"Management's Discussion and Analysis of Financial Condition and Results of Operations" should be read in connection with our accompanying Consolidated Financial Statements (including the notes thereto) appearing elsewhere herein.

We are a biotechnology company developing Surfactant Replacement Therapies (SRT) for respiratory disorders and diseases. Our proprietary technology produces a peptide-containing synthetic surfactant that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for survival and normal respiratory function. We believe that our proprietary technology makes it possible, for the first time, to develop a series of SRT respiratory therapies to treat conditions for which there are few or no approved therapies available for patients in the Neonatal Intensive Care Unit (NICU), Pediatric Intensive Care Unit (PICU), Intensive Care Unit (ICU) and other hospital settings.

Our SRT pipeline is focused initially on the most significant respiratory conditions prevalent in the NICU and PICU. On May 1, 2008, we received from the U.S. Food and Drug Administration ("FDA") a third Approvable Letter for our initial SRT product, Surfaxin® (lucinactant) for the prevention of Respiratory Distress Syndrome (RDS) in premature infants (see"Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations - Research and Development - SRT for Neonatal and Pediatric Indications - Surfaxin for the Prevention of RDS in Premature Infants"). We are also developing Surfaxin for the treatment of Acute Respiratory Failure (ARF) in children up to two years of age and for the prevention and treatment of Bronchopulmonary Dysplasia (BPD), a debilitating and chronic lung disease typically affecting premature infants who have suffered RDS. Aerosurf™ is our proprietary SRT in aerosolized form and is being developed for the treatment of RDS in premature infants. Aerosurf has the potential to obviate the need for endotracheal intubation and conventional mechanical ventilation and holds the promise to significantly expand the use of SRT in respiratory medicine.

We also believe that our SRT will potentially address a variety of debilitating respiratory conditions such as Acute Lung Injury (ALI), cystic fibrosis (CF), chronic obstructive pulmonary disease (COPD), and asthma, that affect other pediatric, young adult and adult patients in the ICU and other hospital settings.

We have implemented a business strategy that includes:

· focusing primarily on our formal response to the Approvable Letter to potentially gain regulatory approval in the United States in 2008 for Surfaxin for the prevention of RDS in premature infants;

· continued investment in the development of Aerosurf for neonatal and pediatric conditions;

· preparing for the potential commercial launch of Surfaxin in the United States, including building our own commercial organization specialized in neonatal and pediatric indications to execute the launch of Surfaxin in the United States;

· seeking collaboration agreements and strategic partnerships in the international and domestic markets for the development and potential commercialization of our SRT pipeline, including Surfaxin and Aerosurf. We continue to evaluate a variety of other potential strategic international and domestic collaborations intended to support the future growth of our SRT pipeline and enhance shareholder value;

· continued investment in our quality systems and manufacturing capabilities, including our recently-completed analytical laboratories in Warrington, Pennsylvania and our manufacturing operations in Totowa, New Jersey. We plan to manufacture sufficient drug product to meet the anticipated pre-clinical, clinical, formulation development and potential future commercial requirements of Surfaxin, Aerosurf and our other SRT product candidates. For our aerosolized SRT, we plan to collaborate with engineering device experts and use contract manufacturers to produce aerosol devices and related components to meet our development and potential future commercial requirements. Our long-term manufacturing strategy includes potentially expanding our existing facilities or building or acquiring additional manufacturing capabilities for the production and development of our proprietary peptide-containing synthetic SRT drug products; and

· seeking investments of additional capital, including potentially from business alliances, commercial and development partnerships, equity financings and other similar opportunities, although there can be no assurance that we will identify or enter into any specific actions or transactions.

Since our inception, we have incurred significant losses and, as of March 31, 2008, we had an accumulated deficit of $298.0 million (including historical results of predecessor companies). The majority of our expenditures to date have been for research and development activities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations."

Historically, we have funded our operations with working capital provided principally through public and private equity financings, debt arrangements and strategic collaborations. As of March 31, 2008, we had: (i) cash and marketable securities of $41.5 million; (ii) approximately 5.2 million shares potentially available for issuance under a Committed Equity Financing Facility (CEFF) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, for future financings (not to exceed $35.5 million), subject to certain conditions, including that the volume weighted average price of our common stock on each trading day must be at least $2.00; (iii) $9.8 million outstanding ($8.5 million principal and $1.3 million of accrued interest as of March 31, 2008) on a loan from PharmaBio Development Inc. d/b/a NovaQuest (PharmaBio), the strategic investment group of Quintiles Transnational Corp., which is due and payable, together with all accrued interest on April 30, 2010; and (iv) $5.2 million outstanding under our equipment financing facility with General Electric Business Financial Services Inc. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."

Research and development expenses for the three months ended March 31, 2008 and 2007 were $7.2 million and $5.4 million, respectively. These costs are charged to operations as incurred and are tracked by category rather than by project. Research and development costs consist primarily of expenses associated with our manufacturing operations, formulation development, development of aerosolization systems, research, clinical, regulatory and other direct preclinical and clinical projects.

These cost categories typically include the following expenses:

Manufacturing Development

Manufacturing development primarily reflects costs to: (i) maintain our manufacturing operations in Totowa, New Jersey and our quality assurance and analytical chemistry capabilities in Totowa and at our recently completed analytical and development laboratories at our headquarters in Warrington, Pennsylvania, to assure adequate production of clinical and anticipated commercial drug supply for our SRT programs, including Surfaxin, in conformance with current good manufacturing practices (cGMP). These costs include employee expenses, depreciation, the purchase of drug substances, quality control and assurance activities and analytical services; (ii) design, develop, manufacture and assemble aerosolization systems necessary to administer Aerosurf, including the initial prototype version and the next-generation version of our aerosol generating device, disposable dose delivery packet and patient interface system, and (iii) develop new formulations of our SRT.

Development Operations (unallocated)

Development operations include (i) clinical, regulatory and biostatistics activities for the management of our clinical trial programs in accordance with current good clinical practices (cGCPs) and (ii) medical affairs capabilities, including medical science liaisons, to provide medical education and scientific support in connection with the potential commercial launch of Surfaxin and other products in our SRT pipeline. These costs include personnel, supplies, facilities, fees to consultants, other related costs of clinical trials and management, clinical quality control and regulatory compliance activities, data management and biostatistics. The 2007 costs also include activities associated with obtaining data and other information included in our Complete Response to the April 2006 Approvable Letter.

Direct Pre-Clinical and Clinical Program Expenses

Direct pre-clinical and clinical program expenses include (i) pre-clinical activities prior to initiation of any potential human clinical trials and (ii) activities associated with conducting human clinical trials, including patient enrollment costs, external site costs, costs of clinical drug supply and related external costs such as contract research consultant fees and expenses.

The following summarizes our research and development expenses by each of the foregoing categories for the three months ended March 31, 2008 and 2007:

                                                           Three Months Ended
     ( in thousands)                                           March 31,
                                                            2008         2007
     Research and Development Expenses:
     Manufacturing development                           $    4,366    $  2,864
     Development operations (unallocated)                     1,980       1,501
     Direct pre-clinical and clinical program expenses          886       1,057
     Total Research & Development Expenses               $    7,232    $  5,422

Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, the nature, timing of completion, and ultimate cost of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty. Results from clinical trials may not be favorable and data from clinical trials are subject to varying interpretation and may be deemed insufficient by the regulatory bodies reviewing applications for marketing approvals. As such, clinical development and regulatory programs are subject to risks and changes that may significantly impact cost projections and timelines.

Currently, none of our drug product candidates are available for commercial sale. All of our potential products are in regulatory review or clinical or pre-clinical development. The status and anticipated completion date of each of our lead SRT programs are discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Plan of Operations." Successful completion of development of our SRT is contingent on numerous risks, uncertainties and other factors, some of which are described in detail in the "Risk Factors" section contained in our most recent Annual Report on Form 10-K.

Chrysalis Technologies, a Division of Philip Morris USA Inc.

In March 2008, we agreed to restructure our December 9, 2005 Strategic Alliance Agreement (the "Original Alliance Agreement") with Philip Morris USA Inc., d/b/a Chrysalis Technologies ("Chrysalis"), which was created to unite two complementary respiratory technologies - our peptide-containing synthetic surfactant technology with Chrysalis' novel capillary aerosolization technology
- to deliver therapeutics to the deep lung.

Under the Original Alliance Agreement, Chrysalis was primarily responsible for development activities related to its proprietary capillary aerosolization technology (the "Chrysalis Technology") and we were responsible for aerosolized drug formulations, clinical and regulatory activities, and the manufacturing and commercialization of the combination drug-device products using the Chrysalis Technology ("Licensed Products"). Under the restructuring, we entered into an Amended and Restated License Agreement dated March 28, 2008 (the "US License Agreement") with Chrysalis to amend and restate the Original Alliance Agreement in the United States. As Chrysalis has assigned to Philip Morris Products S.A. ("PMPSA") all rights in and to the Chrysalis Technology outside of the United States (the "International Rights"), effective March 28, 2008, we also entered into a License Agreement with PMPSA with respect to the International Rights (the "International License Agreement", and together with the US License Agreement, the "License Agreements") on substantially the same terms and conditions as the US License Agreement.

We hold an exclusive license in the United States under the US License Agreement and an exclusive license to the International Rights under the PMPSA License Agreement in and to the Chrysalis Technology for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions (the foregoing uses in each territory, the "Exclusive Field"). In addition, under the US License Agreement, we hold a license to use the Chrysalis Technology with other drugs to treat specified target indications in specified target populations. Our exclusive license under each License Agreement now includes, in addition to the rights we previously had, the right to develop and have developed Licensed Products in the Exclusive Field in the respective territory.

The US License Agreement provides that prior to June 30, 2008, Chrysalis will complete a technology transfer of the Chrysalis Technology to us in scope sufficient to permit us to practice the Chrysalis Technology. The License Agreements provide that we are solely responsible for future development of the Chrysalis Technology; however, Chrysalis has agreed to provide to us continued development support through, but in no event after, June 30, 2008. In addition, the US License Agreement provides that Chrysalis will provide to us transition assistance in the form of payments totaling $4.5 million, with respect to which we expect to receive the last payment in the third quarter 2008.

Under the Original Alliance Agreement, we were obligated to pay Chrysalis royalties based on a multi-tiered royalty structure (that escalated upon attaining collaboration product revenues greater than $500 million and $1 billion). Under the License Agreements, we are now obligated to pay royalties at a rate equal to a low single-digit percent of sales of products sold in the Exclusive Field in the respective territory. In connection with the exclusive undertakings of Chrysalis and PMPSA not to exploit the Chrysalis Technology in the Exclusive Field, we are obligated to pay royalties on all product sales, including sales of any aerosol devices and related components sold by us in the Exclusive Field that are based on aerosolization technology other than the Chrysalis Technology. In addition, we have agreed in the future to pay minimum royalties, but are entitled to a future reduction of royalties in an amount equal to the excess of any minimum royalty paid over royalties actually earned under the License Agreements.

Under the License Agreements, we generally own the intellectual property that we create or reduce to practice in the performance of the License Agreements or exercise of the licenses granted thereunder, except such inventions that relate primarily, in each instance, to the Chrysalis Technology (the "Chrysalis Technology Improvements"). We are obligated to assign to Chrysalis and PMPSA all such Chrysalis Technology Improvements and all such inventions are then made subject to our rights under each License Agreement. The License Agreements also contain provisions related to the calculation and payment of royalties, record-keeping and audit rights, and prosecution of patents, and include customary representations, warranties and indemnities. Each License Agreement, unless terminated earlier will expire as follows as to each Licensed Product in each country in the respective territory, on a country-by-country basis, upon the latest of: (a) the tenth anniversary of the date of the first commercial sale of the Licensed Product; (b) the date on which the sale of such Licensed Product ceases to be covered by a claim of an issued and unexpired patent in such country, or (c) the date a generic form of the product is introduced in such country. The License Agreements may be terminated, by Chrysalis or PMPSA, as appropriate, in the event that we fail to make the payment of the minimum royalties, as provided therein, or by us, in whole or in part, initially upon payment of a termination fee. In addition, either party to each License Agreement may terminate upon a material breach by the other party (subject to a specified cure period).

We have incurred substantial losses since inception and expect to continue to make significant investments for product research, development, manufacturing, sales and marketing and general administrative activities. We will need to generate significant revenues from product sales, related royalties and transfer prices to achieve and maintain profitability.

Through March 31, 2008, we had no revenues from any product sales, and had not achieved profitability on a quarterly or annual basis. Our ability to achieve profitability depends upon, among other things, our ability to develop products, obtain regulatory approval for products under development and enter into collaboration and other agreements for product development, manufacturing and commercialization. In addition, our results are dependent upon the performance of our strategic partners and suppliers. Moreover, we may never achieve significant revenues or profitable operations from the sale of any of our products or technologies.

Through March 31, 2008, we had not generated taxable income. At December 31, 2007, net operating losses available to offset future taxable income for Federal tax purposes were approximately $258.7 million. The future utilization of such loss carryforward may be limited pursuant to regulations promulgated under
Section 382 of the Internal Revenue Code. In addition, we had a research and development tax credit carryforward of $6.1 million at December 31, 2007. The Federal net operating loss and research and development tax credit carryforwards expire beginning in 2008 through 2026.

Over the next 12 to 24 months, we plan to undertake a variety of initiatives that are discussed below.

Research and Development

We will continue to focus our research, development and regulatory activities to advance our pipeline of potential SRT for respiratory diseases. The drug development, clinical trial and regulatory process is lengthy, expensive and uncertain and subject to numerous risks including, without limitation, the applicable risks discussed herein and those contained in the "Risk Factors" section in our most recent Annual Report on Form 10-K. See "Management's Discussion and Analysis - Research and Development."

Our major research and development projects include:

SRT for Neonatal and Pediatric Indications

In order to address the most prevalent respiratory disorders affecting infants in the NICU and PICU, we are conducting several therapeutic programs that target respiratory conditions that have been cited as some of the most significant unmet medical needs in the neonatal and pediatric community.

Surfaxin for the Prevention of RDS in Premature Infants

In October 2007, we submitted to the FDA our Complete Response to the April 2006 Approvable Letter. The FDA thereafter established May 1, 2008, as its target date to complete its review of our NDA.

Since the filing of our Complete Response and prior to receiving the May 1, 2008 Approvable Letter, the following important events have occurred:

· As of March 2008, we have submitted to the FDA 12-month stability data on our Surfaxin process validation batches, which continue to demonstrate conformance to our established stability specifications.

· In March 2008, the FDA completed a pre-approval inspection (PAI) of our manufacturing operations at Totowa, New Jersey, and recently issued an Establishment Inspection Report (EIR) indicating an approval recommendation. We believe that our manufacturing operations are prepared to produce sufficient drug product to meet the commercial requirements of Surfaxin, if approved.

· On April 30, 2008, as part of our NDA review, we completed labeling discussions with the FDA and agreed to the content of the Surfaxin package insert. Although the package insert will not be considered final until the FDA approves our NDA, we are pleased with the competitive profile of the current form of package insert.

On May 1, 2008, we received another Approvable Letter from the FDA. Importantly, this Approvable Letter contains no requirement for additional clinical trials to gain FDA approval for Surfaxin. The Approvable Letter includes, among other things, requests (i) to further tighten an acceptance criterion for our release and stability biological activity test, (ii) to further tighten acceptance criteria for lipid drug substance impurities, and (iii) to submit (for inclusion in the NDA) summary information from certain equipment-related qualification reports.

Based on our assessment of the Approvable Letter, conducted by our regulatory, manufacturing and quality management in consultation with our expert consultants, we believe that with our current dataset for Surfaxin we and the FDA can reach agreement on appropriate acceptance criteria and drug product specifications for Surfaxin. We also believe that the requested equipment qualification summary information will be acceptable to the FDA because the reports in question have been reviewed and found acceptable during the pre-approval inspection of our manufacturing operations at Totowa in March 2008. Based on our regulatory assessment and our experts' advice, we believe the meeting will qualify for priority scheduling and that the FDA may designate our formal response to this Approvable Letter as a Class 1 resubmission, which would result in a target review period of 60 days (whereas a Class 2 resubmission would result in a 6-month target review period).

We anticipate being in a position to submit our formal response to the Approvable Letter in approximately 6 to 8 weeks, although this timeline may be shortened or extended following discussions with the FDA. If our understanding of the timeline is correct, we now anticipate the potential approval of Surfaxin in 2008.

In October 2004, we filed a Marketing Authorization Application (MAA) with the European Medicines Agency (EMEA) for clearance to market in Europe Surfaxin for the prevention and rescue treatment of RDS in premature infants. In June 2006, following the Surfaxin process validation stability failure, we determined that we could not resolve our manufacturing issues within the regulatory time frames mandated by the EMEA procedure. Consequently, in June 2006, we voluntarily withdrew the MAA without resolving with the EMEA certain outstanding clinical issues related to the Surfaxin Phase 3 clinical trials. We have recently consulted with regulatory experts in Europe and, if we receive approval for Surfaxin in the United States, plan to have further discussions with the EMEA and potentially develop a strategy to gain approval for Surfaxin in Europe.

Surfaxin for BPD in Premature Infants

In October 2006, we announced preliminary results of our Phase 2 clinical trial for Surfaxin for the prevention and treatment of BPD, which was designed as an estimation study to evaluate the safety and potential efficacy of Surfaxin in infants at risk for BPD. We believe that these results suggest that Surfaxin may potentially represent a novel therapeutic option for infants at risk for BPD. We plan to seek scientific advice from the FDA and other regulatory agencies with respect to potential clinical trial designs to support the further development of Surfaxin for the prevention of BPD. At this time, we expect to pursue these discussions only after we have successfully gained FDA approval of Surfaxin for the prevention of RDS in premature infants.

Surfaxin for Acute Respiratory Failure

In June 2007, we initiated a clinical trial to determine if restoration of surfactant with Surfaxin will improve lung function and result in a shorter duration of mechanical ventilation and NICU/PICU stay for children up to two years of age suffering with ARF. The Phase 2 clinical trial is a multicenter, randomized, masked, placebo-controlled trial that will compare Surfaxin to standard of care masked by a sham air control. Approximately 180 children (subject to sample size adjustment per protocol) under the age of two with ARF will receive standard of care and be randomized to receive either Surfaxin at 5.8 mL/kg of body weight (expected weight range up to 15 kg) or sham air control. The trial will be conducted at approximately 35-40 sites throughout the world in both the Northern and Southern Hemispheres. The objective of the study is to evaluate the safety and tolerability of Surfaxin administration and to assess whether such treatment can decrease the duration of mechanical ventilation in young children with ARF. Patient enrollment is dependent upon the strength of the viral seasons. Following conclusion of the upcoming viral season in the Southern Hemisphere in the fourth quarter 2008, we plan to assess the status of patient enrollment in this trial and determine at that time whether adjustments to our timeline are required. Currently, we believe that data from this trial will be available in the first half of 2009, although this time line may be extended as we conserver resources to focus on seeking approval of Surfaxin for the prevention of RDS in premature infants.

Aerosurf, Aerosolized SRT

Aerosurf is our first aerosolized SRT that is administered through less-invasive means and is being developed to potentially obviate the need for intubation and conventional mechanical ventilation. Aerosurf holds the promise to significantly expand the use of surfactants in respiratory medicine. We have demonstrated, through both research and feasibility studies that we can aerosolize our SRT and have completed a small Phase 2 clinical study of Aerosurf that concluded that it is feasible to administer Aerosurf through nasal continuous positive airway pressure (nCPAP) and that the treatment was generally safe and well tolerated. We are currently developing Aerosurf using the Chrysalis technology.

Under our restructured strategic alliance with Chrysalis, we have assumed full responsibility for development of the initial prototype version of the novel aerosolization system (see "Corporate Partnerships and Agreements"). Our design engineers, together with our contract manufacturers and third-party medical device experts and consultants, are optimizing the initial prototype version of this novel aerosolization system. Once development milestones have been achieved, we plan to file our regulatory package in support of our Phase 2 . . .