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DMK PHARMACEUTICALS Corp - Quarter Report: 2005 September (Form 10-Q)

Unassociated Document



 
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
 
FORM 10-Q
 
ý
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the quarterly period ended September 30, 2005
 
 
 
OR
 
 
 
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the transition period from                                               to
 
Commission File Number: 0-26372
 
CELLEGY PHARMACEUTICALS, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
82-0429727
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 
1800 Byberry Rd, Building 13, Huntingdon Valley, PA 19006
(Address of principal executive offices, including zip code)
 
(215) 914-0900
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  ý    No   o
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12-b under the Securities Exchange Act of 1934). Yes  o  No   ý
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No ý
 
The number of shares outstanding of the registrant’s common stock at November 4, 2005 was 29,831,625.
 



 
CELLEGY PHARMACEUTICALS, INC.
 
INDEX TO FORM 10-Q
 
 
 
Page
PART I
FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements (Unaudited)
 
 
 
 
 
Condensed Consolidated Balance Sheets
3
 
 
 
 
Condensed Consolidated Statements of Operations
4
 
 
 
 
Condensed Consolidated Statements of Cash Flows
5
 
 
 
 
Notes to Condensed Consolidated Financial Statements
7
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16
 
 
 
Item 3.
Quantitative and Qualitative Disclosure of Market Risk
30
 
 
 
Item 4.
Controls and Procedures
30
 
 
 
PART II
OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings
31
 
 
 
Item 2. Unregistered sales of equity securities and use of proceeds 
31
     
Item 3.
Defaults Upon Senior Securities
31
 
 
 
Item 4.
Submission of Matters to a Vote of Security Holders
31
 
 
 
Item 5.
Other Information
31
 
 
 
Item 6.
Exhibits
31
 
 
 
Signatures
 
32
 
 
 
Certifications
 
33
 
 
 
 
2


 PART I   -   FINANCIAL INFORMATION
 
Item 1. Financial Statements
Cellegy Pharmaceuticals, Inc.
(a development stage company)
Condensed Consolidated Balance Sheets
(Amounts in thousands)
(Unaudited)
 
 
 
September 30,
2005
 
December 31,
2004
 
 
 
 
 
 
 
Assets
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and cash equivalents
 
$
2,305
 
$
8,705
 
Accounts receivable and other receivables
 
1,090
 
886
 
Prepaid expenses and other current assets
 
560
 
282
 
Total current assets
 
3,955
 
9,873
 
Restricted cash
 
 
227
 
Property and equipment, net
 
992
 
1,953
 
Goodwill
 
1,022
 
1,031
 
Intangible assets
 
490
 
779
 
Total assets
 
$
6,459
 
$
13,863
 
 
 
 
 
 
 
Liabilities and Stockholders’ Deficit
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Accounts payable
 
$
1,782
 
$
1,692
 
Accrued expenses and other current liabilities
 
1,972
 
2,725
 
Current portion of deferred revenue
 
37
 
1,196
 
Current portion of note payable
 
4,887
 
 
Total current liabilities
 
8,678
 
5,613
 
Other long-term liability
 
25
 
527
 
Notes payable
 
243
 
190
 
Derivative instruments
 
640
 
411
 
Deferred revenue
 
1,398
 
13,865
 
Total liabilities
 
10,984
 
20,606
 
 
 
 
 
 
 
Commitments and contingencies (Note 13)
 
 
 
 
 
 
 
 
 
 
 
Stockholders’ deficit:
 
 
 
 
 
Common stock
 
2
 
2
 
Additional paid-in capital
 
125,529
 
120,254
 
Accumulated other comprehensive income
 
291
 
304
 
Deficit accumulated during the development stage
 
(130,347
) 
(127,303
)
Total stockholders’ deficit
 
(4,525
) 
(6,743
)
Total liabilities and stockholders’ deficit
 
$
6,459
 
$
13,863
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

 
3


 Cellegy Pharmaceuticals, Inc
(a development stage company)
Condensed Consolidated Statements of Operations
(Amounts in thousands, except per share data)
(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
Period from
 
 
 
 
 
 
 
 
 
 
 
June 26, 1989
 
 
 
 
 
 
 
 
 
 
 
(inception) to
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
2005
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Licensing and contract revenue from affiliates
 
$
 
$
 
$
 
$
 
$
1,145
 
Licensing, milestone and development funding
 
229
 
222
 
6,988
 
638
 
10,216
 
Grants
 
1,252
 
 
3,420
 
 
4,995
 
Product sales
 
471
 
261
 
899
 
613
 
7,514
 
Total revenues
 
1,952
 
483
 
11,307
 
1,251
 
23,871
 
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
 
Cost of product sales
 
237
 
55
 
320
 
132
 
1,975
 
Research and development
 
1,816
 
2,529
 
6,877
 
6,876
 
88,650
 
Selling, general and administrative
 
2,575
 
1,093
 
7,050
 
3,520
 
45,410
 
Acquired in-process technology
 
 
 
 
 
22,332
 
Total costs and expenses
 
4,628
 
3,677
 
14,247
 
10,527
 
158,367
 
Operating loss
 
(2,676
)
(3,194
)
(2,940
) 
(9,276
)
(134,497
)
Interest and other income
 
21
 
69
 
131
 
208
 
6,976
 
Interest and other expense
 
(217
)
 
(478
)
 
(2,011
)
Derivative revaluation
 
79
 
(18
)
242
 
159
 
633
 
Net income (loss)
 
(2,793
)
(3,143
)
(3,044
) 
(8,909
)
(128,899
)
Non-cash preferred dividends
 
 
 
 
 
1,448
 
Net income (loss) applicable to common stockholders
 
$
(2,793
)
$
(3,143
)
$
(3,044
) 
$
(8,909
)
$
(130,347
)
Net income (loss) per common share:
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted
 
$
(0.09
)
$
(0.14
)
$
(0.11
)
$
(0.43
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average number of common shares used in per share calculations:
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted
 
29,832
 
22,396
 
28,048
 
20,874
 
 
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
4


 
Cellegy Pharmaceuticals, Inc.
(a development stage company)
Condensed Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
 
 
 
 
 
 
 
Period from
 
 
 
 
 
 
 
June 26, 1989 (inception) to
 
 
 
Nine Months Ended September 30,
 
September 30,
 
 
 
2005
 
2004
 
2005
 
 
 
 
 
 
 
 
 
Operating activities
 
 
 
 
 
 
 
Net loss
 
$
(3,044
)
$
(8,909
)
$
(128,900
)
Other operating activities
 
(9,148
)
491
 
37,224
 
Net cash used in operating activities
 
(12,192
)
(8,418
)
(91, 676
)
 
 
 
 
 
 
 
 
Investing activities
 
 
 
 
 
 
 
Purchases of property and equipment
 
(170
)
(12
)
(5,574
)
Purchases of investments
 
 
 
(98,910
)
Sales and maturities of investments
 
 
3,687
 
98,814
 
Proceeds from sale of property and equipment
 
 
 
238
 
Costs related to Biosyn acquisition
     
(92
) 
 
Costs used in escrow for Biosyn acquisition
 
 
(275
)
 
Acquisitions, net of cash acquired
 
 
 
(816
)
Net cash provided by (used in) investing activities
 
(170
)
3,308
 
(6,248
)
 
 
 
 
 
 
 
 
Financing activities
 
 
 
 
 
 
 
Proceeds from notes payable
 
 
 
8,047
 
Repayment of notes payable
 
 
 
(6,611
)
Proceeds from restricted cash
 
227
 
 
614
 
Other assets
 
 
 
(614
)
Net proceeds from issuance of common stock and warrants
 
5,747
 
10,873
 
86,842
 
Issuance of convertible preferred stock, net of issuance costs
 
 
 
11,758
 
Deferred financing cost
 
 
 
(80
)
Net cash provided by financing activities
 
5,974
 
10,873
 
99,956
 
Effect of exchange rate changes on cash
 
(12
)
(54
)
273
 
Net (decrease) increase in cash and cash equivalents
 
(6,400
)
5,709
 
2,305
 
Cash and cash equivalents, beginning of period
 
8,705
 
7,650
 
 
Cash and cash equivalents, end of period
 
$
2,305
 
$
13,359
 
$
2,305
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
5


 
 
 
 
 
 
 
Period from
 
 
 
 
 
 
 
June 26, 1989 (inception) to
 
 
 
Nine Months Ended September 30,
 
September 30,
 
 
 
2005
 
2004
 
2005
 
 
 
 
 
 
 
 
 
Supplemental cash flow information:
 
 
 
 
 
 
 
Interest paid
 
$
 
$
 
$
640
 
Supplemental disclosure of non-cash transactions
 
 
 
 
 
 
 
Issuance of common stock in connection with acquired-in-process technology
 
 
 
7,350
 
Conversion of preferred stock to common stock
 
 
 
14,715
 
Issuance of common stock for notes payable
 
 
 
277
 
Issuance of warrants in connection with equity financings
 
471
 
2,082
 
2,553
 
Issuance of warrants in connection with notes payable financing
 
 
 
487
 
Issuance of convertible preferred stock for notes payable
 
 
 
1,268
 
Issuance of common stock for milestone payments
 
 
 
1,500
 
Fair value of assets acquired net of liabilities assumed for Biosyn acquisition
 
 
 
11,856
 
Interest expense amortization for long-term obligations
 
607
 
 
607
 
                     
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 

6


 
Cellegy Pharmaceuticals, Inc.
(a development stage company)
 
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1.  Basis of Presentation
 
The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the Securities and Exchange Commission.  Accordingly, certain information and footnote disclosures normally included in annual financial statements have been condensed or omitted. In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements reflect all adjustments (including normal recurring adjustments and the elimination of intercompany accounts) considered necessary for a fair statement of all periods presented. The results of Cellegy’s operations for any interim periods are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in Cellegy’s Annual Report on Form 10-K for the year ended December 31, 2004.
 
Liquidity and Capital Resources
 
The accompanying unaudited interim financial statements have been prepared assuming the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities and commitments in the normal course of business.  At September 30, 2005, the Company had a deficit accumulated during the development stage of $130.4 million and recurring, negative cash flows from operations. The Company expects negative cash flow from operations to continue for the foreseeable future, with the need to continue or expand development programs and to commercialize products once regulatory approvals have been obtained.  These factors raise substantial doubt about the Company’s ability to continue as a going concern.

On May 12, 2005 Cellegy raised $5.7 million in net proceeds in a private placement of its common stock and warrants to a combination of existing and new individual and institutional investors  (See Note 11). In connection with its amendment of its agreement with ProStrakan Group plc (ProStrakan”) in November of 2005, Cellegy received a payment of $2 million and may receive future milestone payments of up to $750,000 upon approval of the product in certain major European countries (See note 18). Unless it is able to secure additional funding as discussed below, the Company will most likely not be able to support its research programs or its products commercialization activities for most of 2006.

Management is presently considering financing through one or more options to fund its operations through 2006.  These options include, but are not limited to: seeking partnerships with other pharmaceutical companies to co-develop and fund research and development efforts, pursue additional out-licensing arrangements with third parties, and re-licensing and monetizing near term future milestone and royalty payments expected from existing licensees and seeking equity or debt financing.  In addition, the Company will continue to implement further cost reduction programs. There is no assurance that any of the above options will be implemented on a timely basis.  Alternatively, Cellegy may be required to accept less than favorable commercial terms in any such future arrangements.
 
If adequate funds are not available, the Company could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products that the Company would otherwise seek to commercialize internally, or to reduce resources devoted to product development. Accordingly, the failure of the Company to obtain sufficient funds could have a material adverse effect on the Company’s business, results of operations and financial condition. The accompanying unaudited interim financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
The Company has classified the notes due to PDI as current for financial reporting purposes (See Note 12).
 
Note 2.   -   Biosyn Acquisition
 
On October 22, 2004, Cellegy completed its acquisition of Biosyn, Inc., developer of a contraceptive gel product for the prevention of transmission of HIV/AIDS in women.  Under the terms of the acquisition, 12,000 preferred shares and 5,031,267 shares of Biosyn common stock outstanding at the closing of the acquisition were exchanged for approximately 2,462,000 shares of Cellegy’s common stock. In addition, outstanding Biosyn stock options and warrants were assumed by Cellegy and converted into options and warrants to purchase 318,504 shares of Cellegy common stock. The assumed options to acquire Cellegy common stock are fully vested and exercisable.
 

7


The Company has prepared unaudited pro forma financial information showing revenues and net loss for the combined entity for the three and nine months ended September 30, 2004, as if the acquisition had occurred as of January 1, 2004. The following unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations of the Company that would have been reported had the acquisition been completed as of the date presented and should not be taken as representative of the future consolidated results of operations or financial condition of the Company (in thousands, except per share data).
 
 
 
September 30, 2004
 
 
 
Three Months
 
Nine Months
 
Revenues
 
$
1,716
 
$
4,662
 
Net loss
 
$
(2,693
)
$
(9,859
)
Basic and diluted net loss per common share
 
$
(0.12
)
$
(0.42
)
 
Note 3.   -   Comprehensive Income (Loss)
 
Comprehensive income (loss) generally represents all changes in stockholders’ deficit except those resulting from investments or contributions by stockholders. The Company’s foreign currency translation (“FCT”) adjustments represent the only components of comprehensive income that are excluded from the Company’s net income (loss).  Total comprehensive income (loss) during the three and nine months ended September 30, 2005 and 2004 consisted of (in thousands):
 
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
(2,793
)
$
(3,143
)
$
(3,044)
 
$
(8,909
) 
Change in FCT adjustments
 
5
 
62
 
(12
) 
(54
) 
Comprehensive income (loss)
 
$
(2,788
)
$
(3,081
) 
$
(3,056
) 
$
(8,963
) 
 
Note 4.   -   Basic and Diluted Net Income (Loss) per Common Share
 
Basic net income (loss) per common share for the three and nine months ended September 30, 2005 attributable to common stockholders is calculated by dividing the net income (loss) by the weighted-average number of shares of common stock outstanding during the three-month and nine-month periods. Diluted net income per common share incorporates the incremental shares issued upon the assumed exercise of stock options and warrants, when dilutive. Net loss per share attributable to common stockholders should give effect to the dilutive effect of potential issuances of common stock consisting of stock options, warrants, and convertible debt. However, all dilutive securities as well as stock options, warrants and potential shares from convertible debt have been excluded from the diluted net loss per share computations during the three and nine months ended September 30, 2005 and 2004 as they have an antidilutive effect due to our net loss.
 
8

 
The following outstanding stock options and warrants during the three and nine months ended September 30, 2005 and 2004 were excluded in the calculation of diluted net income (loss) per common share as they had an antidilutive effect (in thousands):
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
Options
 
(388
)
(24
) 
4,106
 
4,171
 
Warrants
 
 
604
 
2,375
 
864
 
PDI convertible note
 
 
 
2,121
 
 
Total number of shares excluded
 
(388
) 
580
 
8,602
 
5,035
 
 
Note 5.   -   Stock-Based Compensation
 
The Company accounts for its stock option grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations. The Company has elected to follow the disclosure-only alternative prescribed by the Financial Accounting Standards Board Statement of Financial Accounting Standard No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure”. Under APB 25, compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s common stock and the option’s exercise price.
 
Had compensation cost for the Company’s stock-based compensation plans been determined in a manner consistent with the fair value approach described in SFAS No. 123, the Company’s pro forma net loss and net loss per share as reported would have been increased to the pro forma amounts indicated below (in thousands, except per share amounts):
 
9


 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
Net income (loss) as reported
 
$
(2,793
)
$
(3,143
)
$
(3,044
)
$
(8,909
)
Add: Stock-based employee compensation costs included in the reported net income (loss)
 
 
 
 
70
 
Deduct: Stock-based employee compensation costs determined under the fair value method
 
(35
) 
(186
) 
(301
) 
(351
) 
Net income (loss), pro forma
 
$
(2,828
)   
(3,329
)   
(3,345
)   
(9,551
) 
 
 
 
 
 
 
 
 
 
 
Basic and diluted net income (loss) per share:
 
 
 
 
 
 
 
 
 
As reported
 
$
(0.09
) 
$
(0.14
) 
$
(0.11
) 
$
(0.43
) 
Pro forma
 
$
(0.09
) 
$
(0.15
) 
$
(0.12
) 
$
(0.46
) 
 
The Company values its options on the date of grant using the Black-Scholes valuation model with the following assumptions:
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
Risk-free interest rate
 
4.1
%
3.7
%
4.1
%
3.7
%
Dividend yield
 
0
%
0
%
0
%
0
%
Volatility
 
0.76
 
0.86
 
0.76
 
0.86
 
Expected life of options in years
 
3.2
 
4.2
 
3.2
 
4.2
 
 
The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Under EITF Issue No. 96-18, the fair value of the equity instrument is calculated using the Black-Scholes valuation model at each reporting period with charges amortized to the results of operations over the instrument’s vesting period.
 
Note 6.   -   Segment Reporting
 
The Company has two business segments: pharmaceuticals and skin care.  Pharmaceuticals include primarily research and clinical development expenses for potential prescription products to be marketed directly by Cellegy or through corporate partners.
 
All revenues during the three and nine months ended September 30, 2005 of $1,952,000 and $11,307,000, respectively, were derived from the Company’s pharmaceutical segment. Current pharmaceutical revenues consist primarily of research and development grant revenues, Rectogesic® product sales in Australia, New Zealand, Singapore, United Kingdom and South Korea, and license revenues for Rectogesic and Tostrex® products and Fortigel.
 
The Company did not record any revenues for its skin care product during the nine months ended September 30, 2005.  The product is normally sold to one customer, Gryphon Development, Inc., which sells it exclusively in the United States through a major specialty retailer.
 
Cellegy allocates its revenues and operating expenses to each business segment. Management regularly assesses segment operating performance and makes decisions on how resources are allocated based upon segment performance, with the segment measurement of profitability being net income. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
 
The Company’s segments are business units that will, in some cases, distribute products to different types of customers through different marketing programs. The potential future sales of skin care products require a significantly different marketing effort than sales of pharmaceutical products to physicians and other traditional pharmaceutical distribution channels. Pharmaceutical products require more extensive clinical testing and ultimately regulatory approval by the FDA and other worldwide health registration agencies, requiring a more extensive level of development, manufacturing and compliance than a skin care product.
 

10


The following table contains information regarding revenues and loss from operating each business segment (in thousands):
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
Revenues:
 
 
 
 
 
 
 
 
 
Pharmaceuticals
 
$
1,952
 
$
394
 
$
11,307
 
$
1,070
 
Skin care
 
 
89
 
 
181
 
 
 
$
1,952
 
$
483
 
$
11,307
 
$
1,251
 
Operating income (loss):
 
 
 
 
 
 
 
 
 
Pharmaceuticals
 
$
(2,676
)
$
(3,252
)
$
(2,940
)
$
(9,394
)
Skin care
 
 
58
 
 
118
 
 
 
$
(2,676
)
$
(3,194
)
$
(2,940
)
$
(9,276
)
 
All of the Company’s assets are related to the pharmaceutical segment and most of these assets are located in the United States.
 
Note 7.  -  Recent Accounting Pronouncements
 
In December 2004, the FASB issued SFAS No. 123R,  “Share-Based Payment”, which replaces SFAS No. 123. SFAS No. 123R requires public companies to recognize an expense for share-based payment arrangements including stock options and employee stock purchase plans. The statement eliminates a company’s ability to account for share-based compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair value based method. SFAS No. 123R requires an entity to measure the cost of employee services received in exchanged for an award of equity instruments based on the fair value of the award on the date of the grant, and to recognize the cost over the period during which the employee is to provide service in exchange for the award. SFAS No. 123R is effective for public companies with a fiscal year that begins after June 15, 2005. The cumulative effect of this pronouncement if adopted by the Company, applied on a modified prospective basis, would be measured and recognized starting the first quarter of 2006. Upon adoption of SFAS No. 123R, companies are allowed to select one of three alternative transition methods. Management is currently evaluating the transition methods, as well as valuation methodologies and assumptions for employee stock options in light of SFAS No. 123R. Current estimates of option values using the Black-Scholes method (as shown under “Stock Based Compensation”) may not be indicative of results from valuation methodologies ultimately implemented by the Company upon adoption of SFAS No. 123R.
 
In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3”. The statement requires retrospective application of changes in accounting principle to prior periods’ financial statements, unless it is impracticable to determine either the period specific effects or the cumulative effect of the change. When it is impracticable to determine the period specific effects of an accounting change on one or more individual prior periods presented, this statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable, and that a corresponding adjustment be made to the opening balance of the retained earnings for that period rather than being reported in the income statement. The statement also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. This pronouncement is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company does not believe adoption of SFAS 154 will have a material effect on its consolidated financial position, results of operations or cash flows.
 
Note 8. - Accounts Receivable and Other Receivables
 
At September 30, 2005 and December 31, 2004 this account includes the following (in thousands):
     
 
 
September 30,
2005
 
December 31,
2004
 
 
 
 
 
Accounts Receivable - Trade
 
$
411
 
$
26
Grants Receivable
 
379
 
834
Accounts Receivable - Other
 
300
 
26
Total
 
$
1,090
 
$
886

 Note 9 . - Prepaid Expenses and Other Current Assets

At September 30, 2005 and December 31, 2004 this account includes the following (in thousands):
 
 
 
September 30,
2005
 
December 31,
2004
 
 
 
 
 
Prepaid Insurance
 
$
243
 
$
186
Prepaid Rent
 
86
 
0
Deferred Compensation
 
85
 
0
Inventory
 
84
 
52
Other
 
62
 
44
Total
 
$
560
 
$
282

Deferred compensation of $85,000 represents the unamortized balance of $422,000 in retention bonuses offered and accepted by employees in March 2005. The retention bonuses would be paid if the employee maintains his or her employment with the Company through the retention period indicated in the individual’s offer letter. The retention bonus is in lieu of all other severance or similar payments that the Company may be obligated to make under any other existing agreement, arrangement or understanding, but will be in addition to any accrued salary and vacation earned through the date of termination. The retention periods terminate on dates between October 15, 2005 and December 31, 2005.

11


 
Note 10 .  -  Accrued Expenses and Other Current Liabilities
 
The Company accrues for goods and services received but for which billings have not been received. Accruals for the following expenses and other current liabilities were made for the following expenses (in thousands):
 
 
 
September 30,
2005
 
December 31,
2004
 
 
 
 
 
 
 
Clinical expenses
 
$
63
 
$
613
 
Legal fees
 
 
454
 
Retention and severance
 
700
 
508
 
Consulting fees
 
97
 
339
 
Other
 
1,112
 
811
 
Total
 
$
1,972
 
$
2,725
 
 
Note 11.  -  Deferred Revenue
 
The Company records upfront payments received from licensees as deferred revenue and amortizes them to income over the life of the licensing agreement or the life of the product being licensed, whichever is longer.  At September 30, 2005 total current and long-term deferred revenue of $1,486,000 substantially includes the remaining unearned portion of the $1.5 million upfront licensing fees received from ProStrakan for the right to store, promote, sell and/or distribute the Company’s Tostrex and Rectogesic products.
 
Note 12. -  Notes Payable
 
Notes payable at September 30, 2005 include two non-interest bearing notes issued in April 2005 by Cellegy to PDI pursuant to a lawsuit settlement signed by both parties in April 2005 (see Note 13), and note issued by Biosyn to Ben Franklin Technology Center of Southeastern Pennsylvania (Ben Franklin) in October 1992 for funds provided by Ben Franklin for the development of a compound to prevent transmission of AIDS.  The notes have been recorded at their total net present value of $5.07 million.
 
The terms of the notes issued to PDI are as follows:

The $3.0 million secured promissory note has an outstanding balance of $2.9 million and was recorded at a net present value of $2.4 million. It is payable in October 2006. There is no stated interest rate and no periodic payments are required.  Cellegy is required to make current payments on the note to the extent of (i) 50% of licensing fees, royalties or milestone payments received by Cellegy with respect to any of Cellegy’s agreements or arrangements with respect to the Tostrex® or Rectogesic® products in territories outside of North America, (ii) 50% of licensing fees, royalties or milestone payments received by Cellegy with respect to any of Cellegy’s agreements or arrangements with respect to Fortigel in North American markets. These payments are required to be made to PDI within two business days after Cellegy receives the payments. Cellegy’s obligations under the note are secured by a security interest in favor of PDI, which is reflected in a security agreement between Cellegy and PDI, in Cellegy’s interests in the payments described above and any proceeds therefrom . In addition, Cellegy is required to make payments on the $3.0 million note with respect to 10% of proceeds received by Cellegy in excess of $5.0 million from financing transactions.
 
Amounts owed under the note may be accelerated upon an event of default, which is defined to include, but is not limited to, any of the following: Cellegy’s failure to pay any amounts owed under the note when due; certain kinds of bankruptcy filings or certain related actions or proceedings; any breach of any of Cellegy’s covenants, conditions or agreements in the note or security agreement following notice from PDI that remains uncured for 30 days; the security interest no longer being a valid, perfected, first priority security interest; and a default in indebtedness of Cellegy with an aggregate principal amount in excess of $2.0 million that results in the maturity of such indebtedness being accelerated before its stated maturity. The net present value of the collateralized $3.0 million note will be recalculated based on its remaining principal whenever a payment is made by Cellegy. Cellegy made a $100,000 payment to PDI in October 2005 shortly after the due date specified in the secured note and has paid interest to PDI on that amount.
 
The $3.5 million non-negotiable senior convertible debenture was recorded at a net present value of $2.3 million. It has a maturity date of April 11, 2008, three years from the PDI settlement date of April 11, 2005. There is no stated interest rate and no periodic payments are required. Cellegy may redeem the note at anytime before the maturity date upon prior notice to PDI, at a redemption price equal to the principal amount. If Cellegy delivers such a redemption notice, PDI may convert the note into shares of Cellegy common stocks at a price of $1.65 per share. In addition, after the 18th month anniversary of the debenture, PDI may convert the note into Cellegy common stock at a price of $1.65 per share. If Cellegy does not redeem the note within the first 18 months, then Cellegy has agreed to file a registration statement relating to the possible resale of any shares issued to PDI after 18 months; approximately 2.1 million shares would be issuable upon such conversion. As long as amounts are owed under the note, Cellegy has agreed not to incur or become responsible for any indebtedness that ranks contractually senior or pari passu in right of payment to amounts outstanding under the note. Events of default under the senior note are generally similar to events of default under the secured note.
 
Cellegy has classified the notes as current for financial reporting purposes because of payments expected to be made within the next year and due to the other uncertainties noted above.
 
The company accretes interest and principal to the PDI notes using a rate of 15% using the effective interest rate method.
 
12


 
The Ben Franklin note has a face value of $778,000 and net present value of $183,000 at September 30, 2005.  The note has no scheduled repayment term.  Payment is based on 3% of Biosyn’s revenues excluding research and development grants.
 
At September 30, 2005, future minimum payments on the notes were payable as follows (in thousands):
 
         
2005
 
$
 
2006
 
2,900
 
2007
 
 
2008
 
3,500
 
2009 and thereafter
 
778
 
Total payments
 
7,178
 
Less: Amount representing discount
 
(2,108
)
Net minimum future payments
 
$
5,070
 
 
Note 13.  - Equity Financing
 
On May 12, 2005, Cellegy raised $6.0 million, or approximately $5.7 million after offering expenses, in a private placement of its common stock and warrants, to existing and new institutional and individual investors.  The transaction consisted of the sale of approximately 3,621,819 shares of common stock.  The Company also issued Class A Warrants to purchase approximately 714,362 shares of common stock at an exercise price of $2.25 per share.  The Class A warrants can be called by the Company if the Company’s common stock trades for 20 consecutive days over $5.00. The Company also issued Class B Warrants to purchase approximately 714,362 shares of common stock at an exercise price of $2.50 per share.  Class A and B Warrants can be called by the Company if the Company’s closing bid price of a share of Common Stock equals or exceeds $5.00 or $5.50, respectively, for any twenty (20) consecutive trading days commencing after the Registration Statement has been declared effective at a redemption price equal to $0.01 per share of common stock..  Three directors of Cellegy purchased a total of 50,000 shares in the offering at the closing market price of the common stock on the date of the transaction for $2.13 per share.  The directors did not receive any warrants. The purchase price for shares purchased by the non-director investors was $1.65 per share.  Pursuant to the transaction agreements, the Company has filed a registration statement on Form S-3 with the Securities and Exchange Commission, which was declared effective on July 8, 2005, covering the possible resale of the shares from time to time in the future.
 
Note 14.  - Derivative Instruments.


 The warrants are revalued at the end of each reporting period as long as they remain outstanding. The estimated fair value of all warrants recorded as derivative liability at September 30, 2005 and December 31, 2004 were as follows (in thousands):
 
 
 
 
September 30, 2005
 
December 31, 2004
 
 
 
 
 
 
 
Kingsbridge warrants issued January 2004
 
$
318
 
$
411
 
Warrants issued May 2005
 
322
 
 
Total liability
 
$
640
 
$
411
 
 
The changes in the estimated fair value of the warrants have been recorded as other income and expense in the income statement. For the three and nine months ended September 30, 2005, the Company recognized $79,000 and $242,000, respectively as other income from derivative revaluation.

The Company valued its warrants using the Black-Scholes valuation model with the following assumptions:
 
Kingbridge Warrants issued January 2004
Volatility
   
0.77
 
Contractual life
   
3.2 years
 
Risk free interest rate
   
4.13
%
Dividend yield
   
0
%
         

May 2005 Warrants
Volatility
   
0.81
 
Contractual life
   
5.0 years
 
Risk free interest rate
   
4.06
%
Dividend yield
   
0
%

13


Note 15.  - Commitments and Contingencies
 
Legal Proceedings
 
The December 2002 original exclusive license agreement between the Company and PDI Inc. (“PDI”) related to commercialization of Fortigel product in North American marekts. Under the terms of the agreement, PDI was responsible for marketing and sale of Fortigel if regulatory authorities approved the product.  Cellegy received a non-refundable payment of $15.0 million upon signing the agreement and was entitled to receive a milestone payment upon FDA approval and royalties following a successful product launch.  However, in July 2003, the FDA issued a Not Approvable letter for Cellegy’s New Drug Application relating to Fortigel product. In December 2003, following earlier notices from PDI and mediation proceedings, Cellegy and PDI both initiated legal proceedings against each other relating to the agreement.  PDI asserted several claims relating to the agreement, including the assertion that Cellegy breached several provisions of the agreement and failed to disclose relevant facts.  PDI claimed several kinds of alleged damages, including return of the initial $15.0 million license fee that PDI paid to Cellegy when the agreement was signed.  Cellegy’s action sought, among other things, a declaration that it had fully complied with the license agreement and that PDI’s claims were without merit. The trial had been scheduled to begin in May 2005 but has now been cancelled as a result of the settlement.
 
On April 11, 2005, Cellegy entered into a settlement agreement with PDI resolving the lawsuits that the companies had filed against each other.  Under the terms of the settlement agreement, the license agreement was terminated and all product rights have reverted to Cellegy.  Cellegy paid $2.0 million to PDI upon signing the settlement agreement.  Cellegy also issued a $3.0 million promissory note to PDI, due in October 2006, and a $3.5 million non-negotiable senior convertible debenture (See Note 12). The settlement of the Company’s lawsuit with PDI resulted in the recognition of the remaining $6.5 million in deferred revenue from PDI as license revenue in the second quarter.
 
Lease and Sublease Contracts Termination and Agreements
 
In March 2005, the Company entered into an agreement with VaxGen, Inc. (“VaxGen) to sublease a portion of VaxGen’s available space in Brisbane, California. The initial lease payment is one dollar per month through February 28, 2006, increasing to $17,253 per month starting March 1, 2006. The Company may terminate the lease at any time upon giving VaxGen 10 days advance written notice. As a result of this agreement, the Company recorded the fair value of the rent as a deferred rent asset of $198,000 on March 31, 2005, which is being amortized monthly to rent expense through February 2006. 
 
As a result of the move to its office location in Brisbane in March 2005, the Company wrote off $800,800 in net book value of all leasehold improvements at its former corporate headquarters facilities in South San Francisco, California. The Company also signed a sublease termination agreement in April  2005 with VaxGen at the previous location. The terms of the agreement included payment by VaxGen of $1,090,000 to Cellegy as a sublease termination fee less VaxGen’s rental deposit of $188,000 and Cellegy’s deposit of $10,000 for subleasing part of VaxGen’s vacant office space in Brisbane. The lease termination fee was recognized as a credit to selling, general and administrative expense during the second quarter ended June 30, 2005.
 
In April 2005, the Company officially signed a lease termination agreement with the landlord of its former corporate headquarters facilities. The Company, in September 2005, moved its headquarters to its Biosyn subsidiary’s facility in Huntingdon Valley, Pennsylvania. As a result of this termination, the Company’s commitment for future lease payments has been significantly reduced. Its remaining lease commitment relates to its Biosyn subsidiary’s offices. In July 2005 and in September of 2005 Biosyn’s subsidiary amended their existing lease agreement in Huntingdon Valley, Pennsylvania to include storage area and other space. Future minimum lease payments at September 30, 2005 are as follows (in thousands):
 
 
 
Lease
Commitments
 
2005
 
$
95
 
2006
 
187
 
2007
 
188
 
2008
 
160
 
Total
 
$
630
 
 
 
14


Note 16.  - Listing with Nasdaq Stock Market
 
On July 11, 2005, that the Company received a letter (the “Letter”) from The Nasdaq Stock Market indicating that for ten consecutive trading days prior to the date of the Letter, the market value of the common stock had been below $50 million as required for continued inclusion on the Nasdaq National Market by Marketplace Rule 4450(b)(1)(A), and that Cellegy had until August 8, 2005 to regain compliance.  The Letter indicated that if, at any time before August 8, 2005, the aggregate market value of Cellegy’s common stock remained at $50 million or more for a minimum of ten consecutive business days, the Nasdaq staff would determine if Cellegy is in compliance with Marketplace Rule 4450(b)(1)(A).
 
The Company received a second letter from The Nasdaq Stock Market dated August 9, 2005 indicating that for ten consecutive trading days prior to August 8, 2005, the market value of the common stock had failed to remain at or above $50 million as required for continued inclusion on the Nasdaq National Market by Marketplace Rule 4450(b)(1)(A).

On September 15, 2005, the Company announced that it had received a determination letter dated September 14, 2005 following a hearing by the Listing Qualifications Panel of the Nasdaq Stock Market indicating that the Company’s common stock will transfer from the Nasdaq National Market to the Nasdaq SmallCap Market, effective at the opening of business on September 16, 2005.  The transfer from the Nasdaq National Market is due to the Company not currently satisfying the $50 million market capitalization requirement of Nasdaq Marketplace Rule 4450(b)(1)(A).  The Company did not request a review of the Panel’s determination.
 
Note 17.  - Shareholder Meeting

An Annual Meeting of the Shareholders was held on September 28, 2005 in New York, N.Y. Agenda items included the election of five(5) directors, ratification of the selection of PricewaterhouseCoopers, LLP (“PwC”) as its principal independent public accounting firm to perform the audit of Cellegy’s financial statements for fiscal 2005, and adoption of the 2005 Equity Incentive Plan (the “2005 Plan”). 

Elected as Directors were Richard C. Williams, Tobi B. Klar, M.D., John Q. Adams, Sr., Robert B. Rothermel and Thomas M. Steinberg.
 
Note 18 . - Subsequent Events

On November 8, 2005 a press release was issued relative to the Company’s Savvy Ghana Phase 3 HIV prevention trial. It was announced that the Data Monitoring Committee (DMC) reviewing interim data from the trial recommended that continuing the trial would not allow the effect of Savvy (C31G vaginal gel) on HIV to be determined because of a lower than expected rate of HIV seroconversion in the trial. The estimated annual rate of HIV seroconversion in the Ghana study population was 3.7% at the time of trial initiation, but the observed annual rate was 1.2% eighteen months into the trial, approximately one third of the expected rate. This lower rate was possibly due, in part, to procedures designed to ensure ethical trial design, including counseling on HIV prevention and distribution of condoms.

Most importantly, the DMC concluded that Savvy appears to be safe and that there is no evidence of safety concerns, based on a review of the comparative numbers of HIV seroconversions in the Savvy and placebo groups, and other interim data.

As a result of the data review, Cellegy, Family Health International (FHI) and the United States Agency for International Development (USAID), which is funding the trial, collectively agreed that the trial in Ghana should be discontinued, and that Savvy should continued to be studied for its effect on preventing HIV transmission. Consideration is being given to expansion of the ongoing Savvy Phase 3 HIV prevention trial in Ghana and/or the opening of new trial sites in areas with higher HIV incidence as ways to determine the effectiveness of Savvy.

Additionally, data from the Ghana trial will be analyzed for effects on other endpoints including pregnancy. If the data warrant, the Ghana results will be submitted as a supplemental data package for the contraception New Drug Application. Since the analysis of the HIV data did not indicate any safety concerns, the Savvy Phase 3 contraception trial underway in the United States will continue as planned, with enrollment ongoing at sites throughout the U.S. Planning is underway for a second contraception study also at sites in the U.S. Additional studies are planned to examine effectiveness against other sexually transmitted diseases (STDs), including herpes, in the near future.
 
On November 9, 2005 the Company amended its December 2004 exclusive license and distribution agreement with ProStrakan for the commercialization of Rectogesic in Europe. Under the terms of the amended agreement, ProStrakan will assume responsibility for all manufacturing and other product support functions and will purchase the product directly from the manufacturer rather than purchasing from Cellegy under the terms of the original agreement. In return, Cellegy received a payment of $2 million and may receive future milestone payments of up to $750,000 upon approval of the product in certain major European countries.
 
 
15


Item 2.            Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q and our audited financial statements for the year ended December 31, 2004 included in our Annual Report on Form 10-K previously filed with the SEC. This discussion may contain forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but are based on current expectations, estimates and projections about our industry, our beliefs and our assumptions. Words such as “believes,”“anticipates,”“expects,”“intends” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. These forward-looking statements are not guarantees of future performance and concern matters that could subsequently differ materially from those described in the forward-looking statements. Actual events or results may also differ materially from those discussed in this Quarterly Report on Form 10-Q. These risks and uncertainties include those described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Factors That May Affect Future Operating Results” and elsewhere in this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may arise after the date of this Quarterly Report on Form 10-Q.
 
Cellegy Pharmaceuticals is a development stage specialty biopharmaceutical company engaged in the development and commercialization primarily of prescription drugs targeting women’s health care conditions, including HIV prevention and sexual dysfunction, as well as gastrointestinal conditions using proprietary topical delivery and nitric oxide donor technologies.

General
 
In January 2004, we entered into a Structured Secondary Offering (“SSO”) agreement with Kingsbridge Capital Limited. The agreement requires Kingsbridge to purchase up to 3.74 million shares of newly issued common stock at times and in amounts selected by us over a period of up to two years, subject to certain restrictions. We filed a registration statement with the Securities and Exchange Commission relating to shares assumable under the SSO, which was subsequently declared effective on June 1, 2004. The SSO does not prohibit us from conducting most kinds of additional debt or equity financings, including Private Investments in Public Equity, shelf offerings, secondary offerings or any other non-fixed or future priced securities. If our common stock falls below $1.25 per share, we will not be able to conduct draw downs on the SSO. We completed two draw downs in 2004, issuing a total of 246,399 common shares resulting in net proceeds of approximately $800,000.
 
In July 2004, Cellegy and ProStrakan, entered into an exclusive license agreement for the future commercialization of Tostrex (testosterone gel) product in Europe. Under the terms of the agreement, ProStrakan will be responsible for regulatory filings, sales, marketing and distribution of Tostrex product throughout the European Union and in certain nearby non-EU countries. Cellegy will be responsible for supplying finished product to ProStrakan through Cellegy’s contract manufacturer. Assuming successful commercial launch, Cellegy could receive up to $5.75 million in milestone payments, including the $500,000 non-refundable upfront payment received in July 2004, and a royalty on net sales of Tostrex product. In addition, ProStrakan has granted a right of first negotiation to Cellegy for its orally delivered testosterone glucoside product, which is currently in Phase 1 clinical development.
 
16

 
 
In October 2004, Cellegy acquired Biosyn, Inc., a privately held biopharmaceutical company. Under the terms of the agreement, Cellegy issued approximately 2,462,000 shares of Cellegy’s common stock for all of Biosyn’s issued and outstanding capital stock. In addition, outstanding Biosyn stock options and warrants were assumed by Cellegy and converted into options and warrants to purchase approximately 318,504 shares of Cellegy common stock. The purchase price does not include any provisions for contingent milestone payments of up to $15.0 million, which would be payable to Biosyn stockholders on the achievement of C31G product marketing approval in the United States and a portion of which would be payable earlier upon commercial launch in certain major overseas markets.
 
In December 2004, Cellegy and ProStrakan entered into an exclusive license agreement for the commercialization of Cellegesic product, branded Rectogesic product outside of the United States, in Europe. Under the terms of the agreement, Cellegy received a non-refundable upfront payment of $1.0 million and is entitled to receive up to an additional $4.6 million in milestone payments. ProStrakan will be responsible for additional regulatory filings, sales, marketing and distribution of Rectogesic product throughout Europe. In all, the agreement covers 38 European territories, including all EU member states. Cellegy will be responsible for supplying finished product to ProStrakan through its contract manufacturer. 
 
On April 11, 2005, Cellegy entered into a settlement agreement with PDI resolving the lawsuits that the companies had filed against each other.  Under the terms of the settlement agreement, the license agreement was terminated and all product rights have reverted to Cellegy.  Cellegy paid $2.0 million to PDI upon signing the settlement agreement.  Cellegy also issued a $3.0 million promissory note to PDI and a $3.5 million non-negotiable senior convertible debenture (See Note 12).
 
In April 2005, the Company signed a lease termination agreement with its former landlord at its former headquarters offices in South San Francisco, California.  The Company had moved its headquarters in March 2005 to offices in Brisbane, California. The termination agreement released Cellegy from liability for all future lease payments under the original lease contract. The Company also signed a sublease termination agreement in April 2005 with VaxGen, Inc.  The terms of the agreement include payment by VaxGen of $1,090,000 to Cellegy as a lease termination fee which the Company received in April 2005, net of rental deposit of $188,000 refunded to VaxGen and deposit of $10,000 due from Cellegy under a new sublease contract.
 
In April 2005, the Company submitted a written response to the FDA containing new analyses of data from its Cellegesic Phase 3 trials. The FDA, which had previously issued a Not Approvable Letter for Cellegesic in December 2004, had initially indicated a target response date of June 15 concerning the results of its analysis of the data.  The Company has not yet received the FDA’s response; however the FDA has indicated that it is currently reviewing the submission and will advise the Company of its findings once its review is completed. While we have received no indication as to when the FDA will respond, the Company has maintained discussions with the FDA and understands that the NDA continues to be under review.
 
In May 2005, Cellegy raised approximately $5.7 million after expenses through a PIPE offering to existing and new institutional and individual investors.  The transaction consisted of the sale of approximately 3,621,819 shares of common stock.  Cellegy also issued Class A Warrants to purchase approximately 714,362 shares of common stock at an exercise price of $2.25 per share.  The Class A Warrants can be called by the Company if the common stock trades for 20 consecutive days over $5.00. We also issued Class B Warrants to purchase approximately 714,362 shares of common stock at an exercise price of $2.50 per share.  The Class B Warrants can be called by the Company if the common stock trades for 20 consecutive days over $5.50.  Three directors of Cellegy purchased a total of 50,000 shares in the offering at the closing market price of the common stock on the date of the transaction for $2.13 per share.  The directors did not receive any warrants. The purchase price for shares purchased by the non-director investors was $1.65 per share.
 
Results of Operations
 
Revenues.  Note that the prior year to date consolidated results did not include Biosyn, which Cellegy acquired in October 2004. The third quarter of 2005 represented the first full quarter of Rectogesic sales in the UK. The Company’s European marketing partner, ProStrakan, launched Tostrex in Sweden late in the third quarter and the Company accrued $200,000 in milestone revenue in connection therewith. Sales of Tostrex are not expected to be significant in 2005.

The Company had revenues of $1,952,000 and $483,000 for the three months ended September 30, 2005 and 2004, respectively. The $1,469,000 increase in revenue was primarily due to the inclusion of Biosyn grant revenue in 2005 of $1,252,000, the accrual of a milestone payment of $200,000 relating to the Tostrex launch and product sales to ProStravan relating to the distribution of Rectogesic in the UK.
 
17


 
Revenues for the nine months ended September 30, 2005 were approximately $11.3 million compared to $1.3 million for the same period in 2004. During the nine month period ended September 30, 2005, revenues consisted of non recurring licensing revenue recognized in connection with the PDI settlement of $6.5 million , Rectogesic and Tostrex sales totaling $899,000, Biosyn grant revenue of $3.4 million and $200,000 relating to the Tostrex launch. For the nine months ended September 30, 2004, revenues consisted primarily of $638,000 in licensing revenue and $613,000 in product sales.
 
Our licensing revenue decreased significantly in the third quarter of 2005.  As a result of our settlement agreement with PDI in April 2005, we no longer derive any revenue from the license of our Fortigel product. Unless we are able to sell or license this or other technologies to a new partner, licensing revenues will continue at or below current levels. We expect product sales to decrease in the fourth quarter and in 2006 due to the amendment of our agreement with ProStrakan.
 
Cost of Sales. Cost of sales is comprised primarily of direct labor and raw material manufacturing costs for commercialized products and also includes shipping costs and those costs associated with stability and validation testing of finished goods prior to shipment. Cost of sales also includes similar costs for sales of samples and placebo. The stability and validation testing components of cost of sales will continue to comprise a significant percentage of gross sales unless and until sales volumes increases since these costs are substantially fixed in nature. There can be no assurance that sales volume will increase materially.
 
Research and Development Expenses.  Biosyn was not a component of Cellegy’s consolidated results for the comparable period of the prior year. During the three months ended September 30, 2005 and 2004, research and development expenses were $1,816,000 and $2,529,000, respectively. Expenses for the third quarter included Biosyn expenses of approximately $1.6 million incurred in connection with the manufacture of clinical testing supplies and other clinical activities relating to the development of its HIV products.  The increase attributable to Biosyn research expenses was partly offset by decreases of $1,204,000 due primarily to decreases in clinical activities relating to Cellegesic and Fortigel. At the parent level, Cellegy did not have significant research expenses in the third quarter of 2005.
 
Research and development expenses during the nine months ended September 30, 2005 were $6,877,000, compared to $6,876,000 during the same period in 2004.  The current year results include Biosyn’s research and clinical material manufacturing expenses for its HIV product candidates of approximately $4.4 million.  This was partly offset by a $2,690,000 decrease in Cellegy’s clinical costs and other related expenses resulting from a wind down in clinical activities relating to Cellegesic and Fortigel in 2005. Other related decreases include $488,000 in research salaries due to the curtailment of research for these products. The prior year also includes a $750,000 milestone payment to Neptune Pharmaceuticals relating to acquired research. The Company, in the second quarter of 2005, announced the closing of its Canadian research subsidiary and this facility was substantially wound down by the end of the third quarter.
 
Selling, General and Administrative Expenses.  Selling, general and administrative expenses for the quarter ended September 30, 2005 and 2004 were $2,575,000 and $1,093,000, respectively. The increase of $1,482,000 consisted primarily of Biosyn expenses of $290,000, which was not a component of Cellegy’s results for the comparable period of last year,  increases in salaries including officer severance expenses, consulting expenses, the accrual of retention bonuses to employees incurred in connection with the planned shut down of the California and other facility wind down expenses. California personnel previously engaged in research or development are now being reported under SG&A, as the parent’s efforts in the third quarter have shifted towards the management of its manufacturing activities or towards other administrative functions.
 
Selling, general and administrative expenses during the nine months ended September 30, 2005 and 2004 were $7,050,000 and $3,520,000, respectively. The $3,530,000 increase included expenses of $1.1 million relating to Biosyn. The remaining increase of $2,351,000 was primarily attributable to increases of $1.2 million in legal fees principally due to the PDI litigation. $700,000 in other professional and board fees and $1,187,000 in severance payments and retention accruals. The payment of severance benefits, and the accrual of retention payments to employees was incurred in connection with the planned shut down of the California location.  The overall increase in expenses was partly offset by the receipt of the sublease termination fee of $1,090,000 a decrease in rent expense resulting from the termination of Cellegy’s lease contract for the Company’s South San Francisco offices. The Company announced in the third quarter of 2005 the relocation of its headquarters to its Biosyn facility in Pennsylvania and it is expected that the Brisbane, California office will be closed during the first quarter of 2006.
 
Other Income (Expense).  For the three months ended September 30, 2005, we had a net other expense of $117,000 compared to a net other income of $51,000 for the same period in 2004.  Net other expense for the third quarter of 2005 includes $202,000 of interest accretion relating primarily to the PDI notes. Net other income during the third quarter of 2004 consisted primarily of $69,000 of rental income offset partially by derivative revaluation expense.
 
Net other expense for the nine months ended September 30, 2005 was $104,000 compared to net other income of $367,000 during the same period of 2004.  Net other expense for 2005 included approximately $478,000 of interest expense primarily relating to the PDI notes, partially offset by $131,000 of interest income and $242,000 gain on derivative revaluation. This compares with a net other income of $367,000 for the same period last year which included interest and rental income of $208,000 and $159,000 derivative revaluation income 
 
 
18

 
 
Liquidity and Capital Resources
 
The Company is presently experiencing liquidity difficulties. In connection with its amendment of its agreement with Prostrakan in November of 2005, Cellegy received a payment of $2 million and may receive future milestone payments of up to $750,000 upon approval of the product in certain major European countries. Unless it is able to secure additional funding as discussed below, the Company will most likely not be able to support its research programs or its product commercialization activities for most of 2006.

Cash and cash equivalents were approximately $2.3 million at September 30, 2005 compared to $8.7 million at December 31, 2004. Cash used in operations during the first nine months of 2005 was $12.2 million as compared to $8.4 million during the same period in the prior year.  The $3.8 million increase in the use of cash in operations in 2005 was due primarily to the April settlement of PDI’s lawsuit and its associated legal costs, officer and other severence expenses and the inclusion of Biosyn in 2005.  This was partly offset by approximately $1.1 million received in connection with a sublease termination agreement. The settlement with PDI required the payment of $2.0 million and the issuance of two non-interest bearing long-term notes with an aggregate face value of $6.5 million. These notes are classified as current for financial reporting purposes (see Note 12). The use of cash from operating activities for the first nine months of 2005 was partially offset by $5.7 million in net proceeds provided by the May, 2005 sale of common stock. 

We prepared our financial statements assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities and commitments in the normal course of business.  However, we have experienced net losses from operations since our inception. Through September 30, 2005, we had incurred an accumulated deficit of $130.3 million and had consumed cash from operations of $91.8 million. We expect negative cash flow from operations to continue for the foreseeable future, due to our need to continue or expand development programs, to commercialize products and build inventory once regulatory approvals have been obtained, if any, and to meet our contractual obligations with PDI. 
 
These factors raise substantial doubt about our ability to continue as a going concern. Our plans with regard to these matters include raising additional required funds through one or more of the following options: seeking partnerships with other pharmaceutical companies to co-develop and fund our research and development efforts, sale of all rights to our Fortigel product, pursuing additional out-licensing arrangements with third parties, re-licensing and monetizing in the near term our future milestone and royalty payments expected from existing licensees and seeking equity or debt financing. In addition, we will continue to implement further cost reduction programs and reduce discretionary spending, if necessary, to meet our obligations as they become due for the foreseeable future.
 
There is no assurance that any of the above options will be implemented on a timely basis or that we will be able to obtain additional financing on acceptable terms, if at all. Alternatively, we may be required to accept less than favorable commercial terms in any such future arrangements. If adequate funds are not available on acceptable terms, we could be required to delay development or commercialization of certain products, to license to third parties the rights to commercialize certain products that we would otherwise seek to commercialize internally or to reduce resources devoted to product development. In addition, if we do not receive all, or a portion, of the planned Biosyn grant funding, or if such funding is delayed, this could impact our ability to complete our Biosyn development programs on a timely basis, if at all.
 
The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Any failure to dispel any continuing doubts about our ability to continue as a going concern could adversely affect our ability to enter into collaborative relationships with business partners, make it more difficult to obtain required financing on favorable terms or at all, negatively affect the market price of our common stock and could otherwise have a material adverse effect on our business, financial condition and results of operations.
 
Future expenditures and capital requirements depend on numerous factors including, without limitation, the progress and focus of our research and development programs, the progress of pre-clinical and clinical testing, the time and costs involved in obtaining regulatory approvals, the costs of filing, prosecuting, defending and enforcing patent claims, oppositions and appeals, the timing and level of grant funding to support Biosyn’s clinical programs and operations and our ability to establish new collaborative arrangements.
 
As described in Note 16 to the Condensed Consolidated Financial Statements, the Company received a second letter from The Nasdaq Stock Market dated August 9, 2005 indicating that for ten consecutive trading days prior to August 8, 2005, the market value of the common stock had failed to remain at or above $50 million as required for continued inclusion on the Nasdaq National Market by Marketplace Rule 4450(b)(1)(A).
 
 
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On September 15, 2005 the Company announced that it had received a determination letter dated September 14, 2005 following a hearing by the Listing Qualifications Panel of the Nasdaq Stock Market indicating that the Company’s common stock will transfer from the Nasdaq National Market to the Nasdaq SmallCap Market, effective at the opening of business on September 16, 2005.  The transfer from the Nasdaq National Market is due to the Company not currently satisfying the $50 million market capitalization requirement of Nasdaq Marketplace Rule 4450(b)(1)(A).  The Company did not request a review of the Panel’s determination.

The Company continues to experience fluctuations in its share price. As long as the Company complies with the Nasdaq Small Cap Market’s continued listing requirements, which require, among other things, (i) that our stock price equals or exceeds $1.00 and (ii) that either the aggregate market value of our common stock exceeds $35 million or our stockholder equity exceeds $2.5 million, we will continue to remain listed thereon.  If the Company is unable to meet the requirements for continued listing with the Nasdaq SmallCap Market, it could further reduce the liquidity of our common stock, cause certain investors not to trade in our common stock, and result in a lower stock price.  This could also make it more difficult for us to raise required funds through equity financing transactions and could otherwise have an adverse impact on business, financial condition and results of operations.

Subsequent Events

On November 8, 2005 a press release was issued relative to the Company’s Savvy Ghana Phase 3 HIV prevention trail. It was announced that the Data Monitoring Committee (DMC) reviewing interim data from the trial recommended that continuing the trial would not allow the effect of Savvy (C31G vaginal gel) on HIV to be determined because of a lower than expected rate of HIV seroconversion in the trial. The estimated annual rate of HIV seroconversion in the Ghana study population was 3.7% at the time of trial initiation, but the observed annual rate was 1.2% eighteen months into the trial, approximately on third of the expected rate. This lower rate was possibly due, in part, to procedures designed to ensure ethical trial design, including counseling on HIV prevention and distribution of condoms.

Most importantly, the DMC concluded that Savvy appears to be safe and that there is no evidence of safety concerns, based on a review of the comparative numbers of HIV seroconversions in the Savvy and placebo groups, and other interim data.

As a result of the data review, Cellegy, Family Health International (FHI) and the United States Agency for International Development (USAID), which is funding the trial, collectively agreed that the trial in Ghana should be discontinued, and that Savvy should continue to be studied for its effect on preventing HIV transmission. Consideration is being given to expansion of the ongoing Savvy Phase 3 HIV prevention trial in Ghana and/or the opening of new trial sites in areas with higher HIV incidence as ways to determine the effectiveness of Savvy.

Additionally, data from the Ghana trial will be analyzed for effects on other endpoints including pregnancy. If the data warrant, the Ghana results will be submitted as a supplemental data package for the contraception New Drug Application. Since the analysis of the HIV data did not indicate any safety concerns, the Savvy Phase 3 contraception trial underway in the United States will continue as planned, with enrollment ongoing at sites throughout the U.S. Planning is underway for a second contraception study also at sites in the U.S. Additional studies are planned to examine effectiveness against other sexually transmitted diseases (STDs), including herpes, in the near future.
 
On November 9, 2005 the Company amended its December 2004 exclusive license and distribution agreement with ProStrakan for the commercialization of Rectogesic in Europe. Under the terms of the amended agreement, ProStrakan will assume responsibility for all manufacturing and other product support functions and will purchase the product directly from the manufacturer rather than purchasing from Cellegy under the terms of the original agreement. In return, Cellegy received a payment of $2 million and may receive future milestone payments of up to $750,000 upon approval of the product in certain major European countries. Cellegy will benefit from reduced infrastructure costs by having its partner take over manufacturing responsibilities.

Critical Accounting Policies and Estimates
 
Our critical accounting policies and estimates were discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004.  No changes in those policies and estimates have occurred during the nine months ended September 30, 2005.
 
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Factors That May Affect Future Operating Results
 
Risks Relating to Our Business
 
Our prospects for obtaining additional financing, if required, are uncertain and failure to obtain needed financing could affect our ability to develop or market products.
 
The Company is presently experiencing liquidity difficulties. Throughout our history, we have consumed substantial amounts of cash. Our cash requirements may increase to fund the additional expenses required to continue our research and development programs, and to fund future payments in support of Biosyn’s operations to the extent these are not covered by various government and non-government organizations. In addition, one or more such organizations could withdraw, reduce the extent of, delay or terminate their funding commitments.
 
The amount of cash required to fund future expenditures and capital requirements will depend on numerous factors including, without limitation:
 
requirements in support of our development programs;
 
progress and results of pre-clinical and clinical testing;
 
time and costs involved in obtaining regulatory approvals, including the cost of complying with additional FDA information and/or clinical trial requirements to obtain marketing approval of our Tostrelle, Savvy and Cellegesic product candidates;
 
the commercial success of our products that are approved or may be approved for marketing by the United States or foreign regulatory authorities;
 
the costs of filing, prosecuting, defending and enforcing patent claims, oppositions and appeals, and our other intellectual property rights;
 
our ability to establish new collaborative arrangements;
 
the validation of a second contract manufacturing site; and
 
the extent of expenses required to support Biosyn operations.
 
In order to complete the development, manufacturing and other pre-launch marketing activities necessary to commercialize our products, additional financing will be required. To help fund future cash needs, Cellegy may seek other alternatives such as private or public equity investments, partnerships with other pharmaceutical companies to co-develop and fund our research and development efforts, additional out-licensing agreements with third parties, or agreements to monetize in the near term our future milestone and royalty payments expected from licenses. There is no assurance that such funding will be available for us to finance our operations on acceptable terms, if at all, and any future equity funding may involve significant dilution to our stockholders. Our ability to draw down funds under the SSO is dependent in part on our stock price and the satisfaction of other conditions of the SSO; under certain circumstances we could be prevented from or be limited in fully utilizing planned funding from the SSO.
 
Insufficient funding may require us to delay, reduce or eliminate some or all of our research and development activities, planned clinical trials, administrative programs, personnel, outside services and facility costs; reduce the size and scope of our sales and marketing efforts; delay or reduce the scope of, or eliminate, one or more of our planned commercialization or expansion activities; seek collaborators for our product candidates at an earlier stage than otherwise would be desirable and on terms that are less favorable than might otherwise be available; or relinquish, license or otherwise dispose of rights to technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves on terms that are less favorable than might otherwise be available. In addition, even if we do receive additional financing, we may not be able to complete planned clinical trials, development, manufacturing or marketing of any or all of our product candidates. Failure to obtain additional funds as described above may affect the timing of development, clinical trials or commercialization activities relating to certain products.
 
As described in Note 12 above, in connection with the settlement of its litigation with PDI, Inc. in April 2005 Cellegy issued two promissory notes to PDI in the principal amounts of $3.0 million and $3.5 million. Cellegy is required to make current payments on the note to the extent of (i) 50% of licensing fees, royalties or milestone payments (or, in each case, other payments in the nature thereof) received by Cellegy (or its subsidiaries or controlled affiliates) with respect to any of Cellegy’s (or such other entities’) agreements or arrangements with respect to the Tostrex® or Rectogesic® products in territories outside of North America, (ii) 50% of licensing fees, royalties or milestone payments (or, in each case, other payments in the nature thereof) received by Cellegy (or its subsidiaries or controlled affiliates) with respect to any of Cellegy’s (or such other entities’) agreements or arrangements with respect to Fortigel in North American markets. These payments are required to be made to PDI within two business days after Cellegy receives the payments. Cellegy’s obligations under the note are secured by a security interest in favor of PDI, which is reflected in a security agreement between Cellegy and PDI, in Cellegy’s interests in the payments described above and any proceeds therefrom (and certain related collateral). In addition, Cellegy is required to make payments on the $3.0 million note with respect to 10% of proceeds received by Cellegy in excess of $5.0 million from financing transactions. Amounts owed under the note may be accelerated upon an event of default, which is defined to include, but is not limited to, any of the following: Cellegy’s failure to pay any amounts owed under the note when due (including the payments described above constituting collateral for the note); certain kinds of bankruptcy filings or certain related actions or proceedings; any breach of any of Cellegy’s covenants, conditions or agreements in the note or security agreement following notice from PDI that remains uncured for 30 days; the security interest no longer being a valid, perfected, first priority security interest; and a default in indebtedness of Cellegy with an aggregate principal amount in excess of $2.0 million that results in the maturity of such indebtedness being accelerated before its stated maturity.
 
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PDI may assert that the amount or timing of payments by Cellegy to PDI under the provisions described above constitute an event of default under one or both of the notes. For example, PDI may claim that it is entitled to receive payments that Cellegy believes it is not entitled to receive; and Cellegy made a $100,000 payment to PDI in October 2005 shortly after the due date specified in the applicable note and has paid interest to PDI on that amount . If PDI believes that one or more events of default have occurred under one of the notes, PDI might declare a default, accelerate the maturity date of the notes and contend that the notes are immediately due and payable in full. In addition, PDI might attempt to foreclose on the collateral securing Cellegy’s obligations under the $3.0 million note, initiate litigation against Cellegy and seek damages, injunctive relief or other remedies. In light of its current cash position, Cellegy would be unable to pay the amount of these notes if their maturity dates were accelerated.
 
Cellegy believes it has strong defenses to any such claim and intends to vigorously defend any such claim by PDI. However, defending any litigation that might be initiated could be very expensive, divert management time, adversely impact one or more alternatives for obtaining funds required to continue operations, and have a material adverse effect on the Company.  The Company believes that it is in compliance with the terms and conditions of the security agreement with PDI in all material respects.
 
We have a history of losses, and we expect losses to continue for at least several years.
 
We have incurred losses since our inception and negative cash flows from operations that raise substantial doubt about our ability to continue as a going concern. We have never operated profitably and, given our planned level of operating expenses, we expect to continue to incur losses through at least 2006. We plan to devote significant resources to pre-clinical studies, clinical trials, administrative, marketing, sales and patent activities. Accordingly, without substantial revenues from new corporate collaborations, royalties on product sales or other revenue sources, we expect to incur substantial operating losses in the foreseeable future as our potential products move through development and as we continue to invest in research and clinical trials. As a result of our continuing losses, we may exhaust our resources and may be unable to complete the development of our products, and our accumulated deficit will continue to increase as we continue to incur losses. Our losses may increase in the future, and even if we achieve our revenue targets, we may not be able to sustain or increase profitability on a quarterly or annual basis. The amount of future net losses, and the time required to reach profitability, are both highly uncertain. To achieve sustained profitable operations, we must, among other things, successfully discover, develop, and obtain regulatory approvals for and market pharmaceutical products. We cannot assure you that we will ever be able to achieve or sustain profitability. 
 
We have received a “going concern” opinion from our independent auditors, which may negatively impact our business.
 
The audit opinion from our independent registered accounting firm regarding Cellegy’s consolidated financial statements for the year ended December 31, 2004, included an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern. We have incurred losses from operations since inception and negative cash flows from operations that raise substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Any failure to dispel any continuing doubts about our ability to continue as a going concern could adversely affect our ability to enter into collaborative relationships with business partners, make it more difficult to obtain required financing on favorable terms or at all, negatively affect the market price of our common stock and could otherwise have a material adverse effect on our business, financial condition and results of operations.
 
We are subject to regulation by regulatory authorities including the FDA, which could delay or prevent marketing of our products. Unexpected regulatory outcomes could adversely affect our business and stock price.
 
Cellegy’s prescription product candidates, and our ongoing research and clinical activities such as those relating to our product candidates, including Savvy™ and Cellegesic™, are subject to extensive regulation by governmental regulatory authorities in the United States and other countries. Before we obtain regulatory approval for the commercial sale of our potential drug products, we must demonstrate through pre-clinical studies and clinical trials that the product is safe and efficacious for use in the clinical indication for which approval is sought. The timing of NDA submissions, the outcome of reviews by the FDA and the initiation and completion of other clinical trials are subject to uncertainty, change and unforeseen delays. Under the Prescription Drug User Fee Act, or PDUFA, the FDA establishes a target date to complete its review of an NDA. Although the FDA attempts to respond by the relevant PDUFA date to companies that file NDAs, there is no obligation on the FDA’s part to do so. In addition, extensive current pre-clinical and clinical testing requirements and the current regulatory approval process of the FDA in the United States and of certain foreign regulatory authorities, or new government regulations, could prevent or delay regulatory approval of Cellegy’s products.
 
The process of developing and obtaining approval for a new pharmaceutical product within this regulatory framework requires a number of years and substantial expenditures. There can be no assurance that necessary approvals will be obtained on a timely basis, if at all. Delays in obtaining regulatory approvals could delay receipt of revenues from product sales, increase our expenditures relating to obtaining approvals, jeopardize corporate partnership arrangements that we might enter into with third parties regarding particular products, or cause a decline in our stock price. If we fail to comply with applicable regulatory requirements, we could be subject to a wide variety of serious administrative or judicially imposed sanctions and penalties, any of which could result in significant financial penalties that could reduce our available cash, delay introduction of products resulting in deferral or elimination of revenues from product sales, and could result in a decline in our stock price.
 
One or more of our ongoing or planned clinical trials could be delayed, or the FDA could issue a Not Approvable letter with respect to our current or future product candidates, as it did with our Fortigel product NDA in July 2003 and our Cellegesic product NDA in December 2004. Such actions could result in further clinical trials or necessitate other time consuming or costly actions to satisfy regulatory requirements. For example, in January 2004, Cellegy reported positive results from its confirmatory Phase 3 study using Cellegesic product for the treatment of chronic anal fissure pain, and we submitted an NDA to the FDA in June 2004. The Cellegesic product trial was conducted in accordance with a Special Protocol Assessment, or SPA, agreed to with the FDA. In December 2004, the FDA concluded that the trial data did not satisfy the standards specified in the SPA and did not grant marketing approval for our Cellegesic product.
 
In April 2005, the Company submitted a written response to the FDA containing new analyses of data from its Cellegesic Phase 3 trials. The FDA, which had previously issued a Not Approvable Letter for Cellegesic in December 2004, had initially indicated a target response date of June 15 concerning the results of its analysis of the data.  The Company has not yet received the FDA’s response; however the FDA has indicated that it is currently reviewing the submission and will advise the Company of it findings once its review is completed. While we have received no indication as to when the FDA will respond, the Company has maintained discussions with the FDA and understands that the NDA continues to be under review.
 
Sales of Cellegy’s products outside the United States are subject to different regulatory requirements governing clinical trials and marketing approval. These requirements vary widely from country to country and could delay introduction of Cellegy’s products in those countries. Cellegy may not be able to obtain marketing approval for one or more of its products in any countries in addition to those countries where approvals have already been obtained.
 
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Our clinical trial results are very difficult to predict in advance, and the clinical trial process is subject to delays. Failure of one or more clinical trials or delays in trial completion could adversely affect our business and our stock price.
 
Results of pre-clinical studies and early clinical trials may not be good predictors of results that will be obtained in later-stage clinical trials. We cannot provide any assurances that Cellegy’s present or future clinical trials, will demonstrate the results required to continue advanced trial development and allow us to seek marketing approval for these or our other product candidates. Because of the independent and blind nature of certain human clinical testing, there will be extended periods during the testing process when we will have only limited, or no, access to information about the status or results of the tests. Cellegy and other pharmaceutical companies have believed that their products performed satisfactorily in early tests, only to find their performance in later tests, including Phase 3 clinical trials, to be inadequate or unsatisfactory, or that FDA Advisory Committees have declined to recommend approval of the drugs, or that the FDA itself refused approval, with the result that stock prices have fallen precipitously.
 
Clinical trials can be extremely costly. Certain costs relating to the Phase 3 trials for the Savvy product for contraception and reduction in the transmission of HIV, and other clinical and preclinical development costs for the Biosyn pipeline products acquired by Cellegy, are funded directly by certain grant and contract commitments from several governmental and non-governmental organizations, or NGOs. Nevertheless, these Phase 3 trials and Cellegy’s other planned clinical trials could require Cellegy to provide significant trial funding in future years. There can be no assurance that funding from governmental agencies and NGOs will continue to be available at previous levels or at all, and any other Phase 3 trials that Cellegy may commence in the future relating to its products could involve the expenditure of several million dollars through the completion of the clinical trials. In addition, delays in the clinical trial process can be extremely costly in terms of lost sales opportunities and increased clinical trial costs. The speed with which we complete our clinical trials and our regulatory submissions, including NDAs, will depend on several factors, including the following:
 
the rate of patient enrollment, which is affected by the size of the patient population, the proximity of patients to clinical sites, the difficulty of the entry criteria for the study  and the nature of the protocol;
 
the timely completion of protocol approval and obtaining informed consent from subjects;
 
analysis of data obtained from preclinical and clinical activities;
 
changes in policies or staff personnel at regulatory agencies during the lengthy drug application review; and
 
the availability of experienced staff to conduct and monitor clinical studies, internally or through contract research organizations.
 
Adverse events in our clinical trials may force us to stop development of our product candidates or prevent regulatory approval of our product candidates, which could materially harm our business.
 
Patients participating in the clinical trials of our product candidates may experience serious adverse health events. A serious adverse health event includes death, a life-threatening condition, hospitalization, disability, congenital anomaly, or a condition requiring intervention to prevent permanent impairment or damage. The occurrence of any of these events could interrupt, delay or halt clinical trials of our product candidates and could result in the FDA, or other regulatory authorities, denying approval of our product candidates for any or all targeted indications. An institutional review board or independent data safety monitoring board, the FDA, other regulatory authorities or we may suspend or terminate clinical trials at any time. Our product candidates may prove not to be safe for human use. Any delay in the regulatory approval of our product candidates could increase our product development costs and allow our competitors additional time to develop or market competing products.
 
Due to our reliance on contract research organizations or other third parties to assist us in conducting clinical trials, we are unable to directly control all aspects of our clinical trials.
 
Currently, we rely on contract research organizations, or CROs, and other third parties to conduct our clinical trials. As a result, we have had and will continue to have less control over the conduct of the clinical trials, the timing and completion of the trials and the management of data developed through the trial than would be the case if we were relying entirely upon our own staff. Communicating with CROs can also be challenging, potentially leading to difficulties in coordinating activities. CROs may:
 
have staffing difficulties;
 
experience regulatory compliance issues;
 
undergo changes in priorities or may become financially distressed; or
 
not be able to properly control payments to government agencies or clinical sites, particularly in less developed countries.
 
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These factors may adversely affect their ability to conduct our trials. We may experience unexpected cost increases or experience problems with the timeliness or quality of the work of the CRO. If we must replace these CROs or any other third party contractor, our trials may have to be suspended until we find another contract research organization that offers comparable services. The time that it takes us to find alternative organizations may cause a delay in the commercialization of our product candidates or may cause us to incur significant expenses. Although we do not now intend to replace our CROs, such a change would make it difficult to find a replacement organization to conduct our trials in an acceptable manner and at an acceptable cost. Any delay in or inability to complete our clinical trials could significantly compromise our ability to secure regulatory approval of our product candidates, thereby limiting our ability to generate product revenue resulting in a decrease in our stock price.
 
The type and scope of patent coverage we have may limit the commercial success of our products.
 
Cellegy’s success depends, in part, on our ability to obtain patent protection for our products and methods, both in the United States and in other countries. Several of Cellegy’s products and product candidates, such as Cellegesic, Savvy and Tostrelle, are based on existing molecules with a history of use in humans but which are being developed by us for new therapeutic uses or in novel delivery systems which enhance therapeutic utility. We cannot obtain composition patent claims on the compounds themselves, and will instead need to rely on patent claims, if any, directed to use of the compound to treat certain conditions or to specific formulations. This is the case, for example, with our United States patents relating to Cellegesic and Fortigel products. Such method-of-use patents may provide less protection than a composition-of-matter patent, because of the possibility of “off-label” use of the composition. Cellegy may not be able to prevent a competitor from using a different formulation or compound for a different purpose.
 
No assurance can be given that any additional patents will be issued to us, that the protection of any patents that may be issued in the future will be significant, or that current or future patents will be held valid if subsequently challenged. For example, oppositions have been filed with the European Patent Office regarding our European patent protecting the manufacture and use of nitroglycerin ointment and related compounds for the treatment of anal disorders, including fissures and various hemorrhoidal conditions. In December 2003, we reported that the Board of Opposition of the European Patent Office had rendered a verbal decision revoking Cellegy’s European patent relating to its Cellegesic product and related compounds for the treatment of anal disorders, including fissures and various hemorrhoidal conditions. Although Cellegy has appealed this decision, an additional adverse outcome in the appeal process could have a negative effect on Cellegy, impacting the commercial success of our partner’s marketing and corporate licensing efforts in Europe and adversely affecting our royalty revenues and stock price.
 
The patent position of companies engaged in businesses such as Cellegy’s business generally is uncertain and involves complex legal and factual questions. There is a substantial backlog of patent applications at the United States Patent and Trademark Office, or USPTO. Patents in the United States are issued to the party that is first to invent the claimed invention. There can be no assurance that any patent applications relating to Cellegy’s products or methods will issue as patents, or, if issued, that the patents will not be challenged, invalidated or circumvented or that the rights granted there under will provide us a competitive advantage.
 
In addition, many other organizations are engaged in research and product development efforts in drug delivery and topical formulations that may overlap with Cellegy’s products. Such organizations may currently have, or may obtain in the future, legally blocking proprietary rights, including patent rights, in one or more products or methods under development or consideration by Cellegy. These rights may prevent us from commercializing technology, or may require Cellegy to obtain a license from the organizations to use the technology. Cellegy may not be able to obtain any such licenses that may be required on reasonable financial terms, if at all, and cannot be sure that the patents underlying any such licenses will be valid or enforceable. Moreover, the laws of certain foreign countries do not protect intellectual property rights relating to United States patents as extensively as those rights are protected in the United States. The issuance of a patent in one country does not assure the issuance of a patent with similar claims in another country, and claim interpretation and infringement laws vary among countries, so the extent of any patent protection is uncertain and may vary in different countries. As with other companies in the pharmaceutical industry, we are subject to the risk that persons located in other countries will engage in development, marketing or sales activities of products that would infringe our patent rights if such activities were in the United States.
 
Our product sales strategy involving corporate partners is highly uncertain.
 
Cellegy is seeking to enter into agreements with corporate partners regarding commercialization of our lead product candidates. Cellegy currently has a limited number of agreements with third parties to commercialize our product candidates. In July 2004, Cellegy and ProStrakan Group Limited entered into an exclusive license agreement for the future commercialization of Tostrex product in Europe and in December these parties also entered into an exclusive license agreement for commercialization of Rectogesic product in Europe. However, Cellegy may not be able to establish other collaborative arrangements and we may not have the resources or the experience to successfully commercialize any such products on our own. Failure to enter into other arrangements could prevent, delay or otherwise jeopardize our ability to develop and market products in the United States and in markets outside of North America, reducing our revenues and profitability.
 
With the current and future planned corporate partner arrangements, we may rely on our partners to conduct clinical trials, obtain regulatory approvals and, if approved, manufacture, distribute, market or co-promote these products. Reliance on third party partners can create risks to our product commercialization efforts. Once agreements are completed,
 
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particularly if they are completed at a relatively early stage of product development, Cellegy may have little or no control over the development or marketing of these potential products and little or no opportunity to review clinical data before or after public announcement of results. Further, any arrangements that may be established may not be successful or may be subject to dispute or litigation between the parties.
 
We do not have any history of manufacturing products on a large scale, and we have a limited number of critical suppliers.
 
Cellegy has no direct experience in manufacturing commercial quantities of products and currently does not have any capacity to manufacture products on a large commercial scale. We currently rely on a limited number of contract manufacturers, primarily PendoPharm, Inc. and certain of Biosyn’s suppliers, to manufacture our formulations. Although we are developing other contract manufacturers, there can be no assurance that we will be able to enter into acceptable agreements with them or validate facilities successfully on a timely basis. This is an expensive and time-consuming process and there may be delays and additional costs relating to the technical transfer and validation of alternate suppliers. In the future, we may not be able to obtain contract manufacturing on commercially acceptable terms for compounds or product formulations in the quantities we need. Manufacturing or quality control problems, lack of financial resources or qualified personnel could occur with our contract manufacturers causing product shipment delays, inadequate supply, or causing the contractor not to be able to maintain compliance with the FDA’s current good manufacturing practice requirements necessary to continue manufacturing. Such problems could limit our ability to produce clinical or commercial product, cause us to be in breach of contract obligations with our distributors to supply product to them, reduce our revenues from product sales, and otherwise adversely affect our business and stock price.
 
PendoPharm, Inc. is Cellegy’s contract manufacturer for our North American and European clinical supplies and future commercial supplies of Cellegesic and Fortigel prescription products in those territories, while the Australian and South Korean product sales are sourced by a pharmaceutical manufacturer in Australia and the Gryphon skin care product sales are sourced by a manufacturer in the New York area. In July 2003, PanGeo Pharma, our former contract manufacturer, filed for bankruptcy protection under Canadian law. Under a reorganization plan, PanGeo sold its facilities to an affiliate of Pharmascience, another Canadian manufacturer, and was renamed PendoPharm, Inc. Cellegy has not experienced any material adverse impact to date from the previous bankruptcy filing, The manufacturing facility was inspected and re-certified by Canadian regulatory authorities after its acquisition by PendoPharm, and PendoPharm has continued to supply product from the manufacturing facility without interruption. Nevertheless, uncertainty exists concerning the future operations of PendoPharm manufacturing plant and whether PendoPharm will be able to meet Cellegy’s clinical and product requirements on a timely basis, if at all, in the future. In addition, there can be no assurances relating to PendoPharm’s ability to continue to produce product under Good Manufacturing Practices required by the FDA or other regulatory agencies. There could be difficulty or delays in importing raw materials or exporting product into or out of Canada resulting in delays in our clinical trials or commercial product sale. Cellegy has started the process of establishing an alternative production site at a domestic location. This is an expensive and time consuming process and there may be delays and additional costs relating to the technical transfer and validation of alternate suppliers.
 
We have limited sales and marketing experience.
 
We may market some of our products, if successfully developed and approved, through a direct sales force in the United States. Cellegy has very limited experience in sales, marketing or distribution. To market these products directly, we may seek to establish a direct sales force in the United States or obtain the assistance of a marketing partner. However, Cellegy may not have the financial capability or the experience to successfully establish a direct sales force, marketing or distribution operations, which could delay or prevent the successful commercialization of our products and could reduce the ultimate profitability to Cellegy of such products if we needed to rely on a third party marketing partner to commercialize the products.
 
If medical doctors do not prescribe our products or the medical profession does not accept our products, our product sales and business would be adversely affected.
 
Our business is dependent on market acceptance of our products by physicians, healthcare payers, patients and the medical community. Medical doctors’ willingness to prescribe our products depends on many factors, including:
 
perceived efficacy of our products;
 
convenience and ease of administration;
 
prevalence and severity of adverse side effects in both clinical trials and commercial use;
 
availability of alternative treatments;
 
 
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cost effectiveness;
 
effectiveness of our marketing strategy and the pricing of our products;
 
publicity concerning our products or competing products; and
 
our ability to obtain third-party coverage or reimbursement.
 
Even if we receive regulatory approval and satisfy the above criteria, physicians may not prescribe our products if we do not promote our products effectively. Factors that could affect our success in marketing our products include:
 
the experience, skill and effectiveness of the sales force and our sales managers;
 
the effectiveness of our production, distribution and marketing capabilities;
 
the success of competing products; and
 
the availability and extent of reimbursement from third-party payors.
 
Failure of our products or product candidates to achieve market acceptance would limit our ability to generate revenue and could harm our business.
 
If testosterone replacement therapies are perceived to create health risks, our testosterone gel product candidates may be jeopardized.
 
Recent studies of female hormone replacement therapy products have reported an increase in certain health risks with long-term use. As a result of such studies, some companies that sell or develop female hormone replacement products have experienced decreased sales of these products, and in some cases, a decline in the value of their stock. Publications have, from time to time, suggested potential risks associated with testosterone replacement therapy, or TRT. Potential health risks were described in various articles, including a 2002 article published in Endocrine Practice and a 1999 article published in the International Journal of Andrology. It is possible that further studies on the effects of TRT could demonstrate other health risks. This, as well as negative publicity about the risks of hormone replacement therapy, including TRT, could adversely affect patient or prescriber attitudes and impact the development and successful commercialization of our Tostrex and Tostrelle product candidates. In addition, in a meeting with the FDA, the FDA informed Cellegy that specific guidelines regarding the long-term safety of testosterone for the treatment of female sexual dysfunction are under internal discussion by the Division of Reproductive and Urologic Drug Products. Cellegy is awaiting these guidelines before embarking on a Phase 3 program. If the new FDA guidelines prove to be too onerous or too costly to implement, the Phase 3 program may be significantly delayed or we may decide not to pursue further development of Tostrelle product. The above factors could adversely affect investor attitudes and the price of our common stock.
 
We have very limited staffing and will continue to be dependent upon key personnel.
 
Our success is dependent upon the efforts of a small management team and staff. We have compensation or employment arrangements and a severance/retention plan in place with all of our executive officers, but none of our executive officers is legally bound to remain employed for any specific term. Our key personnel include Richard C. Williams, our Chairman and Interim Chief Executive Officer, and Anne-Marie Corner, Senior Vice President, Women’s Preventive Health. Mr. Williams has a written arrangement describing his compensation and we have a written employment agreement with Ms. Corner. Either Cellegy or the officer may terminate either arrangement at any time upon notice. If key individuals leave Cellegy, we could be adversely affected if suitable replacement personnel are not quickly recruited. There is competition for qualified personnel in all functional areas, which makes it difficult to attract and retain the qualified personnel necessary for the development and growth of our business. Our future success depends upon our ability to continue to attract and retain qualified scientific, clinical and administrative personnel.
 
Our corporate compliance programs cannot guarantee that we are in compliance with all potentially applicable regulations.
 
The development, manufacturing, pricing, sales, and reimbursement of our products, together with our general operations, are subject to extensive regulation by federal, state and other authorities within the United States and numerous entities outside of the United States. We are a relatively small company and we rely heavily on third parties to conduct many important functions. We also have significantly fewer employees than many other companies that have the same or fewer product candidates in late stage clinical development.  In addition, as a publicly traded company we are subject to significant regulations, including the Sarbanes-Oxley Act of 2002, some of which have either only recently been adopted or
 
 

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are currently proposals subject to change. While we have developed and instituted a corporate compliance program and continue to update the program in response to newly implemented or changing regulatory requirements, we cannot assure you that we are now or will be in compliance with all such applicable laws and regulations. If we fail to comply with any of these regulations, we could be subject to a range of regulatory actions, including suspension or termination of clinical trials, restrictions on our products or manufacturing processes, withdrawal of products from the market, significant fines, or other sanctions or litigation. Failure to comply with potentially applicable laws and regulations could also lead to the imposition of fines, cause the value of our common stock to decline, impede our ability to raise capital or lead to the de-listing of our stock.
 
We are evaluating our internal control systems in order to allow management to report on, and our independent auditors to attest to, our internal controls, as required by the Sarbanes-Oxley Act. We will be performing the system and process evaluation and testing (and any necessary remediation) required in an effort to comply with the management certification and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act. As a result, we expect to incur significant additional expenses and diversion of management’s time. While we anticipate being able to fully implement the requirements relating to internal controls and all other aspects of Section 404 by December 2006, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations since there are few or no precedents available by which to measure compliance adequacy. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or the Nasdaq Small Cap Market. In addition, we may be required to incur a substantial financial investment to improve our internal systems and the hiring of additional personnel or consultants.
 
Risks Relating to Our Industry
 
We face intense competition from larger companies, and in the future Cellegy may not have the resources required to develop innovative products. Cellegy’s products are subject to competition from existing products.
 
The pharmaceutical industry is subject to rapid and significant technological change. In the development and marketing of prescription drugs, Cellegy faces intense competition. Cellegy is much smaller in terms of size and resources than many of its competitors in the United States and abroad, which include, among others, major pharmaceutical, chemical, consumer product, specialty pharmaceutical and biotechnology companies, universities and other research institutions. Cellegy’s competitors may succeed in developing technologies and products that are safer and more effective than any that we are developing and could render Cellegy’s technology and potential products obsolete and noncompetitive. Many of these competitors have substantially greater financial and technical resources, clinical production and marketing capabilities and regulatory experience. In addition, Cellegy’s products are subject to competition from existing products. For example, Cellegy’s Fortigel product, if ever commercialized in the United States, is expected to compete with several products, including two currently marketed testosterone gel products sold by Unimed/Solvay and Auxilium Pharmaceuticals, a transdermal patch product sold by Watson Pharmaceuticals, a buccal tablet from Columbia Laboratories and potential generic products which may be introduced before or after Fortigel product is commercialized.
 
Cellegesic product, if ever commercialized, is expected to compete with over-the-counter products, such as Preparation H marketed by Wyeth, and various prescription products. As a result, we cannot assure you that Cellegy’s products under development may be able to compete successfully with existing products or with innovative products under development by other organizations.
 
The Savvy product is subject to competition from other microbicides that are currently undergoing clinical trials and which may be sold by prescription or over the counter, as well as non-microbicide products such as condoms. Additionally, if a vaccine for HIV/AIDS is successfully developed and made available, this could limit the potential market for Savvy and Biosyn’s other products. As a result, Biosyn’s products under development may not be able to compete successfully with existing products or other innovative products under development.
 
We are subject to the risk of product liability lawsuits.
 
The testing, marketing and sale of human health care products entails an inherent risk of allegations of product liability. We are subject to the risk that substantial product liability claims could be asserted against us in the future. Cellegy has obtained insurance coverage relating to our clinical trials in an aggregate amount of $1.0 million and an aggregate amount of $3.0 million relating to the clinical trials relating to products acquired from Biosyn. If any of our product candidates are approved for marketing, we may seek additional coverage. There can be no assurance that Cellegy will be able to obtain or maintain insurance on acceptable terms, particularly in overseas locations, for clinical and commercial activities or that any insurance obtained will provide adequate protection against potential liabilities.
 

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Moreover, our current and future coverage may not be adequate to protect us from all of the liabilities that we may incur. If losses from product liability claims exceed our insurance coverage, we may incur substantial liabilities that exceed our financial resources. In addition, a product liability action against us would be expensive and time-consuming to defend, even if we ultimately prevailed. If we are required to pay a product liability claim, we may not have sufficient financial resources and our business and results of operations may be harmed.
 
Risks Relating to Our Stock
 
Our stock price could be volatile.
 
Our stock price has from time to time experienced significant price and volume fluctuations. Since becoming a public company, our stock price has fluctuated in conjunction with the general price changes on the markets on which our common stock has been listed and sometimes matters more specific to Cellegy, such as an announcement of clinical trial or regulatory results or other corporate developments.
 
Regulatory developments relating to our products,  including but not limited to, the expected response from the FDA concerning Cellegesic. Clinical trial results, particularly the outcome of our more advanced studies; or negative responses from regulatory authorities with regard to the approvability of our products;
 
Period-to-period fluctuations in our financial results, including our cash and investment balance, operating expenses, cash burn rate or revenues;
 
Negative announcements, additional legal proceeding or financial problems of our key suppliers, particularly relating to our Canadian manufacturer and our service providers;
 
Common stock sales in the public market by one or more of our larger stockholders, officers or directors; and,
 
Other potentially negative financial announcements such as review of any of our filings by the SEC, changes in accounting treatment or restatement of previously reported financial results or delays in our filings with the SEC.
 
The Kingsbridge SSO financing arrangement may have a dilutive impact on our stockholders. The SSO arrangement imposes certain limitations on our ability to issue equity or equity-linked securities.
 
There are 4,000,000 shares of our common stock that are reserved for issuance under the structured secondary offering facility arrangement, or Kingsbridge SSO, that we entered into in January 2004 with Kingsbridge Capital Limited, or Kingsbridge, 260,000 shares of which are related to a warrant that we issued to Kingsbridge. In certain circumstances where the registration statement covering those shares is not effective or available to Kingsbridge, additional shares may be issuable to Kingsbridge under the agreement. Such circumstances could include, for example, suspending Kingsbridge’s ability to sell shares pursuant to the registration statement because of the existence of material undisclosed developments relating to Cellegy. If within 15 trading days following any settlement date on which Cellegy issues shares under the Kingsbridge SSO, Cellegy suspends Kingsbridge’s ability to sell shares by delivering a notice to Kingsbridge, referred to as a blackout notice, then if the volume weighted average market price of our common stock, or the VWAP, is higher on the trading day immediately before the blackout notice is delivered than it is on the first trading date after the blackout trading period is lifted, Cellegy is obligated to pay to Kingsbridge an amount based on a percentage, ranging from 75% to 25% depending on when the blackout notice is delivered, of the difference between the two VWAP prices multiplied by the number of shares purchased by Kingsbridge under the most recent draw down and held by Kingsbridge immediately before the suspension was imposed. Cellegy may, in its discretion, pay this amount either in cash or in shares, the value of which is based on the market price of the common stock on the first trading date after the registration statement became available again. In addition, if we fail to issue and sell common stock to Kingsbridge pursuant to drawdowns at least equal to $2.66 million under the Kingsbridge SSO during the term of the agreement, then we have agreed to pay approximately $266,000 to Kingsbridge. The issuance of shares under the Kingsbridge SSO at a discount to the market price of the common stock, and upon exercise of the warrant, will have a dilutive impact on other stockholders, and the issuance or even potential issuance of such shares, if any, could have a negative effect on the market price of our common stock. If we sell stock to Kingsbridge when our share price is decreasing, such issuance will have a more dilutive effect and may further decrease our stock price. A decrease in our stock price or other consequences of issuing shares under the Kingsbridge SSO could potentially cause us not to satisfy one or more requirements for the continued listing of our common stock on the Nasdaq Small Cap Market, or could impair or prevent our ability to obtain additional required financing, resulting in a damaged capital structure.
 

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To the extent that Kingsbridge sells shares of our common stock issued under the Kingsbridge SSO to third parties, our stock price may decrease due to the additional selling pressure in the market. The perceived risk of dilution from sales of stock to or by Kingsbridge may cause holders of our common stock to sell their shares or encourage short sales. This could contribute to decline in our stock price.
 
During the two-year term of the Kingsbridge SSO, we are subject to certain restrictions on our ability to engage in certain equity or equity-linked financings without the consent of Kingsbridge. These restrictions primarily relate to non-fixed future-priced securities. We may not issue securities that are, or may become, convertible or exchangeable into shares of common stock where the purchase, conversion or exchange price for such common stock is determined using a floating or otherwise adjustable discount to the market price of the common stock during the two year term of our agreement with Kingsbridge. However, the agreement does not prohibit us from conducting most kinds of additional debt or equity financings, including Private Investment in Public Equity (PIPEs), shelf offerings, and secondary offerings.
 
We may not be able to maintain our listed status with the Nasdaq Small Cap Market.
 
As described in Note 16 to the Condensed Consolidated Financial Statements, the Company received a second letter from The Nasdaq Stock Market dated August 9, 2005 indicating that for ten consecutive trading days prior to August 8, 2005, the market value of the common stock had failed to remain at or above $50 million as required for continued inclusion on the Nasdaq National Market by Marketplace Rule 4450(b)(1)(A).
 
On September 15, 2005 the Company announced that it had received a determination letter dated September 14, 2005 following a hearing by the Listing Qualifications Panel of the Nasdaq Stock Market indicating that the Company’s common stock will transfer from the Nasdaq National Market to the Nasdaq SmallCap Market, effective at the opening of business on September 16, 2005.  The transfer from the Nasdaq National Market is due to the Company not currently satisfying the $50 million market capitalization requirement of Nasdaq Marketplace Rule 4450(b)(1)(A).  The Company did not request a review of the Panel’s determination.

The Company continues to experience fluctuations in its share price. As long as the Company complies with the Nasdaq Small Cap Market’s continued listing requirements, which require, among other things, (i) that our stock price equals or exceeds $1.00 and (ii) that either the aggregate market value of our common stock exceeds $35 million or our stockholder equity exceeds $2.5 million, we will continue to remain listed thereon.  If the Company is unable to meet the requirements for continued listing with the Nasdaq SmallCap Market, it could further reduce the liquidity of our common stock, cause certain investors not to trade in our common stock, and result in a lower stock price.  This could also make it more difficult for us to raise required funds through equity financing transactions and could otherwise have an adverse impact on business, financial condition and results of operations.
 
Future sales of shares of our common stock may negatively affect our stock price.
 
As a result of our acquisition of Biosyn, we issued approximately 2,462,000 shares and assumed options and warrants to purchase 318,504 shares of our common stock. In addition, from 2002 through September 30, 2005 we have issued 9,088,218 shares of our common stock in private placement transactions and through the Kingsbridge SSO. A substantial portion of these shares is held by a relatively small number of stockholders. Sales of a significant number of the above shares into the public markets, particularly in light of our relatively small trading volume, may negatively affect our stock price. Additionally, as of September 30, 2005, we also have outstanding warrants and vested stock options that can be exercised by the holders to acquire up to approximately 5,460,493 of our common stock. The exercise of these options or warrants could result in significant dilution to our stockholders at the time of exercise.
 
 
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In the future, we will likely issue additional shares of common stock or other equity securities, including but not limited to options, warrants or other derivative securities convertible into our common stock, which could result in significant dilution to our stockholders and adversely affect our stock price
 
Changes in the expensing of stock options could result in unfavorable accounting charges or require us to change our compensation practices.
 
For Cellegy, stock options are a significant component of compensation for existing employees and to attract new employees. We currently are not required to record stock-based compensation charges if the employee’s stock option exercise price equals or exceeds the fair value of our common stock at the date of grant. The Financial Accounting Standards Board has issued a new accounting standard requiring recording of expense for the fair value of stock options granted. During 2006, when we change our accounting policy to record expense for the fair value of stock options granted our net loss will increase. We intend to continue to include various forms of equity in our compensation plans, such as stock options and other forms of equity compensation allowed under our plans. If we continue our reliance on stock options, our reported losses could increase.
 
Item 3.            Quantitative and Qualitative Disclosure of Market Risk
 
Cellegy invests its excess cash in short-term, investment grade, fixed income securities under an investment policy. All of our investments are classified as available-for-sale. All of our securities owned as of September 30, 2005 were in money market funds and are classified as cash equivalents. We believe that potential near-term losses in future earnings, fair values or cash flows related to our investment portfolio are not significant.
 
We are incurring market risk associated with the issuance of warrants to Kingsbridge to purchase 260,000 shares of our common stock and to the May 2005 investors to purchase approximately 1.4 million shares of our common stock. We will continue to calculate the fair value at the end of each quarter and record the difference to other income or expense until the warrants are exercised. We are incurring risk associated with increases or decreases in the market price of our common stock, which will directly impact the fair value calculation and the non-cash charge or credit recorded to the income statement in future quarters.
 
Item 4.            Controls and Procedures
 
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)).
 
Based upon this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of September 30, 2005, our disclosure controls and procedures were adequate to ensure that information required to be disclosed in the reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the United States Securities and Exchange Commission rules and forms.
 
During the period covered by this report, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.  A controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls are met, and no evaluation of controls can provide absolute assurance that all controls and instances of fraud, if any, within a company have been detected.
 
 

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PART II   -  OTHER INFORMATION
 
Item 1.            Legal Proceedings
 
None
 
Item 2.            Unregistered sales of equity securities and use of proceeds 
 
None
 
Item 3.            Defaults Upon Senior Securities
 
   None
 
Item 4            Submission of Matters to a Vote of Security Holders

At the Company’s Annual Meeting of Shareholders, held on September 28, 2005, three matters were submitted to vote of the shareholders: (i) the election of directors; (ii) approval of the Company’s 2005 Equity Incentive Plan; and (iii) the ratification of PricewaterhouseCoopers LLP as the Company’s independent auditors for the 2005 fiscal year.
 
(i) With respect to the election of directors, five nominees (constituting all of the Company’s nominees for election) were elected by, at least, 24,656,198 shares voted for and with no more than 2,688,456 shares withheld.
 
(ii) With respect to the approval of the 2005 Equity Incentive Plan, 16,162,872 shares shares voted in favor, 3,003,875 shares voted against and 12,334 shares were withheld.

(iii) With respect to the ratification of PricewaterhouseCoopers LLP as the Company’s independent auditors for the 2005 fiscal year, 35,618,653 shares voted in favor, 18,827 shares voted against and 9,734 shares were withheld.


Item 5.            Other Information
 
None
 
Item 6.            Exhibits
 
a)
 
Exhibits
 
 
 
 
 
 
 
 
 
 
 
31.1
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
31.2
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
32.1
 
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
32.2
 
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
CELLEGY PHARMACEUTICALS, INC.
 
 
 
 
 
 
Date:
November 14, 2005
 
 
/s/ Richard C. Williams
 
 
 
Richard C. Williams
 
 
Chairman and Interim Chief Executive Officer
 
 
 
 
 
 
Date:
November 14, 2005
 
 
/s/ Robert J. Caso
 
 
 
Robert J. Caso
 
 
Vice President, Finance and Chief Financial Officer
 
 
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