XOMA Corp - Quarter Report: 2009 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, 2009

or

For the transition period from              to             

Commission File No. 0-14710

XOMA Ltd.

(Exact name of registrant as specified in its charter)

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, or a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act). (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act of 1934).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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XOMA Ltd.

FORM 10-Q

TABLE OF CONTENTS

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PART I - FINANCIAL INFORMATION

XOMA Ltd.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

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

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XOMA Ltd.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share amounts)

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

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XOMA Ltd.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

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

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

XOMA Ltd. (“XOMA” or the “Company”), a Bermuda company, is a biopharmaceutical company that discovers, develops and manufactures therapeutic antibodies designed to treat inflammatory, autoimmune, infectious and oncological diseases. The Company’s products are presently in various stages of development and are subject to regulatory approval before they can be commercially launched. The Company receives royalties from UCB Celltech, a branch of UCB S.A., on sales of CIMZIA^® for the treatment of Crohn’s disease and moderate-to-severe rheumatoid arthritis. Through the second quarter of 2009, XOMA also received royalties from Genentech, Inc., a wholly-owned member of the Roche Group (referred to herein as “Genentech”) on LUCENTIS^®, for the treatment of neovascular (wet) age-related macular degeneration. In the third quarter of 2009, the Company sold its LUCENTIS^® royalty stream to Genentech. XOMA’s pipeline includes both proprietary products and collaborative programs at various stages of preclinical and clinical development.

Liquidity and Financial Condition

The Company has incurred significant operating losses and negative cash flows from operations since its inception. As of September 30, 2009, the Company had cash and cash equivalents of $27.7 million. Based on cash and cash equivalents on hand at September 30, 2009 and anticipated spending levels, revenues, collaborator funding, government funding and other sources of funding the Company believes to be available, the Company estimates that it has sufficient cash resources to meet its anticipated net cash needs into 2011.

In September of 2009, the Company fully repaid its term loan facility with Goldman Sachs Specialty Lending Holdings, Inc. (“Goldman Sachs”). As previously disclosed, the Company was not in compliance with the requirements of the relevant provisions of this loan facility, due to the cessation of royalties from sales of RAPTIVA^® related to its market withdrawal in the first half of 2009. Repayment of this loan facility discharged all of the Company’s obligations to the lenders.

Also in the third quarter of 2009, the Company raised approximately $26.4 million in two separate financing transactions, before deducting placement agent fees and estimated offering expenses of approximately $0.4 million, with Azimuth Opportunity Ltd. (“Azimuth”). The Company sold approximately 34.3 million common shares to Azimuth in these financing transactions. The net proceeds from the first transaction, approximately $12.3 million, were used, together with other funds, to repay the Goldman Sachs term loan. Refer to Note 5: Debt and Other Financings – Goldman Sachs Term Loan and Equity Line of Credit for additional disclosure relating to these transactions.

The Company entered into an At Market Issuance Sales Agreement (the “ATM Agreement”), with Wm Smith & Co. (“Wm Smith”) in the third quarter of 2009, under which the Company may sell up to 25,000,000 of its common shares from time to time through Wm Smith, as the agent for the offer and sale of the common shares. Wm Smith may sell these common shares by any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 of the Securities Act of 1933, including but not limited to sales made directly on the NASDAQ Global Market, on any other existing trading market for the common shares or to or through a market maker. Wm Smith may also sell the common shares in privately negotiated transactions, subject to the Company’s approval. The Company will pay Wm Smith a commission equal to 3% of the gross proceeds of all common shares sold through it as sales agent under the ATM Agreement but in no event less than $0.02 per share. Shares sold under the ATM Agreement will be sold pursuant to a prospectus which forms a part of a registration statement declared effective by the Securities and Exchange Commission on May 29, 2008.

        In September of 2009, the Company received notice from the NASDAQ Stock Market that for the thirty consecutive business days preceding September 15, 2009, the bid price of XOMA’s common shares closed below the minimum $1.00 per share requirement under Marketplace Rule 4450(a)(5) for continued inclusion on the NASDAQ Global Market. This notice has no effect on the listing of XOMA’s common shares at this time, and the Company has an initial period of 180 calendar days to regain compliance with this requirement. If at any time before March 15, 2010, the bid price of the Company’s common shares closes at $1.00 per share or more for at least ten consecutive business days, NASDAQ will provide written notification that the Company has achieved compliance, although NASDAQ may require the Company to maintain a closing bid price for a longer period before determining that XOMA has achieved compliance. If the Company does not regain compliance by March 15, 2010, NASDAQ would provide written notification that the Company’s common shares will be delisted, after which the Company may appeal to the NASDAQ Listing Qualifications Panel. Alternatively, the Company could apply to transfer its common shares to The NASDAQ Capital Market if it satisfies all of the requirements, other than the minimum bid price requirement, for initial listing on The NASDAQ Capital Market set forth in

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Marketplace Rule 5505. If the Company were to elect to apply for such transfer and if the Company satisfies the applicable requirements and its application is approved, the Company would have an additional 180 days to regain compliance with the minimum bid price rule while listed on The NASDAQ Capital Market. The Company is considering alternative strategies to address this issue if necessary.

The Company may be required to raise additional funds through public or private financings, strategic relationships, or other arrangements. The Company cannot assure that the funding, if needed, will be available on terms attractive to it, or at all. Furthermore, any additional equity financings may be dilutive to shareholders and debt financing, if available, may involve covenants that place substantial restrictions on the Company’s business. The Company’s failure to raise capital as and when needed could have a negative impact on its financial condition and its ability to pursue business strategies. If adequate funds are not available, the Company has developed contingency plans that may require the Company to delay, reduce the scope of, or eliminate one or more of its development programs. In addition, the Company may be required to reduce personnel and related costs and other discretionary expenditures that are within the Company’s control.

The accompanying interim financial statements have been prepared assuming the Company will continue to operate as a going concern, which contemplates the realization of assets and the settlement of liabilities in the normal course of business. The interim financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from uncertainty related to the Company’s ability to continue as a going concern.

Basis of Presentation

The condensed consolidated financial statements include the accounts of XOMA and its subsidiaries. All intercompany accounts and transactions were eliminated during consolidation. The unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q. These financial statements and related disclosures have been prepared with the assumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these statements should be read in conjunction with the audited Consolidated Financial Statements and related Notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, filed with the SEC on March 11, 2009.

In the opinion of management, the unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the Company’s consolidated financial position as of September 30, 2009, the consolidated results of the Company’s operations for the three and nine months ended September 30, 2009 and 2008, and the Company’s cash flows for the nine months ended September 30, 2009 and 2008. The condensed consolidated balance sheet amounts at December 31, 2008 have been derived from the audited consolidated financial statements. The interim results of operations are not necessarily indicative of the results that may occur for the full fiscal year or future periods.

The Company has evaluated subsequent events through November 9, 2009, the date on which the financial statements being presented were issued, and not beyond that date.

Use of Estimates and Reclassifications

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, management evaluates its estimates, including those related to revenue recognition, research and development expense, long-lived assets, warrant liabilities and share-based compensation. The Company bases its estimates on historical experience and on various other market-specific and other relevant assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates.

        To conform to the current period presentation, prior period disclosures have been expanded in our consolidated statements of operations to reclassify the loss recognized on debt extinguishment in the second quarter of 2008 from interest expense to a separate line item. In addition, the interest expense disclosures in Note 5: Debt and Other Financings have also been revised to conform to the current period presentation. This reclassification had no impact on the Company’s previously reported net earnings (losses), financial position or cash flows.

        In the third quarter of 2008, the Company disclosed a change of accounting estimate as a result of an audit by the National Institutes of Health (“NIH”) of the Company’s 2007 actual data, from which the NIH developed billing rates for the period from January 2007 to June 2009 to be used for all of the Company’s contracts with the National Institute of Allergy and Infectious Diseases (“NIAID”), a part of the NIH, including Contract No. HHSN26620060008C/N01-A1-600081 (“NIAID 2”). While the audited NIH

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

rates are considered final for 2007 billings, these NIH rates are considered provisional for the period from January of 2008 to June of 2009 and thus are subject to future audits at the discretion of NIAID’s contracting office. In September of 2008, XOMA retroactively applied these NIH rates to the invoices from 2007 through the third quarter of 2008 resulting in an adjustment to decrease revenue by $2.7 million. The adjustment increased the Company’s loss from operations and net loss for the three and nine months ended September 30, 2008 by $2.7 million. The adjustment also increased basic and diluted net loss per common share by $0.02 for the three and nine months ended September 30, 2008.

Concentration of Risk

Cash equivalents, short-term investments and receivables are financial instruments, which potentially subject the Company to concentrations of credit risk. The Company maintains money market funds and short-term investments that were previously thought to bear a minimal risk. Volatility in the financial markets created liquidity problems in these types of investments in 2008, and money market fund investors were unable to retrieve the full amount of funds, even in highly-rated liquid money market accounts, upon maturity. The Company has not encountered such issues during 2009.

The Company has not experienced any significant credit losses and does not generally require collateral on receivables. For the nine months ended September 30, 2009, three customers represented 42%, 37% and 10% of total revenues. As of September 30, 2009, there were receivables outstanding from two of these customers and one additional customer representing 35%, 29% and 22% of the accounts receivable balance. For the nine months ended September 30, 2008, three customers represented 48%, 34% and 11% of total revenues.

Recent Accounting Pronouncements

In June of 2009, the Financial Accounting Standards Board (“FASB”) established the FASB Accounting Standards Codification (the “ASC”) as the source of authoritative accounting principles recognized by the FASB. The FASB will issue new standards in the form of Accounting Standards Updates (“ASU”). The ASC is effective for financial statements issued for interim and annual periods ending after September 15, 2009 and therefore is effective for the Company in the third quarter of 2009. The issuance of the ASC does not change U.S. generally accepted accounting principles (“GAAP”) and therefore the adoption of the ASC only affects the specific references to GAAP literature in the notes to the Company’s consolidated financial statements.

Accounting Standards Codification Topic 855, Subsequent Events (“ASC 855”) establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. In particular, ASC 855 sets forth the period after the balance sheet date during which management should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. The new provisions of ASC 855 were effective for interim financial reporting periods ending after June 15, 2009 and did not have a material effect on the Company’s financial statements.

Accounting Standards Codification Topic 320, Investments – Debt and Equity Securities (“ASC 320”) contains an amendment to make previous guidance regarding other-than-temporary impairments more operational and to improve the presentation of other-than-temporary impairments in the financial statements. This amendment replaces the existing requirement that management assert it has both the intent and ability to hold an impaired debt security until recovery with a requirement that management assert it does not have the intent to sell the security and it is more likely than not it will not have to sell the security before recovery of its cost basis. ASC 320 requires increased and more frequent disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. The amended provisions of ASC 320 were effective for interim financial reporting periods ending after April 1, 2009 and did not have a material effect on the Company’s financial statements.

        Accounting Standards Codification Topic 808, Collaborative Arrangements (“ASC 808”) defines collaborative arrangements and establishes reporting requirements for transactions between participants and third parties in a collaborative arrangement. ASC 808 prohibits companies from applying the equity method of accounting to activities performed outside a separate legal entity by a virtual joint venture. Instead, revenues and costs incurred with third parties in connection with the collaborative arrangement should be presented gross or net by the collaborators based on the criteria in Accounting Standards Codification Topic 605, Revenue Recognition (“ASC 605”), and other applicable accounting literature. The new provisions of ASC 808 should be applied to collaborative arrangements in existence at the date of adoption using a modified retrospective method that requires reclassification in all periods presented for those arrangements still in effect at the transition date, unless that application is impracticable. Effective January 1, 2009 the Company adopted the new provisions of ASC 808, which did not have a material effect on the Company’s financial statements. As a result of the restructuring in November of 2008 of the Company’s collaboration agreement with Novartis AG (“Novartis”), this collaboration agreement is no longer within the scope of ASC 808. As of September 30, 2009, the Company does not have any collaboration agreements that fall under the scope of ASC 808. See Note 4: Collaborative and Other Arrangements.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Accounting Standards Codification Topic 815, Derivatives and Hedging (“ASC 815”) clarifies how to determine whether certain instruments or features are indexed to an entity’s own stock. This provision of ASC 815 applies to any free standing financial instrument or embedded feature that has all the characteristics of a derivative, as defined in ASC 815. Effective January 1, 2009, the Company adopted the relevant provisions of ASC 815. Refer to the Significant Accounting Policies and Other Disclosures section below for the effect this adoption had on the Company’s financial statements.

Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures (“ASC 820”) provided a one year deferral of the effective date of certain provisions of ASC 820 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Effective January 1, 2009, the Company adopted the remaining provisions of ASC 820, as it relates to non-financial assets and non-financial liabilities, which did not have a material effect on the Company’s financial statements.

Significant Accounting Policies and Other Disclosures

Accounting for Warrants

In the second quarter of 2009, the Company issued warrants to purchase XOMA’s common shares in connection with two separate registered direct offerings. Refer to Note 5: Debt and Other Financings – Other Equity Financings for additional disclosure relating to these two transactions. The warrants issued include a provision allowing for an adjustment of the exercise price and number of warrant shares. This adjustment occurs if the Company issues or sells certain common shares in the future for a price per share less than the exercise price of the warrants in effect immediately prior to such issuance or sale. Due to this adjustment provision, the warrants do not meet the criteria set forth in ASC 815 to be considered indexed to the Company’s own stock.

Accordingly, the Company has recorded these warrants as a liability at fair value, which was estimated at the issuance date using the Monte Carlo Simulation Model (“Simulation Model”). The warrants were revalued at September 30, 2009 using the Simulation Model and the change in the fair value of the warrants was recognized in the other income (expense) line item in the Company’s consolidated statement of operations. The Company will revalue the unexercised warrants at each reporting period over the life of the warrants using the Simulation Model, and the changes in the fair value of the warrants will be recognized in the Company’s consolidated statement of operations.

Share-Based Compensation

The Company grants qualified and non-qualified share options, shares and other share-related awards under various plans to directors, officers, employees and other individuals. To date, share-based compensation issued under these plans consists of qualified and non-qualified incentive share options and shares. Share options are granted at exercise prices of not less than the fair market value of the Company’s common shares on the date of grant. Generally, share options granted to employees fully vest four years from the grant date and expire ten years from the date of the grant or three months from the date of termination of employment (longer in case of death or certain retirements). However, certain options granted to employees vest monthly or immediately, certain options granted to directors vest monthly over one year or three years and certain options may fully vest upon a change of control of the Company or may accelerate based on performance-driven measures. Additionally, the Company has an Employee Share Purchase Plan (“ESPP”) that allows employees to purchase Company shares at a purchase price equal to 95% of the closing price on the exercise date.

In February of 2009, the Board of Directors of the Company approved a company-wide grant of an aggregate of 4,730,000 share options, of which 4,568,000 were issued as part of its annual incentive compensation package. These options vest monthly over four years and include an acceleration clause based on meeting certain performance measures. In the third quarter of 2009, the Company determined that it was probable that the performance criteria would be achieved and estimated the implicit service period to be within twelve months from the grant date. The Company accelerated expense recognition related to these options, including recognizing a cumulative adjustment of $0.1 million to reflect additional share-based compensation expense pertaining to the first and second quarters of 2009.

As of September 30, 2009, the Company had approximately 9.4 million common shares reserved for future grant under its share option plans and ESPP.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The following table shows total share-based compensation expense included in the condensed consolidated statements of operations for the three and nine months ended September 30, 2009 and 2008 (in thousands):

There was no capitalized share-based compensation cost as of September 30, 2009 and December 31, 2008, and there were no recognized tax benefits related to our share-based compensation cost during the three and nine months ended September 30, 2009 and 2008.

To estimate the value of an award, the Company uses the Black-Scholes Option Pricing Model (the “Black-Scholes Model”). This model requires inputs such as expected life, expected volatility and risk-free interest rate. The forfeiture rate also affects the amount of aggregate compensation. These inputs are subjective and generally require significant analysis and judgment to develop. While estimates of expected life, volatility and forfeiture rate are derived primarily from the Company’s historical data, the risk-free rate is based on the yield available on U.S. Treasury zero-coupon issues.

The fair value of share-based awards was estimated using the Black-Scholes Model with the following weighted-average assumptions for the three and nine months ended September 30, 2009 and 2008:

Share option activity for the nine months ended September 30, 2009 was as follows:

Total intrinsic value of the options exercised for the nine months ended September 30, 2009 was $5,825.

At September 30, 2009, there was $7.3 million of unrecognized share-based compensation expense related to unvested share options with a weighted-average remaining recognition period of 2.4 years.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Comprehensive Income (Loss)

Unrealized gain (loss) on the Company’s available-for-sale securities is included in accumulated comprehensive income (loss). Comprehensive income (loss) and its components for the three and nine months ended September 30, 2009 and 2008 was as follows (in thousands):

Income Taxes

The Company recognized $0.4 million in income tax expense for the three months ended September 30, 2009 relating to federal, minimum, state and other withholding taxes for 2009, compared with no income tax expense for the same period of 2008. The Company’s effective tax rate will fluctuate from period to period due to several factors inherent in the nature of the Company’s operations and business transactions. The factors that most significantly impact this rate include the variability of licensing transactions in foreign jurisdictions.

The Company recognized $6.1 million in income tax expense for the nine months ended September 30, 2009, primarily related to $5.8 million of foreign income tax expense recognized in connection with the expansion of the Company’s existing collaboration with Takeda Pharmaceutical Company Limited (“Takeda”), which was signed in February of 2009. Refer to Note 4: Collaborative and Other Arrangements for additional information. In addition, the Company recognized an additional $0.3 million in income tax expense related to federal, minimum, state and other withholding taxes for 2009. No income tax expense was recognized for the nine months ended September 30, 2008.

Net Income (Loss) Per Common Share

Basic net income (loss) per common share is based on the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per common share is based on the weighted-average number of common shares and other dilutive securities outstanding during the period, provided that including these dilutive securities does not increase the net income (loss) per share.

Potentially dilutive securities are excluded from the calculation of earnings per share if their inclusion is antidilutive. The following table shows the total outstanding securities considered antidilutive and therefore excluded from the computation of diluted net income (loss) per share (in thousands):

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

For the three months ended September 30, 2009, the following is a reconciliation of the numerators and denominators of the basic and diluted net income per share (in thousands):

For the nine months ended September 30, 2009 and for the three and nine months ended September 30, 2008, all outstanding securities were considered antidilutive, and therefore the calculations of basic and diluted net loss per share are the same.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Cash and Cash Equivalents

The Company considers all highly liquid debt instruments with maturities of three months or less at the time the Company acquires them to be cash equivalents. At September 30, 2009 and December 31, 2008, cash equivalents consisted of overnight deposits, money market funds, repurchase agreements and debt securities with original maturities of 90 days or less and are reported at fair value. Cash and cash equivalent balances were as follows as of September 30, 2009 and December 31, 2008 (in thousands):

Short-term Investments

Short-term investments include debt securities classified as available-for-sale. Available-for-sale securities are stated at fair value, with unrealized gains and losses, net of tax, if any, reported in other comprehensive loss. The estimate of fair value is based on publicly available market information. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are also included in investment and other income. The cost of investments sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are also included in investment and other income.

At September 30, 2009, the Company had no short-term investments. At December 31, 2008, all short-term investments had maturities of less than one year.

Short-term investments by security type at December 31, 2008 were as follows (in thousands):

The Company recognized no realized gains or losses on short-term investments for the three and nine months ended September 30, 2009. The Company recognized no realized gains or losses on short-term investments for the three months ended September 30, 2008 and $4,000 in realized gains on short-term investments for the nine months ended September 30, 2008.

Restricted Cash

At September 30, 2009, the Company had no restricted cash due to the repayment in full of the Goldman Sachs term loan in the third quarter of 2009, as discussed in Note 5: Debt and Other Financings – Goldman Sachs Term Loan. Under the terms of the Company’s loan agreement with Goldman Sachs, the Company maintained a custodial account, which has since been closed, for the deposit of royalty revenues in addition to a standing reserve of the next semi-annual interest payment due on the loan. This cash account and the interest earned thereon was used solely for the payment of the semi-annual interest amounts due on each April 1 and October 1 that the loan was outstanding and, at that time, amounts in excess of the interest reserve requirement were used to pay down principal or distributed back to the Company, at the discretion of the lenders.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

At December 31, 2008, the restricted cash balance of $9.5 million included $8.6 million held in the Goldman Sachs custodial account and $0.9 million related to an irrevocable letter of credit arrangement, which was released to the Company in the first quarter of 2009. The December 31, 2008 balances were invested in money market funds and a certificate of deposit, respectively.

Receivables

Receivables consisted of the following at September 30, 2009 and December 31, 2008 (in thousands):

Accrued Liabilities

Accrued liabilities consisted of the following at September 30, 2009 and December 31, 2008 (in thousands):

Supplemental Cash Flow Information

The following table shows the supplemental cash flow information for the nine months ended September 30, 2009 and 2008 (in thousands):

Refer to Note 5: Debt and Other Financings for additional disclosures regarding the warrants liability and the Novartis note.

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

2. FAIR VALUE

The following tables set forth the Company’s fair value hierarchy for its financial assets (cash equivalents and investments) and liabilities measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008.

Financial assets carried at fair value as of September 30, 2009 and December 31, 2008 are classified as follows (in thousands):

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Financial liabilities carried at fair value as of September 30, 2009 are classified as follows (in thousands):

The fair value of the warrants liability was determined at September 30, 2009 using the Simulation Model, as discussed in Note 1: Business and Summary of Significant Accounting Policies – Significant Accounting Policies – Accounting for Warrants.

The Company did not have any financial liabilities carried at fair value as of December 31, 2008.

The following table provides a summary of changes in the fair value of the Company’s Level 3 financial liabilities for the nine month period ended September 30, 2009 (in thousands):

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XOMA Ltd.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

3. RESTRUCTURING CHARGES

On January 15, 2009, the Company announced a workforce reduction of approximately 42%, or 144 employees, a majority of which were employed in manufacturing and related support functions. This decision was made based on the challenging economic conditions and a decline in forecasted contract manufacturing demand in 2009.

As part of this workforce reduction, the Company recorded a charge of $3.3 million related to severance, other termination benefits and outplacement services in the first quarter of 2009. In the second quarter of 2009, the Company recorded an adjustment of $0.2 million to reduce the outplacement services liability related to the expiration of outplacement services offered to terminated employees. Additionally during the second quarter of 2009, the Company vacated one of its leased buildings and recorded a restructuring charge of $0.5 million primarily related to the net present value of the net future minimum lease payments at the cease-use date, less the estimated future sublease income. The Company is currently seeking a sublease tenant. These charges are included as restructuring expenses in the consolidated statement of operations for the nine months ended September 30, 2009. The following table summarizes the restructuring charges and utilization for the nine months ended September 30, 2009 (in thousands):

Employee severance and other termination benefits related to the January of 2009 workforce reduction were fully paid in the third quarter of 2009. The Company does not expect to incur any additional restructuring charges for employee severance and other termination benefits related to the January of 2009 workforce reduction. The facilities consolidation charge is recorded as both a current accrued liability and a long-term liability at September 30, 2009 since the remaining lease term of the vacated building is approximately five years.

Also, as a result of the workforce reduction, the Company significantly reduced operations in four leased buildings in the first quarter of 2009. In the second quarter of 2009, the Company resumed operations in one of these buildings and vacated another resulting in a restructuring charge, as discussed above. The Company’s leases on the remaining two buildings expire in 2011 and 2013, and total minimum lease payments due from October 1, 2009 until expiration of the leases are $4.3 million. The Company is pursuing multiple strategies to provide various options as to the future use of these leased spaces.

As of September 30, 2009, the Company performed an analysis of the long-lived assets related to the two remaining leased buildings, with an approximate net book value of $8.9 million. Based on estimated undiscounted future cash inflows, the Company has determined that there is no current impairment relating to these assets, and will continue to assess for impairment at each future reporting period.

4. COLLABORATIVE AND OTHER ARRANGEMENTS

Sale of the LUCENTIS^® Royalty Stream

Through the second quarter of 2009, the Company received royalties from Genentech on sales of LUCENTIS^®, for the treatment of neovascular (wet) age-related macular degeneration. In the third quarter of 2009, the Company sold the LUCENTIS^® royalty stream to Genentech for a total of $25.0 million, which included the receipt of royalties of $2.7 million earned in the second quarter of 2009 and an additional one-time, non-refundable payment of $22.3 million. The Company recognized the entire payment as royalty revenue in September of 2009 as the terms of the sale were fulfilled and no related continuing performance obligations exist. The net proceeds from this transaction were used, together with other funds, to repay the Goldman Sachs term loan. The Company will not receive any further royalties on sales of LUCENTIS^®.

Antibody Discovery Collaboration with Arana

        In September of 2009, the Company entered into an antibody discovery collaboration with Arana Therapeutics Limited, a wholly-owned subsidiary of Cephalon, Inc. (“Arana”), involving multiple proprietary XOMA antibody research and development technologies, including a new antibody phage display library and a suite of integrated information and data management systems. Arana agreed to pay the Company a fee of $6.0 million, and the Company may be entitled to future milestone payments, aggregating up to $3.0 million per product, and royalties on product sales.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

The fee of $6.0 million will be recognized as revenue upon validation of the technologies by Arana, which is scheduled for the fourth quarter of 2009, at which point the terms of the agreement will be fulfilled and no related continuing performance obligations will exist. As of September 30, 2009, the Company has received payment of $4.0 million due under the arrangement, which is recorded as deferred revenue. The remaining $2.0 million is payable in September of 2010.

Biodefense Subcontract with SRI International

In the third quarter of 2009, the Company began work on two biodefense subcontract awards from SRI International, including a $1.7 million award to develop novel antibody drugs against the virus that causes severe acute respiratory syndrome and a $2.2 million award to develop a novel antibody, known as F10, that has been shown to neutralize group 1 influenza A viruses, including the H1N1 and H5N1 strains. The subcontract awards are funded through NIAID. The Company will recognize revenue under these arrangements as the related research and development costs are incurred. Revenue recognized through the third quarter of 2009 relating to these subcontracts was $0.1 million.

Termination of Target Development Programs with Schering-Plough Research Institute

In May of 2006, the Company entered into a fully funded collaboration agreement with the Schering-Plough Research Institute (“SPRI”), a division of Schering-Plough Corporation, for therapeutic monoclonal antibody discovery and development. SPRI selected the initial discovery and development program at the inception of the collaboration and, in December of 2006, exercised its right to initiate additional discovery and development programs.

In the second quarter of 2009, the number of discovery and development programs under this collaboration was significantly reduced, which resulted in the accelerated recognition of $2.6 million in May of 2009 of the remaining unamortized balance in deferred revenue pertaining to the terminated programs. The Company will continue to amortize the deferred revenue relating to its continuing efforts over the estimated remaining period of the Company’s obligation.

Expansion of Collaboration with Takeda

In February of 2009, the Company expanded its existing collaboration with Takeda to provide Takeda with access to multiple antibody technologies, including a suite of research and development technologies and integrated information and data management systems. The Company was paid a $29.0 million expansion fee, of which $23.2 million was received in cash in February of 2009 and the remainder was withheld for payment to the Japanese taxing authority. After deducting an estimated $1.5 million in costs to be incurred related to the agreement, the Company recognized $27.5 million in revenue in February of 2009 as the terms of the expansion were fulfilled and no related continuing performance obligations exist. In the third quarter of 2009, the final costs were determined, and as a result the Company recognized additional revenue of $0.6 million related to this agreement due to actual costs being lower than the original estimate. The Company continues to conduct multiple discovery programs through this arrangement.

Restructuring of Collaboration with Novartis

The Company entered into a product development collaboration with Novartis (then Chiron Corporation) in 2004 for the development and commercialization of antibody products for the treatment of cancer, which was initially a cost and profit sharing arrangement. Under this agreement, XOMA received initial payments of $10.0 million in 2004, which were recognized from 2004 to 2007, at which point the parties’ mutual obligation to conduct antibody discovery, development and commercialization work in oncology exclusively with one another ended. The expiration of this mutual obligation had no affect on the existing collaboration projects which had reached the development stage and the parties continued to collaborate on a non-exclusive basis. XOMA recognized development expenses relating to the collaboration with Novartis of $4.5 million in 2008 and $3.8 million in 2007.

In November of 2008, the Company restructured its product development collaboration with Novartis. Under the restructured agreement, the Company recognized $13.7 million in revenue in 2008 and may, in the future, receive milestones and double-digit royalty rates for two ongoing product programs and options to develop or receive royalties on four additional programs, in exchange for Novartis receiving control over the two ongoing programs under the original product development collaboration. In addition, as a result of the restructuring of the agreement, the Company does not expect to incur any future development expense under this collaboration agreement.

        In December of 2008, the Company entered into a Manufacturing and Technology Transfer Agreement with Novartis, effective July 1, 2008. Under this agreement, the Company was engaged to perform research and development, process development, manufacturing and technology transfer activities with respect to the ongoing product programs now controlled by Novartis under the restructured product development collaboration. The Company completed this work in the third quarter of 2009. Revenue recognized for the nine months ended September 30, 2009 related to this agreement was $2.5 million.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

5. DEBT AND OTHER FINANCINGS

As of September 30, 2009, the Company had long-term debt of $13.1 million outstanding, all of which was under its note with Novartis. As of December 31, 2008, the Company had long-term debt of $63.3 million outstanding, including $50.4 million outstanding under its term loan with Goldman Sachs and $12.9 million outstanding under its note with Novartis.

Goldman Sachs Term Loan

In September of 2009, the Company fully repaid its term loan facility with Goldman Sachs, which was a five-year term loan facility originally entered into in November of 2006 and refinanced in May of 2008. As previously disclosed, the Company was not in compliance with the requirements of the relevant provisions of this loan facility, due to the cessation of royalties from sales of RAPTIVA^® related to its market withdrawal in the first half of 2009. Repayment of this loan facility discharged all of the Company’s obligations to the lenders.

The Company repaid the outstanding principal balance of $42.0 million, accrued interest to the date of payment of $2.4 million and a prepayment premium of $2.5 million. In the third quarter of 2009, the Company recorded a loss on repayment of debt of $3.6 million, which included the prepayment premium and the recognition of unamortized debt issuance costs of $1.1 million. This loss was recorded as loss on debt extinguishment in the consolidated statement of operations for the three and nine months ended September 30, 2009.

Novartis Note

In May of 2005, the Company executed a secured note agreement with Novartis (then Chiron Corporation), which is due and payable in full in June of 2015. Under the note agreement, the Company borrowed semi-annually to fund up to 75% of the Company’s research and development and commercialization costs under its collaboration arrangement with Novartis, not to exceed $50.0 million in an aggregate principal amount. As of September 30, 2009, the interest rate was 3.18%. At the Company’s election, the semi-annual interest payments can be added to the outstanding principal amount, in lieu of a cash payment, as long as the aggregate principal amount does not exceed $50.0 million. The Company has made this election for all interest payments thus far. Loans under the note agreement are secured by the Company’s interest in the collaboration with Novartis, including any payment owed to it thereunder. At September 30, 2009, the outstanding principal balance under this note agreement totaled $13.1 million and, pursuant to the terms of the arrangement as restructured in November of 2008, the Company will not make any additional borrowings on the Novartis note.

Interest expense and amortization of debt issuance costs, excluding the loss on debt extinguishment, for the Goldman Sachs term loan and Novartis note are shown below (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Equity Line of Credit

In October of 2008, the Company entered into a common share purchase agreement (the “Purchase Agreement”) with Azimuth, pursuant to which it obtained a committed equity line of credit facility (the “Facility”) under which the Company could sell up to $60.0 million of its registered common shares to Azimuth over a 24-month period, subject to certain conditions and limitations. The Purchase Agreement required a minimum share price of $1.00 per share to allow the Company to issue shares to Azimuth under the Facility. However, at its election, Azimuth could buy shares below the threshold price at a negotiated discount. The Company was not obligated to utilize any of the $60.0 million Facility and remained free to enter other financing transactions. Shares under the Facility were sold pursuant to a prospectus which forms a part of a registration statement declared effective by the Securities and Exchange Commission on May 29, 2008. At the end of the third quarter of 2009, the Facility is no longer in effect, and no additional shares can be issued thereunder.

From the inception of the Facility through September 30, 2009, the Company has sold a total of 42,228,428 common shares to Azimuth for aggregate gross proceeds of $33.9 million. This includes the sale of 34.3 million shares in two transactions in September of 2009 that Azimuth agreed to purchase notwithstanding that the relevant volume weighted average prices were below the minimum price of $1.00. The Company negotiated a discount rate (excluding placement agent fees) of 8.0% for both transactions. Prior to the successful conclusion of negotiations, Azimuth was not obligated to purchase these shares. Offering expenses incurred through September 30, 2009 related to sales to Azimuth were $0.7 million. The net proceeds from the first September of 2009 transaction, approximately $12.3 million, were used, together with other funds, to repay the Goldman Sachs term loan.

Other Equity Financings

In May of 2009, the Company entered into a definitive agreement with an institutional investor to sell 11,764,706 units, with each unit consisting of one of the Company’s common shares and a warrant to purchase 0.50 of a common share, for gross proceeds of approximately $10.0 million, before deducting placement agent fees and estimated offering expenses of $0.8 million, in a registered direct offering. The investor purchased the units at a price of $0.85 per unit. The warrants, which represent the right to acquire an aggregate of up to 5,882,353 common shares, are exercisable at any time on or after May 15, 2009 and prior to May 20, 2014 at an exercise price of $1.02 per share.

In June of 2009, the Company entered into a definitive agreement with certain institutional investors to sell 10,434,782 units, with each unit consisting of one of the Company’s common shares and a warrant to purchase 0.50 of a common share, for gross proceeds of approximately $12.0 million, before deducting placement agent fees and estimated offering expenses of $0.8 million, in a second registered direct offering. The investors purchased the units at a price of $1.15 per unit. The warrants, which represent the right to acquire an aggregate of up to 5,217,391 common shares, will be exercisable at any time on or after December 11, 2009 and prior to December 10, 2014 at an exercise price of $1.30 per share.

As discussed in Note 1: Business and Summary of Significant Accounting Policies – Significant Accounting Policies, the fair value of the warrants at the issuance dates was estimated using the Simulation Model, and the Company recorded liabilities of $2.9 million and $3.6 million for the May and June warrant issuances, respectively. The Company revalued the warrants at June 30, 2009 and September 30, 2009 and recorded decreases in the fair value of the warrants of $1.0 million and $0.2 million, respectively, in the other income line item of the Company’s consolidated statement of operations.

6. LEGAL PROCEEDINGS, COMMITMENTS AND CONTINGENCIES

        On April 9, 2009, a complaint was filed in the Superior Court of Alameda County, California, in a lawsuit captioned Hedrick et al. v. Genentech, Inc. et al, Case No. 09-446158. The complaint asserts claims against Genentech, the Company and others for alleged strict liability for failure to warn, strict product liability, negligence, breach of warranty, fraud, wrongful death and other claims based on injuries alleged to have occurred as a result of three individuals’ treatment with RAPTIVA^®. The complaint seeks unspecified compensatory and punitive damages. On April 29, 2009 and May 22, 2009, two additional complaints were filed in the same court in lawsuits captioned Heinen et al v. Genentech, Inc., et al, Case No. 09-449804 and York et al v. Genentech, Inc., et al, Case No. 09-453932. Those complaints allege the same claims and seek the same types of damages based on injuries alleged to have occurred as a result of two individuals’ treatment with RAPTIVA^®. Four of the plaintiffs filed amended complaints on July 21, 2009 and October 10, 2009 that separate the plaintiffs and add factual allegations but do not allege any new causes of action. The fifth plaintiff withdrew her complaint without prejudice. The Company’s agreement with Genentech provides for an indemnity of XOMA and payment of legal fees by Genentech which the Company believes is applicable to this matter. The Company believes the claims against it to be without merit and intends to defend against them vigorously.

        There were no developments material to XOMA in the United States Bankruptcy Court proceedings involving Aphton Corporation (described in XOMA’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008) during the nine months ended September 30, 2009.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

7. SUBSEQUENT EVENTS

Antibody Discovery Collaboration with Kaketsuken

In October of 2009, the Company entered into an antibody discovery collaboration with Kaketsuken, a Japanese research foundation, involving multiple proprietary XOMA antibody research and development technologies, including a new antibody phage display library and a suite of integrated information and data management systems. Subject to certain technical verification required under the collaboration agreement, Kaketsuken agreed to pay the Company a fee of $8.0 million, and the Company may be entitled to future milestone payments and royalties on product sales. The fee will be recognized as revenue upon such technical verification by Kaketsuken, which is scheduled for the fourth quarter of 2009.

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The accompanying discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and the related disclosures, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and accompanying notes. On an on-going basis, we evaluate our estimates, including those related to terms of revenue recognition, research and development expense, long-lived assets, warrant liabilities and share-based compensation. We base our estimates on historical experience and on various other market-specific and other relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates.

Overview

We are a leader in the discovery, development and manufacture of therapeutic antibodies designed to treat inflammatory, autoimmune, infectious and oncological diseases. Our proprietary development pipeline includes XOMA 052, an anti-IL-1 beta antibody, XOMA 3AB, a biodefense anti-botulism antibody candidate, and five antibodies in preclinical development. Our proprietary development pipeline is funded by multiple revenue streams resulting from the licensing of our antibody technologies, product royalties, discovery and development collaborations and biodefense contracts, and sales of our common shares. Our technologies and experienced team have contributed to the success of marketed antibody products, including LUCENTIS^® (ranibizumab injection) for (wet) age-related macular degeneration and CIMZIA^® (certolizumab pegol, CDP870) for Crohn’s disease and rheumatoid arthritis.

We have a premier antibody discovery and development platform that includes six antibody phage display libraries and our proprietary Human Engineering™ and bacterial cell expression technologies. Our bacterial cell expression technology is a key biotechnology for the discovery and manufacturing of antibodies and other proteins. Thus far, more than 50 pharmaceutical and biotechnology companies have signed bacterial cell expression licenses with us. We are currently in discussions with multiple companies to license our antibody technologies.

In addition to developing our own potential products, we develop products for premier pharmaceutical companies including Novartis AG (“Novartis”), Takeda Pharmaceutical Company Limited (“Takeda”) and Schering-Plough Research Institute (“SPRI”). We have a fully integrated product development infrastructure, extending from preclinical science to manufacturing.

Our ability to fund ongoing operations is dependent on the progress of our proprietary development pipeline, specifically XOMA 052 and XOMA 3AB. In October of 2009, we announced the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease. The clinical trials are designed to further evaluate the use of multiple dose regimens on the safety, pharmacodynamics and efficacy of XOMA 052 in cardiometabolic and other diseases, and based on positive results, select doses for pivotal Phase 3 studies. The initiation of the Phase 2 clinical program follows the announcement in July of 2009 of positive results from the U.S. Phase 1 trial, which continued to demonstrate that XOMA 052 is well tolerated in patients. Further, XOMA 052 showed clinically meaningful reductions in glycosylated hemoglobin, fasting blood glucose, high sensitivity C-reactive protein and erythrocyte sedimentation rate, a standard biomarker of systemic inflammation and cardiovascular risk. Generally, a more consistent response was seen across patients in the multiple dose regimen compared to single dose regimen. Pharmacokinetic results continue to support monthly or less frequent dosing.

We are in ongoing discussions with a number of companies offering to collaborate on development of XOMA 052 for Type 2 diabetes and now as a novel anti-inflammatory therapeutic for cardiovascular disease. We may complete a collaboration arrangement for XOMA 052 by the end of 2009 or it may take additional time to do so in order to, among other things, allow potential partners to include our new cardiovascular results in their analyses.

Our initial biodefense anti-botulism antibody candidate, XOMA 3AB, is a multi-antibody product that targets the most potent of the botulinum toxins, Type A. Our anti-botulism program was recently expanded to include additional product candidates and is the first of its kind to combine multiple human antibodies to target a broad spectrum of the most toxic botulinum toxins, including the three most toxic serotypes of botulism, Types A, B and E. The antibodies are designed to bind to each toxin and enhance the clearance of the toxin from the body. The use of multiple antibodies increases the likelihood of clearing the harmful toxins by providing specific protection against each toxin type. To date, we have been awarded three contracts, totaling nearly $100 million, from the National Institute of Allergy and Infectious Diseases (“NIAID”), a part of the National Institutes of Health (“NIH”), to support our ongoing development of XOMA 3AB and additional product candidates toward clinical trials in the treatment of botulism poisoning.

        We also have the ability to generate revenues from funded research and development and other development activities. We are developing a number of products, both proprietary and under collaboration agreements with other companies and may enter into additional arrangements. Our objective in development collaborations is to leverage our existing development infrastructure to broaden and strengthen our proprietary product pipeline thereby diversifying our development risk and gaining financial support from our collaboration partners.

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In September of 2009, we fully repaid our term loan facility with Goldman Sachs Specialty Lending Holdings, Inc. (“Goldman Sachs”). As previously disclosed, we were not in compliance with the requirements of the relevant provisions of this loan facility, due to the cessation of royalties from sales of RAPTIVA^®, a product for the treatment of moderate-to-severe plaque psoriasis, related to its market withdrawal in the first half of 2009. Repayment of this loan facility discharged all of our obligations to the lenders. Refer to the Liquidity and Capital Resources – Goldman Sachs Term Loan section for additional details relating to this repayment.

In connection with the repayment of this loan, we sold our LUCENTIS^® royalty stream to Genentech, Inc., a wholly-owned member of the Roche Group (referred to herein as “Genentech”), in the third quarter of 2009 for a total of $25.0 million, which included the receipt of royalties of $2.7 million earned in the second quarter of 2009 and an additional one-time, non-refundable payment of $22.3 million. We will no longer receive royalties on sales of LUCENTIS^®. We continue to receive royalties from UCB Celltech, a branch of UCB S.A., on sales of CIMZIA^® for the treatment of Crohn’s disease and moderate-to-severe rheumatoid arthritis.

Also in the third quarter of 2009, we raised approximately $26.4 million in two separate financing transactions, before deducting placement agent fees and estimated offering expenses of approximately $0.4 million, with Azimuth Opportunity Ltd. (“Azimuth”). We sold approximately 34.3 million common shares to Azimuth in these financing transactions. Refer to Liquidity and Capital Resources – Equity Line of Credit for additional disclosure relating to these equity financing transactions. The net proceeds from the first transaction, approximately $12.3 million, were used, together with other funds, to repay the Goldman Sachs term loan.

In January of 2009, we announced a workforce reduction of approximately 42%, or 144 employees, a majority of which were employed in manufacturing and related support functions. This decision was made based on the challenging economic conditions and a decline in forecasted manufacturing demand in 2009. We expected an annualized reduction of approximately $27 million in cash expenditures when changes are completed and are on track to achieve these savings. We remain staffed with approximately 190 employees to develop XOMA 052, develop and license proprietary products and technology, and continue fully funded antibody discovery and development activities with our pharmaceutical partners in collaborations and the U.S. government in biodefense. We recorded a charge in the first quarter of 2009 of $3.3 million for severance, other termination benefits and outplacement services in connection with the workforce reduction. In the second quarter of 2009, we recorded an adjustment of $0.2 million to reduce the outplacement services liability upon expiration of such services offered to the terminated employees.

Also, as a result of the workforce reduction, we significantly reduced operations in four leased buildings in the first quarter of 2009. In the second quarter of 2009, we resumed operations in one of these buildings and vacated another resulting in a restructuring charge of $0.5 million primarily related to the net present value of the future minimum lease payments, less the estimated future sublease income. We are currently seeking a sublease tenant. Our leases on the remaining two buildings expire in 2011 and 2013, and total minimum lease payments due from October 1, 2009 until expiration of the leases are $4.3 million. In addition, the net book value of fixed assets in these two buildings potentially subject to write-down is approximately $8.9 million as of September 30, 2009. We are pursuing multiple strategies to provide various options as to the future use of these leased spaces. We anticipate the potential for incurring further restructuring charges through the remainder of 2009 as we continue to evaluate our options as to the future use of our facilities.

In September of 2009, we received notice from the NASDAQ Stock Market that for the thirty consecutive business days preceding September 15, 2009, the bid price of our common shares closed below the minimum $1.00 per share requirement under Marketplace Rule 4450(a)(5) for continued inclusion on the NASDAQ Global Market. This notice has no effect on the listing of our common shares at this time, and we have an initial period of 180 calendar days to regain compliance with this requirement. If at any time before March 15, 2010, the bid price of our common shares closes at $1.00 per share or more for at least ten consecutive business days, NASDAQ will provide written notification that we have achieved compliance, although NASDAQ may require us to maintain a closing bid price for a longer period before determining that we have achieved compliance. If we do not regain compliance by March 15, 2010, NASDAQ would provide written notification that our common shares will be delisted, after which we may appeal to the NASDAQ Listing Qualifications Panel. Alternatively, we could apply to transfer our common shares to The NASDAQ Capital Market if we satisfy all of the requirements, other than the minimum bid price requirement, for initial listing on The NASDAQ Capital Market set forth in Marketplace Rule 5505. If we were to elect to apply for such transfer and if we satisfy the applicable requirements and our application is approved, we would have an additional 180 days to regain compliance with the minimum bid price rule while listed on The NASDAQ Capital Market. We are considering alternative strategies to address this issue if necessary.

        We incurred negative cash flow from operations in four of the past five years and expect to remain in this position until sufficient cash flow can be generated from XOMA 052 partnering agreements, technology licensing, biodefense contracts with the government and various discovery and development collaboration arrangements, or until we achieve additional regulatory approvals and commence commercial sales of additional products. The timing and likelihood of additional approvals is uncertain and there can be no assurance that approvals will be granted or that cash flow from product sales will be sufficient to fully fund operations.

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Results of Operations

Revenues

Total revenues for the three and nine months ended September 30, 2009, and 2008, were as follows (in thousands):

License and collaborative fee revenue includes fees and milestone payments related to the out-licensing of our products and technologies. License and collaborative fee revenue increased by $0.1 million and $27.8 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008. The increase in license and collaborative fee revenue for the three months ended September 30, 2009, compared to the same period of 2008, was due to $0.6 million in revenue recognized on the determination of final costs related to the expansion of our collaboration agreement with Takeda, which was entered into in the first quarter of 2009, partially offset by a decrease in new licensing revenues in the period.

The increase in license and collaborative fee revenue for the nine months ended September 30, 2009, compared to the same period of 2008, was primarily due to a total of $28.1 million in revenue recognized during the first and third quarters of 2009 related to the expansion of our collaboration agreement with Takeda, partially offset by a decrease in new licensing revenues in the period. The generation of future revenues related to license fees and other collaboration arrangements is dependent on our ability to attract new licensees to bacterial cell expression and other antibody technologies and new collaboration partners.

Contract and other revenue increased by $1.7 million and $3.9 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008. These revenues include agreements where we provide contracted research and development and manufacturing services to our collaboration partners, including Takeda, SPRI and NIAID. The increases in contract and other revenue for the three and nine months ended September 30, 2009 are primarily related to work performed under our contracts with NIAID Contract No. HHSN272200800028C (“NIAID 3”), which was awarded in September of 2008, and Novartis, which was entered into in December of 2008. The work performed under our contract with Novartis was completed in the third quarter of 2009. Additionally, we accelerated the recognition of $2.6 million of unamortized deferred revenue in the second quarter of 2009 related to the termination of certain discovery and development programs under our collaboration with SPRI.

These increases in contract revenue were partially offset by a decrease in revenue recognized for research and development activities performed under our SPRI contract in 2009 as a result of the termination of these programs. In addition, contract and other revenue decreased related to our AVEO Pharmaceuticals, Inc. (now with SPRI and referred to herein together as “SPRI/AVEO”) contract as a result of our nearing the end of the contracted service arrangement. Contract revenue in the third quarter of 2008 included an adjustment for NIAID Contract No. HHSN266200600008C/N01-A1-60008 (“NIAID 2”) to decrease revenue by $2.7 million due to a change in billing rates. This resulted in a net increase in revenue recognized in 2009 on NIAID 2, despite nearing the end of the NIAID 2 contracted service arrangement.

In the third quarter of 2009, we began work on two biodefense subcontract awards from SRI International, including a $1.7 million award to develop novel antibody drugs against the virus that causes severe acute respiratory syndrome and a $2.2 million award to develop a novel antibody, known as F10, that has been shown to neutralize group 1 influenza A viruses, including the H1N1 and H5N1 strains. The subcontract awards are funded through NIAID. Revenue recognized through the third quarter of 2009 relating to these subcontracts was $0.1 million. Depending on whether and when we obtain new government and other contracts, we expect to experience a decline in contract revenues in the fourth quarter of 2009 as compared to 2008 levels.

Revenue from royalties increased by $17.7 million and $14.0 million for the three and nine months ended September 30, 2009, compared to the same periods of 2008, due to the sale of our LUCENTIS^® royalty stream to Genentech for a total of $25.0 million, which included the receipt of royalties of $2.7 million recognized in the second quarter of 2009 and an additional one-time, non-refundable payment of $22.3 million in September of 2009. We recognized the payment of $22.3 million as royalty revenue in the third quarter of 2009, as the terms of the sale were fulfilled and no related continuing performance obligations exist. Royalties earned

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from sales of LUCENTIS^® for the first half of 2009 were $5.1 million. For the three and nine months ended September 30, 2008, royalties earned from sales of LUCENTIS^® were $1.5 million and $5.7 million, respectively. We will not receive any further royalties on sales of LUCENTIS^®.

The cessation of royalties earned from sales of RAPTIVA^® in the second quarter of 2009 partially offsets these increases. RAPTIVA^® was withdrawn from the market in the first half of 2009. Royalties earned from sales of RAPTIVA^® for the nine months ended September 30, 2009 were $1.2 million. Royalties earned from sales of RAPTIVA^® for the three and nine months ended September 30, 2008 were $3.1 million and $9.0 million.

During the three and nine months ended September 30, 2009, royalties received from sales of CIMZIA^® were $0.2 million and $0.3 million, respectively. Royalties received from sales of CIMZIA^® in 2008 were immaterial. CIMZIA^® was approved by the U.S. Food and Drug Administration (“FDA”) in May of 2009 for the treatment of moderate-to-severe rheumatoid arthritis in adults. We expect royalty revenues from sales of CIMZIA^® to increase in the fourth quarter of 2009.

Research and Development Expenses

Biopharmaceutical development includes a series of steps, including in vitro and in vivo preclinical testing, and Phase 1, 2 and 3 clinical studies in humans. Each of these steps is typically more expensive than the previous step, but actual timing and the cost to us depends on the product being tested, the nature of the potential disease indication and the terms of any collaborative arrangements with other companies. After successful conclusion of all of these steps, regulatory filings for approval to market the products must be completed, including approval of manufacturing processes and facilities for the product. Our research and development expenses currently include costs of personnel, supplies, facilities and equipment, consultants, third party costs and other expenses related to preclinical and clinical testing.

Research and development expenses were $13.4 million and $43.5 million for the three and nine months ended September 30, 2009, compared with $19.7 million and $62.4 million for the three and nine months ended September 30, 2008. The decrease of $6.3 million and $18.9 million for the three and nine months ended September 30, 2009, as compared to the same periods in 2008, is primarily a result of our continuing focus on cost control. In addition, spending on NIAID 2, SPRI/AVEO and Novartis-related contract activities decreased in 2009 due to our nearing the end of contracted service arrangements, and spending on SPRI-related contract activities decreased in 2009 due to the termination of certain discovery and development programs under the collaboration. These decreases were partially offset by increased spending on the preclinical development of five antibodies, and on our contracts with NIAID 3 and Takeda. Spending on XOMA 052 decreased in the first nine months of 2009, as compared to same period of 2008, due to the completion of enrollment in our two Phase 1 clinical trials in April of 2009. However, spending on XOMA 052 increased for the three months ended September 30, 2009, as compared to the same period of 2008, due to the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease in October of 2009.

We recorded research and development salaries and employee-related expenses of $6.2 million for the three months ended September 30, 2009, compared with $9.3 million for the same period of 2008. The decrease of $3.1 million for the third quarter of 2009 was due to decreases in salaries and benefits of $3.1 million and accrued bonus expense of $0.1 million primarily due to the workforce reduction announced in January of 2009. Partially offsetting these decreases was an increase in share-based compensation expense of $0.1 million for the three months ended September 30, 2009, as compared to the same period of 2008. See Results of Operations: Share-Based Compensation for further discussion of our share-based compensation expense.

For the nine months ended September 30, 2009, we recorded research and development salaries and employee-related expenses of $20.0 million, compared with $27.6 million for the same period of 2008. The decrease of $7.6 million for the nine months ended September 30, 2009 was due to decreases in salaries and benefits of $7.2 million and accrued bonus expense of $0.3 million primarily due to the workforce reduction announced in January of 2009. In addition, share-based compensation decreased by $0.1 million. See Results of Operations: Share-Based Compensation for further discussion of our share-based compensation expense.

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Our research and development activities can be divided into earlier stage programs and later stage programs. Earlier stage programs include molecular biology, process development, pilot-scale production and preclinical testing. Also included in earlier stage programs are costs related to excess manufacturing capacity, which we expect will continue to decrease in the fourth quarter of 2009 as we continue to consolidate facilities. Later stage programs include clinical testing, regulatory affairs and manufacturing clinical supplies. The costs associated with these programs approximate the following (in thousands):

Our research and development activities can also be divided into those related to our internal projects and those projects related to collaborative and contract arrangements. The costs related to internal projects versus collaborative and contract arrangements approximate the following (in thousands):

For the three and nine months ended September 30, 2009, our largest development program (XOMA 052) accounted for more than 20% but less than 30% of our total research and development expense, and one development program (NIAID 3) accounted for more than 10% but less than 20% of our total research and development expense. No development program accounted for more than 30% of our total research and development expense for the three and nine months ended September 30, 2009. For the three and nine months ended September 30, 2008, our largest development program (XOMA 052) accounted for more than 20% but less than 30%, and no development program accounted for more than 30% of our total research and development expense.

We continue to expect our research and development spending in 2009 will be less than research and development spending in 2008. In October of 2009, we announced the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease. We are in ongoing discussions with a number of companies offering to collaborate on development of XOMA 052 for Type 2 diabetes and now as a novel anti-inflammatory therapeutic for cardiovascular disease. We may complete a collaboration arrangement for XOMA 052 by the end of 2009 or it may take additional time to do so in order to, among other things, allow potential partners to include our new cardiovascular results in their analyses.

Future research and development spending may be impacted by potential new licensing or collaboration arrangements, as well as the termination of existing agreements. Beyond this, the scope and magnitude of future research and development expenses are difficult to predict at this time.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries and related personnel costs, facilities costs and professional fees. Selling, general and administrative expenses were $7.2 million and $19.0 million for the three and nine months ended September 30, 2009, compared with $6.7 million and $19.0 million for the same periods of 2008. The $0.5 million increase for the three months ended September 30, 2009, as compared to the same period of 2008, primarily relates to $1.3 million in fees incurred in the third quarter of 2009 related to the restructuring negotiations and repayment of the Goldman Sachs term loan discussed in further detail below in the Liquidity and Capital Resources section. This increase was partially offset by a decrease in salaries and employee-related expenses in the third quarter of 2009 of $0.5 million, as discussed below, a decrease in professional fees of $0.2 million, and other decreases due to our continued focus on cost control.

Selling, general and administrative expenses remained the same for the nine months ended September 30, 2009, as compared to the same period of 2008. However, salaries and employee-related expenses decreased by $1.7 million in 2009 as compared to the same period of 2008, as discussed below. This decrease was offset by an increase in fees incurred for the nine months ended September 30, 2009, related to the restructuring negotiations and repayment of the Goldman Sachs term loan of $1.8 million.

We recorded salaries and employee-related expenses of $3.3 million for the three months ended September 30, 2009, compared with $3.8 million for the same period of 2008. The decrease of $0.5 million for the third quarter of 2009 was due to a decrease in salaries and benefits of $0.7 million and accrued bonus expense of $0.1 million primarily due to the workforce reduction announced in January of 2009, partially offset by an increase in share-based compensation of $0.3 million. See Results of Operations: Share-Based Compensation for further discussion of our share-based compensation expense.

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For the nine months ended September 30, 2009, we recorded salaries and employee-related expenses of $9.8 million, compared with $11.4 million for the same period of 2008. The decrease of $1.6 million for the nine months ended September 30, 2009 was due to decreases in salaries and benefits of $1.1 million and accrued bonus expense of $0.1 million primarily due to the workforce reduction announced in January of 2009. In addition, share-based compensation decreased by $0.4 million for the nine months ended September 30, 2009, as compared to the same period of 2008. See Results of Operations: Share-Based Compensation for further discussion of our share-based compensation expense.

Restructuring Charges

As discussed in the Overview section, we announced a workforce reduction of approximately 42% in January of 2009. As part of this workforce reduction, in the first quarter of 2009, we recorded a charge of $3.3 million related to severance, other termination benefits and outplacement services. In the second quarter of 2009, we recorded an adjustment of $0.2 million to reduce the outplacement services liability upon expiration of such services offered to the terminated employees. Employee severance and other termination benefits related to the January of 2009 workforce reduction were fully paid in the third quarter of 2009. We do not expect to incur any additional restructuring charges for employee severance and other termination benefits related to the January of 2009 workforce reduction.

As a result of the workforce reduction, we significantly reduced operations in four leased buildings in the first quarter of 2009. In the second quarter of 2009, we resumed operations in one of these buildings and vacated another resulting in a restructuring charge of $0.5 million primarily related to the net present value of the future minimum lease payments, less the estimated future sublease income. We are currently seeking a sublease tenant. Our leases on the remaining two buildings expire in 2011 and 2013, and total minimum lease payments due from October 1, 2009 until expiration of the leases are $4.3 million. We are currently pursuing multiple strategies to provide various options as to the future use of these leased spaces.

As of September 30, 2009, we performed an analysis of the long-lived assets related to the two leased buildings, with an approximate net book value of $8.9 million. Based on estimated undiscounted future cash inflows, we have determined that there is no current impairment relating to these assets, and will continue to assess for impairment at each future reporting period.

We anticipate the potential for incurring further restructuring charges in the fourth quarter of 2009 as we continue to evaluate our options as to the future use of our facilities.

Other Income (Expense)

Investment and interest income was $9,000 and $47,000 for the three and nine months ended September 30, 2009, compared with $0.2 million and $0.8 million for the same periods of 2008. Investment and interest income consists primarily of interest earned on our cash and investment balances. The differences between 2009 and 2008 balances resulted from varying average cash balances and interest rates and a decrease in the investments balance.

Interest expense and amortization of debt issuance costs for the Goldman Sachs term loan to the date of repayment, and Novartis note are shown below for the three and nine months ended September 30, 2009 (in thousands):