HERON THERAPEUTICS, INC. /DE/ - Quarter Report: 2010 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2010

OR

For the transition period from              to             

Commission File Number 001-33221

A.P. PHARMA, INC.

(Exact name of registrant as specified in its charter)

(650) 366-2626

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the 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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

At October 31, 2010, the number of outstanding shares of the Company's common stock, par value $.01, was 40,112,960.

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A.P. Pharma, Inc

INDEX

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PART I. Financial Information

A.P. Pharma, Inc.

Condensed Balance Sheets

(in thousands)

See accompanying notes to condensed financial statements

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A.P. Pharma, Inc.

Condensed Statements of Operations

(in thousands, except per share amounts)

(Unaudited)

See accompanying notes to condensed financial statements.

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A.P. Pharma, Inc.

Condensed Statements of Cash Flows

(in thousands)

(Unaudited)

See accompanying notes to condensed financial statements.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements

September 30, 2010 and 2009 (unaudited)

(1) BUSINESS AND BASIS OF PRESENTATION

A.P. Pharma, Inc. (the “Company,” “we,” “us” and “our”) is a specialty pharmaceutical company focused on developing products using our proprietary Biochronomer™ polymer-based drug delivery technology designed to release drugs over a defined period of time. Our primary focus is on our lead product candidate, APF530, which is being developed for the prevention of chemotherapy-induced nausea and vomiting (CINV). In May 2009, we filed a New Drug Application (NDA) with the U.S. Food and Drug Administration (FDA) seeking approval for APF530. In March 2010, we received a Complete Response Letter to the APF530 NDA and we intend to respond to the issues in the Complete Response Letter in as timely and expeditious a manner as possible. We intend to discuss some of the issues with the FDA at an End of Review meeting prior to resubmitting the APF530 NDA. A date for this meeting has not been set. If we obtain regulatory approval for APF530, we intend to seek a collaborative arrangement to commercialize APF530, or anticipate obtaining additional funding and resources that would be required to launch APF350 without a partner.

In addition to APF530, we have a pipeline of other product candidates that use our Biochronomer technology. One product candidate, an undisclosed opiate for a long-acting pain management product, has been licensed on a world-wide basis to Merial Limited for use with companion animals. Further development of our pipeline products has been temporarily deferred in order to focus managerial, technical and financial resources on the APF530 resubmission responsive to issues identified in the March 2010 Complete Response Letter.

The accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. All adjustments (all of which are of a normal recurring nature) considered necessary for a fair presentation have been included. We have evaluated subsequent events through the date that these financial statements were issued. Operating results for the three and nine months ended September 30, 2010 are not indicative of the results that may be expected for the year ending December 31, 2010 or for any other period. The condensed balance sheet as of December 31, 2009 has been derived from the audited financial statements as of that date but it does not include all of the information and notes required by U.S. GAAP. These condensed financial statements and the notes thereto should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the Securities and Exchange Commission (SEC) on March 15, 2010 (our “2009 10-K”).

Going Concern Considerations

The accompanying financial statements have been prepared assuming we will continue as a going concern. We have incurred significant operating losses and negative cash flows from operations and have an accumulated deficit of $146.8 million as of September 30, 2010.

At September 30, 2010, we had cash and cash equivalents of $3.0 million and working capital of $2.3 million. Presently, we believe our cash resources are sufficient to fund our operations into the first quarter of 2011 since we continue to defer certain discretionary activities. We will require additional capital to fund our drug development and operating activities and are currently seeking additional financing to continue our activities, which may include a collaborative arrangement, an equity offering or a debt financing. If we are unable to complete such a financing or are unable to obtain sufficient financing on acceptable terms or otherwise, due to various factors including our ability to continue trading on the Nasdaq Capital Market, we may be required to further reduce, defer or discontinue our activities or may not be able to continue as a going concern.

In March 2010, we received a Complete Response Letter for our APF530 NDA. In the letter, the FDA raised questions which preclude the approval of the APF530 NDA in its current form. The full extent of activities, costs and time required to address the FDA’s questions is not currently known; however, we expect to clarify the actions required for resubmission and approval of our NDA at an End of Review meeting. A date for this meeting has not been set. Until we meet with the FDA and clarify the actions we need to take prior to resubmitting the NDA for APF530, we will not know how much additional cash may be required for approval of APF530.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. GAAP requires our management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ materially from those estimates. We evaluate our critical accounting policies and estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our 2009 10-K.

Recent Accounting Pronouncements

There have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended September 30, 2010, as compared to the recent accounting pronouncements described in our 2009 10-K, that are of significance, or potential significance to us, except as noted below.

In April 2010, the Financial Accounting Standards Board (FASB) issued ASU 2010-17, Revenue Recognition - Milestone Method (Topic 605). The ASU provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. ASU 2010-17 is effective on a prospective basis for milestones achieved in fiscal years and interim periods within those years, beginning on or after June 15, 2010. The adoption of ASU 2010-17 did not have a material impact on our financial position and results of operations.

In February 2010, the FASB issued ASU 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments in the ASU remove the requirement for an SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. The amendment is effective for interim or annual periods ending after June 15, 2010. The adoption of ASU 2010-09 did not have a material effect on our financial condition or results of operations.

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820) — Improving Disclosures about Fair Value Measurements. ASU No. 2010-06 requires an entity to disclose separately the amounts of significant transfers in and out of Level 1 and 2 fair value measurements, and describe the reasons for the transfers. Also, it requires additional disclosure regarding purchases, sales, issuances and settlements of Level 3 measurements. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for the additional disclosure of Level 3 measurements, which is effective for fiscal years beginning after December 15, 2010. The adoption of ASU 2010-06 did not have a material impact on our financial position and results of operations.

(2) CASH EQUIVALENTS

Our available-for-sale securities as of September 30, 2010 and December 31, 2009 consisted of money market funds primarily containing U.S. government-backed or collateralized overnight securities with original maturities of ninety days or less. The carrying value of our money market funds is included in cash equivalents and approximates their fair value.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

Fair Value Measurements

The three tier fair value hierarchy utilized prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require us to develop our own assumptions. The hierarchy requires us to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, we measure our available-for-sale securities at fair value. We used quoted prices in active markets (Level l) to measure our cash equivalents at fair value on a recurring basis in our balance sheets at September 30, 2010 and December 31, 2009. Cash equivalents consist of highly rated money market funds with maturities of ninety days or less, and are purchased daily at par value with specified yield rates. Due to the high ratings and short-term nature of these funds, we consider all cash equivalents as Level 1 inputs.

(3) NET LOSS PER SHARE INFORMATION

Basic and diluted net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per share excludes the effect of potentially dilutive securities because they are anti-dilutive. The following table shows the potentially dilutive options, unvested restricted stock awards and warrants outstanding (in thousands) for the nine months ended September 30, 2010 and 2009:

(4) STOCK-BASED COMPENSATION

The following table shows the stock-based compensation expense for all awards (in thousands, except per share amounts):

In the three months ended June 30, 2010, we recorded additional stock-based compensation expense as a result of accelerated vesting of stock options in connection with the resignation of our former chief executive officer.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

The following table summarizes option activity for the nine months ended September 30, 2010:

The following table summarizes restricted stock award activity for the nine months ended September 30, 2010:

Employee Stock Purchase Plan. We adopted an Employee Stock Purchase Plan (Purchase Plan) in 1997. Qualified employees may elect to have a certain percentage of their salary withheld to purchase shares of our common stock under the Purchase Plan. The purchase price per share is equal to 85% of the fair market value of the stock on specified dates. Sales under the Purchase Plan during the nine months ended September 30, 2010 and 2009 were 25,567 and 57,336 shares at an average price of $0.68 and $0.42, respectively. Shares available for future purchase under the Purchase Plan are 132,512 at September 30, 2010.

(5) COMPREHENSIVE LOSS

Comprehensive loss for the three and nine months ended September 30, 2010 and 2009 consists of the following (in thousands):

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

(6) INCOME TAXES

There was no provision for income taxes for three and nine months ended September 30, 2010 or 2009 because we incurred net operating losses.

(7) STOCKHOLDERS’ EQUITY

Private Placement

In October 2009, in a private placement, we sold 7,954,543 shares of our common stock at $0.88 per share and warrants to purchase 3,977,270 shares of our common stock, exercisable through January 7, 2015, at $0.88 per share (Private Placement). The purchasers paid an additional $0.125 per underlying share for the warrants. Additionally the purchasers had the right to purchase up to an additional 5,165,286 shares at $0.97 per share prior to May 14, 2010 and paid $0.125 per underlying share for the right to purchase such additional shares. Total proceeds were approximately $7.9 million, after deducting expenses associated with the issuance. We were required to prepare and file Form S-3 registration statements, as permissible under SEC rules and regulations, beginning within 30 days of October 22, 2009, with the SEC for the purpose of registering the securities sold in this Private Placement for resale. We filed a Form S-3 covering 7,532,617 shares on November 6, 2009, which was declared effective by the SEC on November 17, 2009. However, if we fail to keep any registration statements continuously effective, we may be obligated to pay to the holders of the shares and warrants liquidated damages in the amount of 1% per month of the purchase price for the shares and warrants, up to a maximum cap of 8% of such purchase price. In addition, in connection with the closing of the Private Placement, Baker Brothers Investments was granted the right to designate a representative to our board of directors. In February 2010, Stephen R. Davis was appointed to our board of directors as the Baker Brothers Investments designee.

On May 14, 2010, the right of the investors to purchase up to an additional 5,165,286 shares of our common stock at $0.97 per share under the Private Placement expired unexercised. Additionally, the right granted to Baker Brothers Investments to designate an additional representative to our board of directors should they exercise their right to purchase designated additional shares of our common stock under the terms of the securities purchase agreement relating to the Private Placement also expired on May 14, 2010. On June 30, 2010, we filed a Form S-3 covering the remaining 421,926 shares of our common stock related to the October 2009 Private Placement and the 3,977,270 shares of our common stock underlying the warrants, which was declared effective by the SEC on July 8, 2010.

Shareholders’ Rights Plan

In connection with the Private Placement in October 2009, we amended our Preferred Shareholders Rights Agreement to permit Tang Capital Partners and Baker Brothers Investments, both purchasers in the Private Placement, to each beneficially own up to 34% and 30%, respectively, of our outstanding common stock. Once exercisable, each right entitles the holder to purchase, at a price of $44.00, one one-thousandth of a share of Series A Participating Preferred Stock. For a limited period of time following the announcement of any such acquisition or offer, the rights are redeemable by us at a price of $0.01 per right.

If the rights are not redeemed or exchanged, each right will then entitle the holder to receive, upon exercise of such right, a number of shares of our common stock having a then current value equal to two times the purchase price of such right. Similarly, if the rights are not redeemed or exchanged, and following the acquisition of 20% (34% for Tang Capital Partners, LP and 30% for Baker Brothers Investments) or more of the outstanding shares of our common stock by a person or group of affiliated or associated persons: (i) we consolidate with or merge into another entity; (ii) another entity consolidates with or merges into us; or (iii) we sell or otherwise transfer 50% or more of our consolidated assets or earning power, each right will then entitle the holder to receive, upon exercise of such right, a number of shares of common stock of the acquiring company having a then current value equal to two times the purchase price. For a limited period of time after the exercisability of the rights, each right, at the discretion of the board of directors, may be exercised for such number of shares of common stock determined in accordance with the rights agreement. We have initially reserved 200,000 shares of preferred stock pursuant to the exercise of these rights. These rights expire on December 31, 2016.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

2007 Equity Incentive Plan

At our annual meeting in May 2010, our stockholders approved an amendment to our 2007 Equity Incentive Plan to increase the maximum number of shares of common stock available for grant by 2,000,000 shares of common stock, resulting in an aggregate of 5,000,000 shares of common stock authorized for issuance pursuant to awards granted under our 2007 Equity Incentive Plan.

(8) DISCONTINUED OPERATIONS

Cosmeceutical and Toiletry Business

On July 25, 2000, we completed the sale of certain technology rights for our cosmeceutical and toiletry business to RP Scherer Corporation (RP Scherer), a subsidiary of Cardinal Health, Inc. Under the terms of the agreement with RP Scherer, we guaranteed a minimum gross profit percentage on RP Scherer’s combined sales of products to Ortho Neutrogena (Ortho) and Dermik Laboratories, Inc. (Dermik) (Gross Profit Guaranty). The guaranty period initially commenced on July 1, 2000 and was to end on the earlier of July 1, 2010 or the end of two consecutive guaranty periods where the combined gross profit on sales to Ortho and Dermik equals or exceeds the guaranteed gross profit (the “two period test”). The Gross Profit Guaranty expense totaled $944,000 for the first seven guaranty years and in those years profits did not meet the two period test. Effective March 2007, in conjunction with a sale of assets by RP Scherer’s successor company to an Amcol International subsidiary (Amcol), a new agreement was signed between us and Amcol to provide continuity of product supply to Ortho and Dermik. This new agreement potentially extends the Gross Profit Guaranty period an additional three years to July 1, 2013, unless it is terminated earlier with the two period test. Amcol has indicated that its costs differ from those it charged historically to the RP Scherer successor company to produce the products. We have requested documentation of the actual costs, but have accrued at the amount Amcol represents it is currently owed. As there is no minimum amount of Gross Profit Guaranty due, no accrual for the guaranty is estimable for future years. A liability of $0.6 million related to the current amount due under gross profit guarantees is recorded as accrued disposition costs as of September 30, 2010.

The cosmeceutical and toiletry business is reported as discontinued operations for all periods presented in the accompanying Consolidated Statements of Operations.

Loss from discontinued operations represents primarily the loss attributable to changes in estimates of our cosmeceutical and toiletry business that was sold to RP Scherer on July 25, 2000, as follows (in thousands):

There was no material basic and diluted loss per common share from discontinued operations for the three and nine months ended September 30, 2010 and 2009.

(9) SIGNIFICANT AGREEMENTS

Merial Limited

In September 2009, we entered into a world-wide license and development agreement with Merial Limited, a world leading animal health company, for a long-acting pain management product for cats and dogs. The license and development agreement follows a successful proof-of concept agreement. Under the terms of the new agreement, we received an upfront license fee and will receive development funding and potential future milestones in addition to royalties following commercialization.

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A.P. Pharma, Inc.

Notes to Condensed Financial Statements—(Continued)

September 30, 2010 and 2009 (unaudited)

Under the license and development agreement, we are obligated to perform reimbursable development services and provide any improvements related to the licensed technology during the six-year development period. We are recognizing the upfront license fee ratably over the development period, and will recognize revenue from the development services when the services are rendered. Any milestone payments will be recognized when receipt of the payments is probable.

We recognized $0.3 million and $0.1 million of revenue related to development services to Merial Limited in the three months ended September 30, 2010 and 2009, respectively, and $1.0 million and $0.1 million in the nine months ended September 30, 2010 and 2009, respectively.

Paul Royalty Fund

On January 18, 2006, we sold our rights to royalties on sales of Retin-A Micro^® and Carac^®, effective October 1, 2005, to an affiliate of the Paul Royalty Fund for up to $30 million. Proceeds of $25 million were received upon the closing of the transaction and used primarily to fund the Phase 3 pivotal trial of APF530, our drug candidate for the prevention of both acute and delayed CINV. The remaining $5 million was to be received upon the achievement of certain milestones over the successive four years. Upon attainment of one milestone in 2007, an additional $2.5 million was received. The final $2.5 million was received in January 2010. No additional payments are due to us.

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Forward-looking Statements

This Form 10-Q contains “forward-looking statements” as defined by the Private Securities Reform Act of 1995. These forward-looking statements involve risks and uncertainties including uncertainties associated with: the progress of our research, development and clinical programs, the possibility that the FDA will require us to take additional steps before resubmitting our NDA for APF530, which will require substantial time and expense on our part, and the timing of regulatory approval and commercial introduction of APF530 and future product candidates; our ability to market, commercialize and achieve market acceptance for APF530 or other future product candidates; our ability to establish collaborations for our technology, APF530 and other future product candidates; our estimates for future performance; our estimates regarding our capital requirements and our needs for additional financing; and other risks and uncertainties identified in our filings with the Securities and Exchange Commission. We caution investors that forward-looking statements reflect our analysis only on their stated date. We do not intend to update them except as required by law.

Overview

We are a specialty pharmaceutical company focused on developing products using our proprietary Biochronomer polymer-based drug delivery technology. The Biochronomer technology consists of bioerodible polymers designed to release drugs over a defined period of time. Our primary focus is on our lead product candidate, APF530, which is being developed for the prevention of chemotherapy-induced nausea and vomiting (CINV). APF530 contains the 5-HT3 antagonist, granisetron, formulated in our proprietary Biochronomer drug delivery system, which allows therapeutic drug levels to be maintained for five days with a single subcutaneous injection. In May 2009, we filed a New Drug Application (NDA) with the U.S. Food and Drug Administration (FDA) seeking approval for APF530. During 2008, APF530 completed a pivotal Phase 3 clinical trial which was the basis for the application. In March 2010, we received a Complete Response Letter to the APF530 NDA and intend to respond to the issues in the Complete Response Letter in as timely and expeditious a manner as possible. We intend to discuss some of the issues with the FDA at an End of Review meeting prior to resubmitting the APF530 NDA. A date for this meeting has not been set. Until we meet with the FDA and clarify the actions we need to take prior to resubmitting the NDA for APF530, we will not know what additional expenses and how much time may be required for approval of APF530. If we obtain regulatory approval for APF530, we intend to seek a collaborative arrangement to commercialize APF530, or anticipate obtaining additional funding and resources that would be required to launch APF530 without a partner.

In addition to APF530, we have a pipeline of other product candidates that use our Biochronomer technology. One product candidate, an undisclosed opiate for a long-acting pain management product, has been licensed on a world-wide basis to Merial Limited for use with companion animals. Further development of our pipeline products has been temporarily deferred in order to focus managerial, technical and financial resources on the APF530 resubmission responsive to issues identified in the March 2010 Complete Response Letter.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions. Management bases these estimates and assumptions on historical results and known trends as well as management forecasts. Actual results could differ from these estimates and assumptions. See our Annual Report on Form 10-K for the year ended December 31, 2009 in Part II, Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates.”

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Recent Accounting Pronouncements

Recent accounting pronouncements are disclosed in Note 1 to the Condensed Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q.

Results of Operations for the Three and Nine months Ended September 30, 2010 and 2009

Contract revenue, which is derived from work performed under collaborative research and development arrangements, was $0.4 million and $1.1 million for the three months ended September 30, 2010 and 2009, respectively and $1.1 million for both the nine months ended September 30, 2010 and 2009. The majority of our contract revenue for the three and nine months ended September 30, 2010 was derived from an agreement with Merial Limited we entered into in September 2009 for a long-acting pain management product for companion animals. Contract revenues for the three and nine months ended September 30, 2009 included $1.0 million of revenue recognized upon termination of our agreement with RHEI Pharmaceuticals, Inc.

The amount of contract revenue varies from period to period depending on the level of activity requested of us by our collaborators. Therefore, we cannot predict the amount of contract revenue in future periods.

Our research and development costs consist primarily of employee salaries and other personnel-related expenses, facility-related expenses, laboratory consumables, polymer development manufacturing, clinical and pre-clinical related services performed by clinical research organizations, research institutions and other outside service providers.

Research and development expenses under collaborative agreements approximate the revenue recognized, excluding milestone and up-front payments received under such arrangements.

Research and development expense for the three months ended September 30, 2010 increased by $0.1 million from $1.4 million for the three months ended September 30, 2009 to $1.5 million. The slight increase was primarily due to costs associated with the development, manufacturing and project-related expenses related to our NDA submission to the FDA. Research and development expense for the nine months ended September 30, 2010 decreased by $0.6 million from $6.4 million for the nine months ended September 30, 2009 to $5.8 million. The decrease in research and development expenses for the nine months ended September 30, 2010 as compared with the comparable period in 2009 was primarily due to headcount reductions in May 2009 and the suspension of other research and development projects to conserve resources which were partially offset by increased development, manufacturing and project-related expenses related to our NDA submission to the FDA. Research and development expense for the year 2010 is expected to be slightly lower as compared to 2009 for the same reasons mentioned above related to the decrease for the nine months ended September 30, 2010.

Our general and administrative costs consist of salaries and related expenses, professional fees, directors’ fees, investor relations costs, insurance expense and related overhead cost allocation.

General and administrative expense for the three months ended September 30, 2010 decreased by $0.5 million from $0.9 million for the three months ended September 30, 2009 to $0.4 million. The net decrease in the three months ended September 30, 2010 was primarily a result of cost containment measures associated with our headcount reductions in May 2009 and outside services. General and administrative expense for the nine months ended September 30, 2010 increased by $0.7 million from $2.9 million for the nine months ended September 30, 2009 to $3.6 million. The net increase in the nine months ended September 30, 2010 included compensation expense incurred in the three months ended June 30, 2010 related to the resignation of our chief executive officer which was partially offset by lower expense resulting from the cost containment measures associated with our headcount reductions in May 2009 and outside services. General and administrative expense is expected to be higher in 2010, as compared to 2009, primarily due to the compensation expense related to the resignation of our former chief executive officer.

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In January 2010, we received a $2.5 million milestone payment from an affiliate of the Paul Royalty Fund. The payment represents a milestone payment that became due to us in January 2010 under an agreement that we entered into effective October 1, 2005 to sell our royalty rights to Retin-A Micro^® and Carac^®. No additional payments are due to us under this agreement.

Loss from discontinued operations for the three and nine months ended September 30, 2010 was $36,000 and $47,000, respectively, which represents the loss attributable to the Gross Profit Guaranty associated with the sale of our cosmeceutical and toiletry business. There was no Gross Profit Guaranty gain or loss for the three and nine months ended September 30, 2009. See Note 8 of Notes to Condensed Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q.

Capital Resources and Liquidity

We had cash and cash equivalents of $3.0 million at September 30, 2010. Cash and cash equivalents decreased by $4.6 million at September 30, 2010 from December 31, 2009 due primarily to our operating loss for the nine months ended September 30, 2010, offset by the receipt of the $2.5 million milestone from an affiliate of the Paul Royalty Fund.

In October 2009, we sold 7,954,543 shares of our common stock in a private placement at $0.88 per share and warrants to purchase 3,977,270 shares of our common stock, exercisable through January 7, 2015, at $0.88 per share (the Private Placement). The purchasers paid an additional $0.125 per underlying share for the warrants. Additionally the purchasers had a right to purchase up to an additional 5,165,286 shares at $0.97 per share prior to May 14, 2010 and paid $0.125 per underlying share for the right to purchase such additional shares. No purchasers exercised their right to purchase up to an additional 5,165,286 shares of our common stock at $0.97 per share under the Private Placement and the right expired unexercised on May 14, 2010. Total proceeds were approximately $7.9 million, after deducting expenses associated with the issuance. We were required to prepare and file Form S-3 registration statements, as permissible under SEC rules and regulations, with the SEC for the purpose of registering for resale the securities sold in this transaction. On November 6, 2009, we filed a Form S-3 covering 7,532,617 shares of our common stock sold in a private placement, which was declared effective by the SEC on November 17, 2009. On June 30, 2010, we filed a Form S-3 covering the remaining 421,926 shares of our common stock related to the Private Placement and the 3,977,270 shares of our common stock underlying the warrants, which was declared effective by the SEC on July 8, 2010.

Net cash used in continuing operating activities for the nine months ended September 30, 2010 was $4.6 million, compared to net cash used of $9.0 million for the nine months ended September 30, 2009. The $4.4 million decrease in net cash used by continuing operating activities from 2009 to 2010 was primarily due to the $2.4 million decrease in net loss for the nine months ended September 30, 2010, as compared to the same period in 2009, a $0.9 million decrease from non-cash changes primarily related to stock compensation expense and deferred revenue and a $1.1 million net change in other operating assets and liabilities.

Net cash used in investing activities for the nine months ended September 30, 2010 was $75,000 compared to net cash of $572,000 provided by investing activities for the nine months ended September 30, 2009. The change in 2010 from 2009 in cash flows associated with investing activities was primarily due to the purchase of equipment in the nine months ended September 30, 2010 and maturities of marketable securities in the nine months ended September 30, 2009.

Net cash provided by financing activities for the nine months ended September 30, 2010 was $60,000 compared to net cash provided of $29,000 for the nine months ended September 30, 2009. The increase is due primarily to higher proceeds from stock option exercises.

Historically, we have financed our operations, including technology and product research and development, primarily through sales of our common stock, royalties received, the sale of our rights to royalties, income from collaborative research and development fees, proceeds received from the sales of our Analytical Standards division and our cosmeceutical and toiletry business and interest earned on short-term investments.

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In March 2010, we received a Complete Response Letter for our APF530 NDA. In the letter, the FDA raised questions which preclude the approval of the APF530 NDA in its current form. The full extent of activities, costs and time required to address the FDA’s questions is not currently known, however, we expect to clarify the actions required for resubmission and approval of our NDA at an End of Review meeting. A date for this meeting has not been set. Until we meet with the FDA and clarify the actions we need to take prior to resubmitting the NDA for APF530, we will not know how much additional cash may be required for approval of APF530. The amount of additional funding that we may require depends on various factors, including the results of the on-going regulatory review by the FDA of our APF530 NDA, our efforts to respond to the FDA’s Complete Response Letter, our ability to establish a partnership with a pharmaceutical company for the commercialization of APF530, the time and costs related to manufacturing of APF530, if approved, and technological and market developments from drugs that may compete with APF530.

Presently, we believe our cash resources are sufficient to fund our operations into the first quarter of 2011. We will require additional funding to support our continued operations. Our capital requirements going forward will depend on numerous factors including: the number and characteristics of product development programs we pursue and the pace of each program; the scope, rate of progress, results and costs of preclinical testing and clinical trials; the time, cost and outcome involved in seeking regulatory approvals; scientific progress in our research and development programs; the magnitude and scope of our research and development programs; our ability to establish and maintain strategic collaborations or partnerships for research, development, clinical testing; manufacturing and marketing of our product candidates; the cost and timing of establishing sales, marketing and distribution capabilities for a specialty sales force if we commercialize any products independently; the cost of establishing clinical and commercial supplies of our product candidates and any products that we may develop; and general market conditions.

We are currently seeking additional financing to continue our activities, which may include a collaborative arrangement, an equity offering, debt financing, or some combination of these funding sources. If we are unable to complete such a financing or are unable to obtain sufficient financing on acceptable terms or otherwise, due to various factors including our ability to continue trading on the Nasdaq Capital Market, we may be required to further reduce, defer, or discontinue our activities or may not be able to continue as a going concern.

We may not be able to raise sufficient additional capital when we need it or to raise capital on favorable terms. The sale of additional equity or convertible debt securities in the future may be dilutive to our stockholders, and debt financing arrangements may require us to pledge certain assets and enter into covenants that could restrict certain business activities or our ability to incur further indebtedness and may contain other terms that are not favorable to us or our stockholders. If we are unable to obtain adequate funds on reasonable terms, we may be required to curtail operations significantly or to obtain funds by entering into financing, supply or collaboration agreements on unattractive terms. We do not currently have the financial resources to launch APF530. If APF530 is approved, we anticipate pursuing either a collaborative arrangement with a partner who will provide the necessary financial resources and expertise to launch APF530 or anticipate obtaining additional funding and resources that would be required to launch APF530 without a partner. There can be no assurance that APF530 will be approved and, if approved, that we will be successful in obtaining the additional necessary financial resources and expertise, with or without a partner, that will be required to launch APF530.

Below is a summary of fixed payments related to certain contractual obligations (in thousands). This table excludes amounts already recorded on our condensed balance sheet as current liabilities as of September 30, 2010.

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Off- Balance Sheet Arrangements

As of September 30, 2010 we did not have any off-balance sheet arrangements.

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. Due to the financial crisis and our anticipated cash flow requirements, we have 100% of our available cash and cash equivalents in cash and a money market fund containing U.S. Government-backed or collateralized overnight securities.

Evaluation of disclosure controls and procedures: We carried out an evaluation, under the supervision and with the participation of our management, including the Acting Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) and 15(d)-15(e) of the Securities and Exchange Act of 1934. Based upon that evaluation, the Acting Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2010, the end of period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in internal controls: During the three months ended September 30, 2010, there have been no significant changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

There have been no material changes to the risk factors set forth in the “Risk Factors” section of our 2009 Annual Report on Form 10-K other than the following:

We may not obtain regulatory approval for APF530 or any of our product candidates. Regulatory approval may also be delayed or cancelled or may entail limitations on the indicated uses of a proposed product.

The process for obtaining approval of a New Drug Application (NDA) is time consuming, subject to unanticipated delays and costs, and requires the commitment of substantial resources. The regulatory process, particularly for pharmaceutical product candidates like ours, is uncertain, can take many years and requires the expenditure of substantial resources. Any product that we develop must receive all relevant regulatory agency approvals or clearances, if any, before it may be marketed in the United States or other countries. In particular, human pharmaceutical therapeutic products are subject to rigorous preclinical and clinical testing and other requirements by the U.S. Food and Drug Administration (FDA or Agency) and similar health authorities in foreign countries. We may not receive necessary regulatory approvals or clearances to market APF530 or any other product candidate.

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On March 19, 2010, we announced that we had received a Complete Response Letter from the FDA which stated that the NDA we submitted in May 2009 requesting approval of APF530 could not be approved in its present form. The primary points raised in the FDA Complete Response Letter are as follows:

Dosing System

Chemistry, Manufacturing and Control

Clinical

We intend to discuss some of the issues with the FDA at an End of Review meeting prior to resubmitting the APF530 NDA. A date for this meeting has not been set.

Our NDA for APF530 may not be approved after our resubmission, or approval may be delayed, as a result of changes in FDA policies for drug approval prior to the resubmission of our NDA. For example, although many products have been approved by the FDA in recent years under Section 505(b)(2) under the Federal Food, Drug and Cosmetic Act, objections have been raised to the FDA’s interpretation of Section 505(b)(2). If challenges to the FDA’s interpretation of Section 505(b)(2) are successful, the Agency may be required to change its interpretation, which could delay or prevent the approval of our NDA for APF530. The review of our resubmitted NDA may also be delayed due to the FDA’s internal resource constraints.

Additionally, data obtained from preclinical and clinical activities is susceptible to varying interpretations that could delay, limit or prevent regulatory agency approvals or clearances. For example, the FDA may require additional clinical data to support approval, such as confirmatory studies and other data or studies to address questions or concerns that may arise during the FDA review process.

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Delays in resubmitting an NDA and obtaining regulatory agency approval for APF530, or a second Complete Response letter, would, among other consequences:

All of these consequences would increase our need for additional capital resources.

Even if granted, regulatory approvals may include significant limitations on the uses for which products may be marketed. Failure to comply with applicable regulatory requirements can, among other things, result in warning letters, imposition of civil penalties or other monetary payments, delay in approving or refusal to approve a product candidate, suspension or withdrawal of regulatory approval, product recall or seizure, operating restrictions, interruption of clinical trials or manufacturing, injunctions and criminal prosecution.

In addition, the marketing and manufacturing of drugs and biological products are subject to continuing FDA review, and later discovery of previously unknown problems with a product, its manufacture or its marketing may result in the FDA requiring further clinical research or restrictions on the product or the manufacturer, including withdrawal of the product from the market.

Additional capital will be needed to enable us to implement our business plan, and we may be unable to raise capital when needed, which would force us to limit or cease our operations and related product development programs. Raising such capital may have to be accomplished on unfavorable terms, possibly causing dilution to our existing stockholders.

As disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the SEC on March 15, 2010, we believed we had sufficient cash resources to fund operations through fiscal year 2010. On March 19, 2010 we announced the receipt of a Complete Response Letter from the FDA on the APF530 NDA. In the letter, the FDA raised questions which preclude the approval of the APF530 NDA in its current form. The full extent of activities, costs and time required to address the FDA’s questions is not currently known, however, we expect to clarify the actions required for resubmission and approval of our NDA at an End of Review meeting. A date for this meeting has not been set. Until we meet with the FDA and clarify the actions we need to take prior to resubmitting the NDA for APF530, we will not know how much additional cash may be required to reach approval for APF530.

We presently expect current capital resources to allow us to operate into the first quarter of 2011 as we continue to defer certain discretionary activities. We will require additional capital to fund our drug development and operating activities. If we are unable to complete a collaborative arrangement, equity offering, debt financing or otherwise obtain sufficient financing, we may be required to further reduce, defer, or discontinue our activities or may not be able to continue as a going concern. In addition, the amount of additional funding that we may require in 2011 and beyond depends on various factors, including the results of an End of Review Meeting with the FDA for our APF530 NDA, our ability to establish a partnership with a pharmaceutical company for the commercialization of APF530, the time and costs related to manufacturing APF530, if approved, and technological and market developments that compete with APF530. We do not currently have the financial resources to launch APF530. If APF530 is approved, we anticipate pursuing either a collaborative arrangement with a partner who will provide the necessary financial resources and expertise to launch APF530 or anticipate obtaining additional funding and resources that would be required to launch APF530 without a partner. There can be no assurance that APF530 will be approved and, if approved, that we will be successful in obtaining the additional necessary financial resources and expertise, with or without a partner, that will be required to launch APF530.

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In addition, the timing and degree of any longer-term capital requirements will depend on many factors, including:

We do not anticipate that we will generate significant continuing revenues for at least several years, if ever. Until we can generate significant continuing revenues, we expect to satisfy our future cash needs through public or private equity offerings, debt financings, as well as strategic collaborations, in the form of license fees, research and development fees and milestone payments. If we issue additional equity securities or securities convertible into equity securities to raise funds, our stockholders will suffer dilution of their investment and it may adversely affect the market price of our common stock. Any debt financing we enter into may involve covenants that restrict our operations. These restrictive covenants may include, among other things, limitations on borrowing, specific restrictions on the use of our assets, as well as prohibitions on our ability to create liens, pay dividends, redeem capital stock or make investments. In the event that additional funds are obtained through arrangements with collaborative partners, these arrangements may require us to relinquish rights to some of our technologies, product candidates or products on terms that are not favorable to us or require us to enter into a collaboration arrangement that we would otherwise seek to develop and commercialize ourselves. If adequate funds are not available, we may again be required to delay, reduce the scope of, or eliminate one or more of our product development programs and reduce personnel-related and other costs, which will have a material adverse effect on our business.

If our suppliers and contract manufacturers fail to complete pre-commercialization manufacturing development activities for APF530 on a timely basis or fail to comply with stringent regulatory requirements, we will face delays in our ability to obtain regulatory approval for, and to commercialize, APF530, and our costs will increase.

We do not manufacture APF530, and do not currently plan to develop any capacity to do so. Instead, we have relied on third-parties to manufacture and perform important pre-commercialization manufacturing development activities for APF530. As part of the process for obtaining regulatory approval, we must demonstrate that the facilities, equipment and processes used to manufacture APF530 are capable of consistently producing a product that meets all applicable quality criteria, and that is comparable to the product that was used in our clinical trials. We must also provide the FDA with information regarding the validation of the manufacturing facilities, equipment and processes of our third-party suppliers and manufacturers, and data supporting the stability of APF530. If our third-party suppliers and manufacturers are not in compliance with current good manufacturing practice requirements, the approval of our marketing application may be delayed, existing product batches may be compromised, and we may experience delays in the availability of APF530 for commercial distribution.

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For example, our Complete Response Letter from the FDA regarding our NDA submission for APF530 stated that the NDA could not be approved in its present form due to, among other issues, deficiencies observed during an inspection of the facilities used by our third-party suppliers and manufacturers to produce APF530. We anticipate that our third-party suppliers and manufacturers will submit a response to the FDA to address such issues. If the FDA is not satisfied with these responses and any corrective actions taken by these third parties, or if the FDA determines that it is necessary to re-inspect our third-party suppliers’ and manufacturers’ facilities before agreeing that the inspectional observations have been adequately addressed, we may be required to complete additional manufacturing development activities or provide other information in order to resubmit our NDA, which could cause substantial delays in obtaining regulatory approval for APF530, increase our costs and have a material adverse effect on our business and financial condition.

Our common stock may be delisted from The NASDAQ Capital Market, which could negatively impact the price of our common stock and our ability to access the capital markets.

Our common stock is currently listed on The NASDAQ Capital Market. The listing standards of The NASDAQ Capital Market require that a company maintain stockholders’ equity of at least $2.5 million and a minimum bid price subject to specific requirements of $1.00 per share.

On May 18, 2010, we received a letter from the Nasdaq Stock Market (Nasdaq) indicating that the minimum closing bid price of our common stock had fallen below $1.00 for 30 consecutive days, and therefore, we were not in compliance with the listing standards. As of September 30, 2010, our stockholders’ equity met the $2.5 million minimum required for continued listing on the NASDAQ Capital Market. We have been provided 180 calendar days, or until November 15, 2010, to regain compliance with the minimum bid price requirement. To regain compliance, our share price must exceed $1.00 for a minimum of 10 consecutive business days prior to November 15, 2010. Since as of the filing of this 10Q report, our share price has remained below $1.00, we anticipate receiving a written notification that our shares are subject to delisting. We will have the opportunity to appeal this notice and present Nasdaq with a plan for regaining compliance.

Should we fail to comply with the minimum listing standards applicable to issuers listed on The NASDAQ Capital Market, our common stock may be delisted from The NASDAQ Capital Market. If our common stock is delisted, it could significantly reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the delisting of our common stock could materially adversely affect our access to the capital markets, and any limitation on liquidity or reduction in the price of our common stock could materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting from The NASDAQ Capital Market could also result in other negative implications, including the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest and fewer business development opportunities.

Exhibit 31.1 - Certification of Chief Executive Officer pursuant to Rule 13A-14(a) promulgated under the Securities Exchange Act of 1934 as amended.

Exhibit 31.2 - Certification of Chief Financial Officer pursuant to Rule 13A-14(a) promulgated under the Securities Exchange Act of 1934 as amended.

Exhibit 32.1 - Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.2 - Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted 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.

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