse and, pursuant to the terms of the amendment, Lighthouse promptly loaned approximately the same amount to us as part of the New Commitment. On September 1, 2010, we made a subsequent payment of approximately $300,000 to Lighthouse which was promptly loaned back to us from Lighthouse as the balance of the New Commitment.

The New Commitment is due and payable on December 31, 2010 in one lump sum payment equal to the aggregate principal amount plus accrued interest through the due date at a stated interest rate of 13.0% per annum. In the event we enter into certain strategic transactions with proceeds of at least $40.0 million prior to the applicable due date, the New Commitment will be amortized and payable in equal monthly installments of principal and interest over the 18 months following the closing of such strategic transaction. Upon the occurrence of an event of default or liquidation event, all outstanding amounts under the New Commitment shall be immediately due and payable.

The terms of the Lighthouse loan further provide that any assignment of the Notes without Lighthouse’s consent would now constitute an event of default under the Lighthouse loan agreement. We also granted Lighthouse a security interest in all of our assets including our intellectual property in connection with the amendment to the Lighthouse loan agreement and the New Commitment.

As of September 30, 2010, following our receipt of the New Commitment, the total principal amount borrowed under the Lighthouse loans was $21.3 million and the total unpaid principal balance outstanding was $7.9 million. The total accrued and unpaid balloon interest outstanding was $0.4 million as of September 30, 2010. We recorded interest expense related to the Lighthouse loan, including amortization of expense related to the terminal payments and the warrants issued under the agreement, of $299,000 and $488,000 for the three months ended September 30, 2010 and 2009, respectively, and $1.1 million and $1.4 million for the nine months ended September 30, 2010 and 2009, respectively.

The total principal amount borrowed under the Bridge Financing arrangement was $4.0 million and the total unpaid principal balance outstanding as of September 30, 2010, was $4.0 million. We recorded interest expense related to the Bridge Financing, including amortization of expense related to capitalized loan expenses and the warrant issued under the agreement, of $57,900 and none for the three months ended September 30, 2010 and 2009, respectively, and $57,900 and none for the nine months ended September 30, 2010 and 2009, respectively.

The total principal amount borrowed under the Oxford loan was $1.0 million and the total unpaid principal balance outstanding as of September 30, 2010, was $459,000. The total accrued and unpaid balloon interest outstanding was $12,000 as of September 30, 2010. We recorded interest expense related to the Oxford loan, including amortization of expense related to the terminal payment and the warrant issued under the agreement, of $17,800 and $27,000 for the three months ended September 30, 2010 and 2009, respectively, and $60,500 and $87,000 for the nine months ended September 30, 2010 and 2009, respectively. Pursuant to the terms of the Oxford loan, Oxford maintains a security interest in certain of our fixed assets.

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The total principal amount borrowed under the GE loans was $1.9 million and as of September 30, 2010 the loans had been fully repaid. We recorded no interest expense related to the GE loans for the three months ended September 30, 2010 and $5,000 for the three months ended September 30, 2009. For the nine months ended September 30, 2010 and 2009, respectively, we recorded $650 and $20,000 in interest expense related to the GE loans.

Equity Line Financing Facility

On October 6, 2009, we entered into a common stock purchase agreement, or the Purchase Agreement, with Commerce Court Small Cap Value Fund, Ltd., or Commerce Court, providing for a financing arrangement that is sometimes referred to as a committed equity line financing facility. The Purchase Agreement provided that, upon the terms and subject to the conditions set forth in the Purchase Agreement, Commerce Court would be committed to purchase up to $35.0 million of shares of our common stock over the 24-month term of the Purchase Agreement under certain specified conditions. Under the terms of the Purchase Agreement, in no event could we sell more than 5,380,090 shares of common stock, which is equal to one share less than 20% of our outstanding shares of common stock on October 6, 2009, the closing date of the Purchase Agreement, less the number of shares of common stock we issued to Commerce Court on the closing date as Commitment Shares described below. Furthermore, in no event would Commerce Court be obligated to purchase any shares of our common stock which, when aggregated with all other shares of our common stock then beneficially owned by Commerce Court, would result in the beneficial ownership by Commerce Court of more than 9.9% of the then outstanding shares of our common stock. We issued to Commerce Court, upon execution of the Purchase Agreement, 114,200 shares of our common stock, or the Commitment Shares.

On December 11, 2009, we delivered notice to Commerce Court to effect a draw down of up to $1.0 million. The first trading day of the 10-day pricing period for this draw down was December 14, 2009. In connection with this draw down, we issued an aggregate of 413,896 shares of our common stock to Commerce Court, at a per share purchase price of approximately $2.42 and an aggregate purchase price of $1.0 million. The settlement date for this draw down was December 30, 2009. The per share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average prices of our common stock on The NASDAQ Global Market during the pricing period, net a discount of 7.0% per share. We received net proceeds from the sale of these shares of approximately $781,000 after deducting our offering expenses of approximately $219,000 including a placement agent fee of $10,000 paid to Reedland Capital Partners, an Institutional Division of Financial West Group, member FINRA/SIPC. Of the total offering cost, approximately $180,000 was incurred as one time expenses related to the filing of a registration statement on Form S-1 covering the resale of the shares of Common Stock sold to Commerce Court and legal fees incurred upon entering into the Purchase Agreement with Commerce Court.

On January 4, 2010, we delivered notice to Commerce Court, as subsequently amended, to effect a draw down of up to $1.4 million. The first trading day of the 10-day pricing period for this draw down was January 5, 2010. In connection with this draw down, we issued an aggregate of 490,864 shares of our common stock to Commerce Court, at a purchase price of approximately $2.85 per share and an aggregate purchase price of $1.4 million. The settlement date for this draw down was January 20, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average prices of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 6.1% per share. We received net proceeds from the sale of these shares of approximately $1.38 million after deducting our offering expenses of approximately $25,000, including a placement agent fee of $14,000 paid to Reedland Capital Partners connection with this draw down.

On February 19, 2010, we delivered notice to Commerce Court, to effect a draw down under the Purchase Agreement. The first trading day of the 10-day pricing period for this draw down was February 22, 2010. In connection with this draw down, we issued an aggregate of 2,764,546 shares of our common stock to Commerce Court, at a purchase price of approximately $1.19 per share and an aggregate purchase price of approximately $3.29 million. The settlement date for this draw down was March 8, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average price of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 7.0% per share. We received net proceeds from the sale of these shares of approximately $3.24 million after deducting our estimated offering expenses of approximately $45,000, including a placement agent fee of $33,000 paid to Reedland Capital Partners in connection with this draw down.

On March 11, 2010, we delivered notice to Commerce Court, to effect a draw down under the Purchase Agreement. The first trading day of the 10-day pricing period for this draw down was March 12, 2010. In connection with this draw down, we issued an aggregate of 1,710,784 shares of our common stock to Commerce Court, at a purchase price of approximately $1.07 per share and an aggregate purchase price of approximately $1.83 million. The settlement date for this draw down was March 26, 2010. The share price at which Commerce Court purchased these shares from us was established under the Purchase Agreement by reference to the volume weighted average price of our common stock on The NASDAQ Global Market during the pricing period, net a discount of approximately 7.0% per share. We received net proceeds from the sale of these shares of approximately $1.8 million after deducting

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our estimated offering expenses of approximately $30,000, including a placement agent fee of $18,311 payable to Reedland Capital Partners in connection with this draw down.

As of March 26, 2010, we had issued the maximum amount of common stock available under the Commerce Court Purchase Agreement and therefore will no longer be able to utilize the facility.

At Market Issuance Facility

On May 20, 2010, we entered into an at market issuance sales agreement, or Sales Agreement, with McNicoll, Lewis & Vlak LLC, or MLV, and Wm Smith & Co., or Wm Smith, pursuant to which we may issue and sell shares of our common stock having an aggregate offering price of up to $6.0 million from time to time through MLV and Wm Smith as our sales agents. Sales of our common stock through MLV and Wm Smith, if any, will be made on The NASDAQ Global Market by means of ordinary brokers’ transactions at market prices, in block transactions or as otherwise agreed by us and these sales agents. Subject to the terms and conditions of the Sales Agreement, MLV and Wm Smith will use commercially reasonable efforts to sell our common stock from time to time, based upon our instructions (including any price, time or size limits or other customary parameters or conditions we may impose). We will pay these sales agents an aggregate commission rate of 3.0% of the gross proceeds of the sales price per share of any common stock sold through the sales agents under the Sales Agreement. The number of shares we are able to sell under this arrangement will be limited in practice based on the trading volume of our common stock. As of September 30, 2010 we had not issued or sold any shares of our common stock pursuant to the Sales Agreement. In connection with this financing arrangement, we incurred costs of approximately $150,000 that were expensed during the second quarter of 2010 and are included within our selling, general and administrative expense.

Qualifying Therapeutic Discovery Project Grant

On October 29, 2010 we received notice from the United States Internal Revenue Service that we had received certification of our qualification for a research and development grant pursuant to the Federal Qualifying Therapeutic Discovery Project (“QTDP”) to which we had applied in July 2010. The grant totaling $943,900 was awarded based on certain research and development costs incurred to date. We expect to receive payment for the grant in November 2010 and we expect to record it as other income in the fourth quarter of 2010.

Future Funding Requirements

Our future funding requirements will depend upon many factors, including:

·                  the extent of our success in monetizing the value of our current product candidate portfolio;

·                  the size, complexity and cost of our remaining business operations;

·                  the terms and timing of any collaborative, licensing and other arrangements that we may establish;

·                  the cost, timing and outcomes of regulatory approvals;

·                  the timing, receipt and amount of sales or royalties generated, if any, from our product candidates; and

·                  the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights.

Our ability to continue operations will be dependent on our ability to obtain substantial additional funding and such funding may not be available to us on acceptable terms, or at all. We may seek to raise necessary additional funds through public or private equity, debt financings, collaborative arrangements with corporate partners or other sources. If we are unable to raise additional funds when needed, we may not be able to continue our current operations and we may not have sufficient resources to fully explore the strategic options available to us. If we raise additional funds through the issuance of debt securities, these securities could have rights that are senior to the holders of our common stock and could contain covenants that restrict our operations. If we raise additional funds by issuing equity securities, including sales under our Sales Agreement with MLV and Wm Smith, dilution to our existing stockholders may result. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights superior to our existing stockholders. To the extent that we raise additional capital through licensing or other arrangements, we may be required to relinquish, on terms that are not favorable to us, rights to some of our technologies or product candidates that we would otherwise seek to develop or commercialize ourselves for a higher profit margin. The terms of future financings may restrict our ability to raise

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additional capital, which could delay or prevent the further development of our product candidates or our ability to fully explore our strategic options. Our failure to raise capital when needed may harm our business and operating results.

Recent Accounting Pronouncements

See Note 1 of the Notes to our Condensed Consolidated Financial Statements included elsewhere in this report for recent accounting pronouncements that could have an effect on us.

Off-Balance Sheet Arrangements

Since inception, except for standard operating leases and employment agreements, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There were no material changes to our market risk from those disclosed in our annual report on Form 10-K filed with the Securities and Exchange Commission on March 30, 2010.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of September 30, 2010, an evaluation was performed by management, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15-d and 15(e) under the Securities Exchange Act of 1934, as amended). Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations described below, our disclosure controls and procedures were effective as of September 30, 2010.

Limitations on the Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

Changes in Internal Control over Financial Reporting

No change was made in our internal control over financial reporting during the quarter ended September 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

From time to time we are involved in legal proceedings arising in the ordinary course of our business. We believe there is no litigation pending that could have, individually or in the aggregate, a material adverse effect on our results of operations or financial condition.

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ITEM 1A. RISK FACTORS

We have identified the following risks and uncertainties that may have a material adverse effect on our business, financial condition or results of operations. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also significantly impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and our investors may lose all or part of their investment. We have marked with an asterisk (*) those risks described below that reflect substantive changes from the risks described in our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the Securities and Exchange Commission on March 30, 2010. In assessing these risks, you should also refer to the other information contained in this quarterly report on Form 10-Q, including our financial statements and related notes.

Risks Related to Our Business

We will need substantial additional funding in the near term and may be unable to raise capital when needed, which would force us to limit or cease our operations and related product development programs.*

As of September 30, 2010, we had $3.0 million in cash, cash equivalents and marketable securities on hand, which is only sufficient to fund our current operations into the fourth quarter of 2010. As of September 30, 2010, we had current payables and accrued liabilities of $0.9 million, current notes and related interest payable of $6.9 million and outstanding non-current liabilities of $5.9 million. Our ability to continue operations as a going concern, to evaluate strategic alternatives and potentially resume development activities with respect to our product candidates is dependent upon our ability to obtain substantial additional capital in the near term. Our operations have consumed substantial amounts of cash since inception, and we expect to continue to incur net losses for the foreseeable future as we explore strategic options in an effort to optimize the value of our assets. While we are currently exploring strategic options available to us, including collaboration arrangements to continue the development and potential commercialization of one or more of our lead product candidates or the sale of any or all of our assets, we cannot forecast with any degree of certainty whether a strategic transaction and/or collaboration arrangement will be achieved on optimal terms or at all. However, should such collaboration arrangements fail to provide sufficient revenue to fund our operations adequately, we will need to raise additional capital to fund our operations and complete development of our product candidates. Our future funding requirements will depend on many factors, including:

·                  the terms and timing of any collaborative, licensing and other arrangements that we may establish, if any;

·                  the extent of our success in monetizing the value of our current product candidate portfolio;

·                  the cost, timing and outcomes of regulatory approvals;

·                  the size, complexity and cost of our remaining business operations;

·                  the timing, receipt and amount of sales or royalties, if any, from our potential products; and

·                  the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights.

Until we can generate a sufficient amount of collaboration or product revenue to finance our cash requirements, which we may never do, we expect to finance future cash needs primarily through public or private equity offerings, debt arrangements, including our at market issuance sales agreement with McNicoll, Lewis & Vlak LLC and Wm Smith & Co, and/or a possible sale, collaboration or license of development and/or commercialization rights to one or more of our product candidates. We do not know whether additional funding will be available to us on acceptable terms, or at all.

If we raise additional funds by issuing equity securities, including under our Sales Agreement with MLV and Wm Smith, our stockholders will experience dilution, which may be significant. Any debt financing or additional equity that we raise may contain terms that are not favorable to our stockholders or us. If we raise additional funds through collaboration, sales or licensing arrangements with third parties, we may be required to relinquish some rights to our technologies or our product candidates, grant licenses on terms that are not favorable to us or enter into a collaboration arrangement for a product candidate at an earlier stage of development or for a lesser amount than we might otherwise choose.

Our existing capital resources are not sufficient to enable us to continue the development of any of our product candidates. Additional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available on a timely basis, we may:

·                  terminate or delay future clinical trials for one or more of our product candidates; or

·                  further reduce our headcount and capital or operating expenditures.

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As we explore strategic options, no significant development activity is currently underway on any of our product candidates, and therefore we are not able to advance their development.

We have incurred significant operating losses since inception and expect to continue to incur substantial and increasing losses for the foreseeable future. We may never achieve or sustain profitability.*

We have a limited operating history and have incurred significant losses since our inception. As of September 30, 2010, we had an accumulated deficit of approximately $199.6 million. We expect to continue to incur net losses for the foreseeable future as we explore strategic options available to us. These losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital.

Because of the numerous risks and uncertainties associated with drug development, we are unable to predict with certainty the costs we will incur in support of our product candidates as we pursue strategic options, including potential collaboration arrangements. Currently, we have no products approved for commercial sale, and, to date, we have not generated any product revenue. We have financed our operations primarily through the sale of equity securities, capital lease and equipment financings, debt financings and a single corporate partnership with Procter & Gamble Pharmaceuticals, Inc., or P&G, that was terminated in July 2008. We have devoted substantially all of our efforts to research and development, including clinical trials. If we are unable to develop and commercialize any of our product candidates, if development is delayed, if sales revenue from any product candidate approved by the U.S. Food and Drug Administration, or the FDA, is insufficient or if we fail to enter into partnering arrangements for our product candidates on terms favorable to us, we may never become profitable. Even if we do become profitable, we may not be able to sustain or increase our profitability on a quarterly or annual basis.

Our loan agreements impose restrictions on us that may adversely affect our ability to operate our business.*

Certain of our loan agreements with our lenders, including our debt arrangements with Lighthouse, Oxford and the Bridge Investors, contain covenants that restrict or limit, among other things, our ability to create liens supporting indebtedness, sell assets, make certain distributions, and incur additional debt. In addition, our debt agreements contain, and those we enter into in the future may contain, restrictive covenants and other limitations with which we will need to comply. Our ability to comply with these covenants may be affected by many events beyond our control, and we cannot assure you that our future operating results will be sufficient to comply with the covenants or, in the event of a default under any of our debt agreements, to remedy that default.

Our failure to comply with the covenants in our loan agreements and other related transactional documents could result in events of default. Upon the occurrence of such an event of default, the lenders could elect to declare all amounts outstanding under a particular facility to be immediately due and payable and terminate all commitments, if any, to extend further credit. An event of default or an acceleration under one loan agreement could cause a cross-default or cross-acceleration of another loan agreement. Such cross- default or cross-acceleration could have a wider impact on our liquidity than might otherwise arise from a default or acceleration of a single loan facility. If an event of default occurs, or if other loan agreements cross-default, and the lenders under the affected loan agreements accelerate the maturity of any loans or other debt outstanding to us, we may not have sufficient liquidity to repay amounts outstanding under such loan agreements.

Our ability to repay, extend or refinance our existing debt obligations and to obtain future credit will depend primarily on our operating performance and ability to raise additional capital to continue our operations, which will be affected by general economic, financial, regulatory, business and other factors, many of which are beyond our control. Our ability to refinance existing debt obligations will also depend upon the current conditions in the credit markets and the availability of credit generally. If we are unable to meet our debt service obligations or are unable to obtain future credit on acceptable terms, if at all, we could be forced to restructure or refinance our indebtedness, seek additional equity capital or sell or liquidate our assets. In such an event, we may be unable to obtain financing or sell our assets on acceptable terms, or at all.

Unfavorable economic and market conditions may negatively impact our business, results of operations, and financial condition, and may make it difficult or costly to raise additional capital.*

The deterioration in worldwide economic conditions and the disruption to the credit and financial markets in the United States and worldwide have led to, among other things, extreme volatility in security prices, declining valuations of certain investments, and reduced liquidity and credit availability. As a company having no commercial operations, a protracted downturn may hurt our business in a number of ways, including the impact on our ability to access capital and credit markets to meet our financing objectives to allow us to continue our operations, and on our ability to manage our cash balance, current portfolio of cash equivalents or investments in marketable securities. While we are unable to predict the likely duration and severity of these unfavorable economic conditions in the United States and other countries, any of the circumstances mentioned above could adversely affect our business, financial condition, operating results, cash flow or cash position, and our ability to raise capital.

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Our success depends substantially on our most advanced product candidates, which are still under development. If we are unable to bring any or all of these product candidates to market, or experience significant delays in doing so, our ability to generate product revenue and our likelihood of success will be harmed.